HRTG - Heritage Insurance: An Unjustified Premium

2024-01-18 01:13:55 ET

Summary

• Heritage Insurance provides property and casualty insurance for residential properties primarily on the East Coast.
• HRTG's financial results have been rocky, with the share price dropping below $2 in 2022 and now standing above $6 per share.
• I believe it must underwrite at a consistent profit and improve its balance sheet before this current premium is deserved.

Heritage Insurance ( HRTG ) provides property and casualty insurance for residential properties in the Southeast. Dichotomy Capital wrote one of Seeking Alpha's more prominent articles on it in 2016. They observed:

Headed by Bruce Lucas, the company pounced on an extraordinary reinsurance market by locking in low reinsurance rates for several years at levels unheard of. While most advantages in insurance are fleeting, Heritage will be able to gain scale quicker than competitors and can transact other types of business with less worry. The model for expansion into other states is reasonable and has been accomplished by several other players in the industry...Ultimately, Heritage will be an attractive acquisition candidate for a larger national homeowner insurance company that would like to gain access to HRTG's reinsurance book and profitable policies.

HRTG traded at $11.94 back then. Rocky financial results in the years that followed sent the share price well below $2 in the latter half of 2022. Standing above $6 per share as we enter 2024, the risk and reward are very different now. I will make the case that the current premium to tangible book value lacks justification (particularly for those interested in a safe, long-term compounder of value) and why current holders would be better off selling.

Business Model

The company's insurance business (and its subsidiaries) covers both personal and commercial real estate. They operate primarily on the East Coast.

Most of their material business is concentrated in the Northeast, but they have a heavy concentration in Florida.

The business is one of providing coverage when claims on residential real estate are made, a type of insurance probably familiar to most readers. In addition to collecting revenues for the premiums, the business has a vertical model that produces revenue from adjacent services.

Most of their revenues come from the premiums on policies written, less cessions to reinsurance. With the damage that can come from hurricanes in this turf and winter storms in the north, reinsurance is an important way to mitigate their risk. Yet, even that can squeeze the company. As we can see, the expenses exceed the revenues, and the company does not generate an underwriting profit.

While the company reported over $2.3 billion in assets in Q3 2023, its cash position is somewhat small, reported at $228.9 million.

Bolstering the portfolio of its invested float is valued at around $665m.

Most of this portfolio is invested in debt securities connected to the public sector. Their 2022 Form 10-K explains the investment strategy:

Our investment objectives include liquidity, safety and security of principal, and returns. The investment policy limits investments in common and preferred stocks and requires a minimum weighted average portfolio quality of A for our bond portfolio with an overall duration of three to five years. No more than 2% of admitted assets can be invested in any one issuer, with slightly higher limits for highly rated securities, excluding government-related securities. Investments in commercial mortgages cannot exceed 10% of admitted assets. Prohibited investments include short sales and margin purchases, oil, gas, mineral or other types of leases, speculative uses of futures and options, unrated corporate securities, non-US denominated securities, convertible securities, high risk CMO instruments, repurchase agreements, securities lending transactions and speculative foreign currency valuation transactions.

As such, I believe the portfolio to be relatively sound from a short-term perspective. Despite that, the size of the liabilities (at $2.2b) pushes the limits on the company's liquidity.

Financial History

Founded in 2012 with its IPO in 2014 , the company has a decade of financial data to give us an idea of how well it performs over a long duration of time, which is key in seeing how it manages the risk inherent to insurance underwriting.

As indicated in Dichotomy's article, many folks were hopeful that Heritage would experience large growth out of Florida to diversify its risk. As shown by the rise of revenues over time, it technically accomplished this, but there is more to the story than that.

Earnings did not grow. In fact they were their best in the first three years of this period (likely why Dichotomy was optimistic in 2016). The trend shifted toward losses, which were heavy in 2021 and 2022. What exactly occurred here?

As their income statement from 2017 shows, their ceded premiums to reinsurance and expenses for losses shot up more than gross premiums did. In essence, the easy start that Dichotomy mentioned, with its low reinsurance costs, did not last. The company inevitably found itself doing business in Florida's more typical risk profile. The situation was not helped by the financial impact of the powerful Hurricane Irma in that year. Quoting the 2017 10-K:

Gross catastrophe losses related to Hurricanes Hermine and Matthew were $21.8 million for the year ended December 31, 2016 and increased to $28.3 million as of December 31, 2017. Catastrophe losses related to Hurricanes Hermine and Matthew were fully retained by the Company. Gross catastrophe losses related to Hurricane Irma for the year ended December 31, 2017 are estimated at approximately $560.0 million . Retained losses were $20 million pursuant to Heritage P&C's reinsurance agreements with third parties.

Hurricanes Michael and Ian would also strike in 2018 and 2022, incurring similarly heavy costs.

The risk of storms on a Florida-centric insurance business was one thing. The continuing rise of demand for real estate there and thus the value of losses to be covered was another. The result is that payments for claims grew at much faster rates than the net income from premiums, hurting the bottom line and making Heritage an insurer that does not make an underwriting profit. Let's look at the long-term impact to the company's financial health.

The company's tangible book value, while rising for a while, is roughly back to where it started. If one looks at a stock chart, though, you'd get a different impression of the company's value.

What gives? The company hasn't been heavily diluted. In fact, until this recent sale of new shares, the company was doing incremental buybacks. Why is the share price half of what it was at the IPO?

The negative earnings and how they make investors feel about the future is one thing. The state of the balance sheet is another. As hardships stacked, the gap between assets and liabilities tightened. In 2014, buyers during the IPO got assets valued at 70.9% over the liabilities. As of Q3 2023, assets only exceeded liabilities by 6.8%.

While the TBV per share is almost the same, the risk being offered for that TBV is clearly much higher.

A Look to the Future

Underwriting

What are the prospects going forward? Well, management is aware of the struggles.

One of their priorities is to run an insurance business that underwrites profitably. Over the last few years, they have worked to turn this ship around.

The number of policies in place has declined from 581K to 489K, a substantial decrease. This strategy also largely depends on decreasing exposure to Florida specifically.

With YTD earnings for 2023 of $14.3m, they are narrowly moving into profitability, but investors will want to watch for a consistent trend. I believe it will be a few years, at the very least, before enough consistent earnings have been retained to strengthen the balance sheet.

Investments

On top of generating profits, a key part of the long-term value comes from Heritage's portfolio of investments. As mentioned before, this is primarily in debt securities.

Most of these investments have and have had a pretty short duration and average to pretty low yields. Given the precarious state of the balance sheet, this is probably wise, but the limits on the portfolio may prove burdensome, particularly as the company becomes healthier and would benefit from greater investment in equities.

The portfolio may grow as more earnings are put into bonds, but their return is likely to keep up with inflation at best, given these low yields and the strict nature of their investment strategy.

Buybacks and Dividends

If greater returns cannot be realized through the portfolio, the company can still benefit shareholders by carefully distributing dividends or issuing buybacks. Given the concentrated, negative impact of major storms, a regular dividend policy is likely not a welcome sign. I believe a more reassuring sign would be situational declarations of special dividends. Similarly, buybacks at a discount to TBV (which the company has done before) are welcome and better than dividends when the share price is down. The recent sale of shares that I cited earlier, at a premium to TBV, also makes sense.

Only after the company has strengthened its balance sheet and has a risk model to make underwriting profits the norm should a regular dividend policy be considered.

When Is a Buy Case?

Obviously, I think the company needs to improve its fundamentals more before I buy at a price of around $6. To borrow terms from Peter Lynch , it's a candidate for a turnaround. This type of insurance is also inherently very cyclical, as it will rise and fall when storms and other disasters cause property damage, and it's a cycle that can be difficult to predict. Yet, in context, it can also be an asset play .

In late 2022, investors could have gotten a share price under $2. Naturally, the market was responding to the impacts of that hurricane season, but folks who were following the company would have seen it was at a discount to TBV:

While there is still some risk in this situation, there are more contexts for a happy ending. One is that hurricane season comes and goes. While it can return the next year, the seasons don't typically come in 12-month onslaught of Category 5s and go straight for Florida. This gives the company a buffer of time to breathe. The lower it goes compared to TBV, the more attractive it also becomes as an acquisition target by a better-capitalized insurer or conglomerate.

With the TBV per share as of Q3 at $4.29, HRTG is trading at a premium. In essence, asset players of 2022 are in a position to finish their play favorably. That makes the shares an easy SELL in my eyes.

Conclusion

The company launched with tremendous tailwinds that made investors and even certain analysts very hopeful about the company. Once those dissipated, the exuberant underwriting, followed by major hurricane strikes, pummeled earnings and created a significantly weaker balance sheet.

Management is wise to these problems and has taken material actions to improve the situation. Yet, it is still in the process of execution and needs to be delivered before it is worth taking a position. In the meantime, a sufficiently bad weather event on the East Coast could finally knock down a stumbling Heritage. Those who got in at a discount to TBV barely a year ago now have a hefty premium at which to exit. Given the risks, I think it's a pretty easy sell. Investors can put their money into a profitable insurer in the meantime.

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