VRSK - Verisk Analytics: This Regulation Beneficiary Is Just A Hold

2024-01-13 01:34:04 ET

Summary

• Verisk has a deeply entrenched competitive position based on its long history with government regulators in the insurance industry.
• Verisk is not immune to headwinds in the insurance business, but management has made good decisions, including divesting non-core operations.
• Verisk's valuation is not interesting, but investors should add to watchlists in case temporary issues cause investors to doubt its moat.

Regulatory capture is negative by definition, but it isn't always an obvious negative. Businesses that intermingle with government regulators often enable an industry to operate more efficiently. In the process, this typically results in tremendous pricing power for the business in question. While on the surface, this certainly can result in higher prices for end consumers, it's more complex to consider the disfunction if the market was more fragmented.

Such businesses are fascinating to analyze, Verisk Analytics (VRSK) fits the bill as perhaps the best example of potential regulatory capture in the public markets. Government intermingling is typically a foundational piece to businesses with semblance of regulatory capture, as is the case with Verisk.

Verisk was founded as a non-profit called the Insurance Service Office, it was a consortium of insurance companies that gathered data and statistics to report to regulators to meet requirements. ISO basically helped to standardize the insurance industry, helping businesses define products and rates. It's easy to see the problems created if home or auto insurance means one thing at one insurance company and another at a different company. And again, the industry is heavily regulated, so one company may not be in compliance.

Verisk has a virtually monopoly position in managing relationships between insurance companies and regulators. Verisk counts the top 100 P&C insurance companies as its customers, their claims database covers 90% of the industry by premium volume. Verisk also reports a "substantial majority" use their services for regulatory reporting, while a "majority" use actuarial services.

The argument can be made that Verisk's monopoly position is a positive by making the industry function better and eliminating some redundancy. In theory, claim disputes should be resolved much faster if terms are standardized and well understood. While with any company with a competitive position as advantageous, there will always be some threat from government. Ultimately, the government writes the rules, and businesses must follow. But, Verisk provides a valuable service, if they are able to carefully navigate these relationships, the business should be well positioned to compound for decades.

Industry & Financials:

In some form or another, the "insurance business" has been around since the dawn of time. Early tribal leaders would offer basic necessities to other tribes, in case their tribe fell on hard times, they could rely on others for survival.

Individual insurance companies can be volatile and suffer losses. Verisk mentioned underwriting losses through the first 6 months of 2023 were $24.5B compared with $26.9B for the entirety of 2022. Verisk also mentioned 73 out of 92 days in the third quarter had a property claims services event. Factors like inflation and climate change pressure insurance companies as customers shop when rates rise, and the loss-making events keeps rising.

Despite challenges to the industry, Verisk remains resilient. Verisk is targeting revenue growth of 6-8% through 2025, which Verisk has handily exceeded over the past several quarters excluding divestitures. Verisk has generated free cash flow margins of 47% throughout the first 9 months of 2023. Any growth at Verisk is incremental given the mature nature of the insurance business, Verisk's primary objective is increasing penetration with customers.

Capital Allocation:

The most notable recent capital allocation move for Verisk was the decision to divest their energy and financial services operations :

This marks a significant value-creating step for Verisk, which returns the company to its roots as a dedicated strategic partner to the global insurance industry. We'll continue to execute our strategy to deliver long-term sustainable growth by enabling our customers to make better decisions, increase efficiency and reduce operating expenses, while delivering a better experience to their customers.

This is a significant positive. In many cases, companies with strong positions will engage in "diworsification" by wandering away from core competencies.

The rest of Verisk's capital allocation policies are solid and fairly standard. They pay a small dividend and have a $2.5B repurchase program outstanding. But as we'll see, the valuation isn't compelling to support large scale buybacks.

Valuation:

Verisk trades at 35x forward earnings, in-line with other strong information services businesses. The one negative of Verisk relative to some of its peers, is its reliance on a single industry. Businesses like Moody's (MCO) and MSCI (MSCI) are not bound to a single business, their growth is really only dependent on general economic growth, this makes it less appealing at the same multiples.

Nonetheless, Verisk's competitive position is dominant, and it deserves to trade at a premium. The challenge for investors is that beating the market by owning fringe valuation multiples is very challenging. The most alpha is generated when both the business model and the valuation aligns. Verisk might be the right business model, but the valuation is not compelling. Verisk would be interesting to review should the stock trade closer to 25x next year's earnings, that would be closer to $165/share.

With businesses this strong, it typically takes some questioning of the business's relationship with regulators to create a compelling entry point. Verisk is an interesting business to add to watchlists and reevaluate should the valuation become more compelling.

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