Time Arbitrage with Primerica
Jun/110
There is an opportunity to time arbitrage the stock market by owning shares of Primerica. The market is not assigning any premium to the expected low-risk growth at Primerica over the next 5 years. The growth is expected because Citi shrunk the size of Primerica prior to the IPO. Over the next few years, Primerica will replace the term life policies that were removed with new policies. This will translate into attractive earnings growth, but Primerica trades for 1.1x book value and under 9 times this year’s estimated earnings per share. Buyers of the stock can earn an attractive return assuming no multiple growth by relying on the expectations for earnings growth in the coming years.
Last July, I wrote a bullish article about Primerica. I saw an opportunity because the company’s balance sheet was restructured prior to its April 2010 IPO. Through March, the investment thesis played out as Primerica reported 4 quarters of better than expected earnings. The stock rose from $20 last July to $26.
In April, Citigroup announced that it was selling a second tranche of Primerica, which has beaten up Primerica’s stock as the market has struggled to digest the additional supply of shares. This recent decline is an opportunity to buy shares in a company with solid earnings growth prospects at a low valuation. At these levels, I believe there is assymetrical risk / reward in the shares of Primerica.
Read the rest of this post which has my investment thesis on Primerica at Seeking Alpha.
Citibank Should Have Split-Off Student Loan Corp with an Exchange Offer
Oct/100
This post is an excerpt from my 2010 3rd Quarter investor letter. If you would like to see the entire letter, please send me an email at derek.pilecki@gatorcapital.com.
In early August, I posted an article on the Internet arguing that Student Loan Corp was undervalued. I did not have to wait long as seven weeks later the company was sold to Discover Financial. The gain was 24%. I had purchased Student Loan because it appeared abnormally cheap for a profitable lending company. At the time of purchase, it was trading for 35% of tangible book value. Credit quality appeared manageable given that 75% of the loan portfolio was government guaranteed.
The question surrounding STU was: How desperate was its 80% owner, Citibank? Citi had stated that Student Loan was part of its CitiHoldings and therefore on the block to be sold. I thought the market was too pessimistic about how desperate Citi was to sell down its CitiHoldings assets. I thought Citi would not sell STU unless they received a price higher than the current stock price and potentially at least at book value. My thesis was that Citi could extract at least the current stock price from earnings and release of capital in as little as 10 quarters if they put STU into run-off. My model was the Primerica transaction earlier this year where Citi created a growth company from a slow growing life insurer by retaining most of the existing term life policies on its balance sheet and allowing the policies to run-off naturally. In the Primerica example, Citi showed that it was not desperate and structured a smart transaction that created value for its shareholders.
I was both right and wrong about Citi’s desperation. Citi did sell Student Loan for higher than the then current stock price, but they still sold it for only 45% of book value. The acquisition which will close in Q4 is a complex four-party deal between Student Loan, Citi, Discover and Sallie Mae. To make it simple, Citi essentially gave the government guaranteed student loan portfolio to Sallie Mae for little premium. Then, Citi gave Discover about $400 million, a perfectly good private student loan lending platform that had scarcity value and a portfolio of the recently originated, pristine-quality private student loans at par. Finally, Citi booked a $500 million loss and still kept all of the risk by retaining questionable quality 2006-07 vintage private student loans.
There was a better solution for Citi shareholders that could have still moved the assets off of Citi’s balance sheet without Citi retaining the same risk. Citi should have made STU an independent company. STU is too small relative to Citibank to spin-off the shares directly to Citi shareholders because a Citi shareholder would only receive 1 share for every 1,500 Citi shares held. Instead, Citi should have proposed an exchange offer where Citi shareholders could choose to swap 4.5 of their Citi shares for 1 share of STU owned by Citibank. This would have put STU into the hands of shareholders who made an active decision to own STU. This exchange transaction would have moved STU’s assets off of the CitiHoldings balance sheet and Citi shareholders would have benefitted from 72 million share reduction in Citi shares outstanding, but Citi would have still had a $6 billion loan outstanding to STU. After the exchange offer was completed and STU was independent, STU’s management and shareholders could have decided on the best way to pay off Citi’s loan to STU and create value for STU shareholders. Either they could have found another lender to take out Citi’s loans to the company and continued to originate new student loans, or they could have run-off STU’s loan portfolio and paid-off Citi from the natural pay-down of their loans. Either way, both STU’s and Citi’s shareholders would have been better off with an exchange transaction than they are with the deal to sell STU’s assets to Discover and Sallie Mae.
At the end of the day, Citi did not help its own shareholders with this transaction. They had an undervalued asset and gave it away to competitors, but Citi still kept all of the risk. They sold STU at such a cheap price in order to demonstrate that they are making progress in reducing the assets of CitiHoldings. However, this is a bill of goods because Citi kept all of the risky assets and gave away capital that could have covered the losses from those risky assets. I would argue that this transaction increased the risk at CitiHoldings. If regulators were awake and truly concerned about risk instead of asset size, they would stop Citi from consummating this transaction. Of course, it is deplorable that Citi’s management doesn’t recognize the poor economics of this transaction and stop the transaction themselves.
Primerica: Earnings Growth Regardless of the Economy
Jul/103
Primerica (NYSE: PRI – $20.98)
Introduction
I recently purchased shares of Primerica, which is a life insurance and mutual fund marketing company. Primerica was recently IPO’d by Citigroup (C) as part of Citi’s balance sheet reduction program. It has been one of the best performing IPO’s of the year so far. I believe Primerica’s shares are undervalued because investors are not factoring earnings growth that will be stronger than published Street expectations.
Company Background
Primerica provides financial products and services to middle-market America through a salesforce of independent producers. The company’s two main products are term life insurance and 3rd-party mutual funds. The company was formerly run by the legendary salesman A.L. Williams, who used inspiring motivational speeches to energize the salesforce. Sandy Weil bought the company in the early days of creating his Citigroup empire.
Main Investment Thesis
My main investment thesis is the current valuation does not factor earnings growth that will be stronger than the Street’s published expectations.
Why do I think earnings growth will be stronger than the Street estimates?
Prior to the IPO on April 1, 2010, Primerica entered into a reinsurance transaction with Citigroup that took about 80% of Primerica’s existing term insurance book off of its balance sheet and put it onto Citi’s balance sheet. This dropped the existing term life in-force block to drop from $650 billion to $130 billion. This also caused a one-time step down in Primerica’s earnings from to a $500 million annual run-rate to a $150 million annual run rate. Going forward, Primerica still has the same salesforce that was selling enough term life policies to grow a $650 billion term life block 3% annually. This salesforce producing the same amount of business can grow a $130 billion term life block at 51% annually.
How does 3% growth become 51% growth?
Primerica’s reinsurance transaction with Citigroup reduced the company’s existing block of term life insurance from $650 billion to $130 billion, but it did not diminish the capabilities of the company’s salesforce from adding new policies. In 2009, Primerica had a 10% lapse rate on its term life policies and added $80 billion in new term life policies. This led to a 3% growth rate.
In 2010, if will assume a continuation of the 10% lapse rate and another $80 billion of new term policies, the new $130 billion block of term life policies will grow to $197 billion or a 51% growth rate.
How does this growth translate into earnings?
The term life insurance division accounts for about 60% of the pre-tax earnings. I think this segment can grow 40% in 2011. The mutual fund sales can grow 5% a year, which assumes no in-flows and 5% market appreciation. Combined, I believe earnings in 2011 can be north $2.40 for a growth rate of over 20%.
Why don’t investors see this potential earnings growth?
Primerica’s potential earnings growth is hard to see because the reinsurance transaction with Citigroup is confusing and not what investors normally encounter.
Does Primerica have the capital available to support this level of growth?
Yes, Primerica has extra capital currently. The risk-based capital ratio is estimated to be north of 450%. Plus, the mutual fund savings division generates capital equal to its net income because it does not need capital for growth. Lastly, Primerica is only going to pay a token dividend while it is in this high growth mode.
Other Positive Parts of the Primerica Story
Plain vanilla business with no legacy issues – Primerica’s business is simple to understand. It is mainly a salesforce distributing straightforward term life insurance and a 3rd party mund funds. Term life insurance is one of the easiest forms of insurance for a life insurance company to manage on its balance sheet.
Potential for management to respond to improved incentives – Primerica’s management team should be motivated to show good results out of the gate from the IPO. This is an organization built on motivation and financial incentives. When the company was a subsidiary of Citigroup, I’m sure management had financial incentives, but the were still paid partly with options on Citigroup overall. It was impossible for them to move the needle on Citigroup’s stock. Now as an independent company, Primerica’s management team can directly impact the stock price by delivering strong results.
Ownership presence of Warburg Pincus – As minority shareholders, we are helped by Warburg Pincus’s ownership stake and presence on the board of directors. We can expect Warburg Pincus to focus on shareholders returns. With Warburg’s presence, we also expect management compensation to be under control and expect no value destroying acquisitions.
Leverage will add to returns – As part of the spin-off from Citigroup, Primerica took on some modest leverage at the holding company level that will improve equity returns. Since Primerica’s business seems stable and cash producing, I am comfortable the modest leverage will enhance returns without adding to the risk of financial distress.
Valuation
I believe Primerica is undervalued. At $21 per share, Primerica trades at 1.4x tangible book value and 9.5x the Street’s 2011 EPS estimates. These valuations are in-line with their life insurance peers. However, I believe the Primerica story is cleaner than the rest of the industry because they have fewer legacy issues (such as the investment portfolio at Aflac (AFL) or commercial real estate at Principal (PFG)) and are not dependent on the stock market for earnings growth (such as Prudential (PRU), Ameriprise (AMP), Hartford (HIG) or Lincoln (LNC)) Plus, with the reinsurance transaction with Citi, Primerica will have attractive growth for the next 5 years.
In addition, I believe Primerica could earn as much as $2.40 (or 22 cents more than consensus estimates) in 2011 as they regrow their term life book. As analysts increase estimates, the stock may attract attention from investors attracted to companies with rising estimates. The stock’s multiple could rise to 12x leading to a $29 stock price.
Risks
The main risks to my investment thesis on Primerica are: 1) I am overestimating the potential for earnings growth and 2) the market already recognizes the potential earnings growth and has appropriately priced the stock.
Primerica does have at least one potential issue with a reinsurance company facing financial difficulty. It has about $50 million reinsurance recoverable exposure to Scottish Re, which is in run-off. If they had to write-off this amount, it would be equal to a quarter of earnings. I believe the market would look through this issue if it happened.
I discount some commentators’ views that the Primerica salesforce is a risk. I believe the Primerica salesforce is a vital asset of the company. Yes, they recruit heavily and have high churn, but financial sales is not easy and not every recruit is able to make in sales. I think of Primerica’s salesforce as similar to Aflac’s. Both are high energy, depend on multi-level principles and have high turnover. While I wouldn’t succeed as a Primerica salesman, I admire the results of the organization. As Phil Fisher wrote, you want to own companies with outstanding salesforces.
Conclusion
I purchased shares of Primerica recently because I believe the shares do not factor in the potential earnings growth of the company. The business is a plain vanilla term life insurance business with some 3rd-party mutual fund sales. The earnings growth is not dependent on the stock market improving, rather, it just depends on Primerica’s salesforce delivering similar results to the recent past.
Disclosure: Long PRI, PFG
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