2023-06-16 07:48:12 ET
Summary
- Arch Capital's Summer '23 presentation showcases its superior risk-adjusted returns, specialization, and conservative balance sheet, leading me to rate the company a 'buy'.
- The company's valuation and financials are compared with industry and market standards, demonstrating its strong position.
- The presentation also addresses risks and challenges faced by Arch Capital, including regulatory complexity and pressure, and inverse interest rate demand convexity.
The Arch Capital Group (ACGL) is a US, Bermuda-based insurer which provides a wide range of insurance, reinsurance, and mortgage insurance products worldwide, with a focus on specialty insurance lines.
Over the first quarter of the year, these activities have enabled Arch to generate a net income of $715mn- up 265.17%- and free cash flows of $952mn, all the while maintaining a healthy balance sheet, recording a book value of $35.35/share.
Introduction
On a broad level, Arch has identified three keys to success; the company's focus on specialty insurance businesses, which are often highly specialized and require specific expertise, the orientation of the long-term financial cycle towards long-run growth, and the effective and disciplined deployment of capital towards organic growth, deleveraging, and opportunistic buybacks.
At a more granular level, the firm seeks to provide superior returns and mitigate risk through incentives for executives and efficient capital management. Concurrently with Arch Capital's concentration on underwriting with specialty lines and talent-centricity and a risk-minimizing, secure balance sheet, Arch Capital is poised for steady, accretive growth.
The combined effects of a focus on specialty insurance products, a long-term, risk-sensitive philosophy- as demonstrated by executive incentives and balance sheet commitments- and strong capital deployment, in addition to a moderate undervaluation, lead me to rate the company a 'buy'.
Valuation & Financials
General Overview
In the TTM period, Arch Capital - up 59.47% - has experienced superior price action to both the insurance industry, as represented by the TradingView Insurance Index- up 11.18% - and the S&P500 ( SPY ) - up 16.72% for the year.
I believe this is a reflection of strong earnings on the part of Arch Capital, as well as a general recovery theme for the company. Nonetheless, I see room for growth, with Arch Capital's operational capabilities and long-term growth potential still discounted.
Comparable Companies
The operational diversity of Arch Capital leads to a lack of direct competition. As such, it is most justifiable to compare the firm to similarly sized insurance companies. These include Allstate ( ALL ), which can be viewed as a universal retail insurance provider, the Markel Corporation ( MKL ), which primarily provides specialty insurance, and Cincinnati Financial, a major New England-based P&C insurer.
As demonstrated above, Arch Capital has overperformed relative to peers, with the greatest 1Y price increase and the second-largest quarterly price increase. Despite this, the firm remains undervalued on a multiples and growth-capability basis.
For instance, of the peer group, Arch retains the second-lowest trailing and forward P/E ratios. In conjunction with the lowest debt/equity ratio, Arch Capital seems to be in an enviable financial situation.
Moreover, with a history of best-in-class shareholder returns, the lowest PEG, and the highest profitability, ROE, and ROA, Arch Capital only further underlines its ability to drive continued growth over a multi-year period.
Valuation
My discounted cash flow analysis, at its base case, estimates that Arch Capital's fair value is $96.91, meaning, at its current price of $70.15, the firm is undervalued by 28%.
My model, calculated over 5 years without perpetuity, assumes a discount rate of 8%, incorporating the firm's low debt levels and average beta whilst accounting for potential recessionary pressures. Furthermore, I calculated a conservative revenue growth rate of 6%, much lower than the trailing five-year average growth of 12.07%.
Alpha Spread's multiples-based relative valuation tool contrasts with my own analysis, calculating a base case overvaluation of 26%, with the fair price of the company being $52.04.
However, I believe Alpha Spread's models- which solely compare multiples to peers- fail to holistically capture the firm's operational context, growth capabilities, and lower debt levels.
Superior Risk-Adjusted Returns Specialization & Conservative Balance Sheet
At the core of Arch Capital's business is the balancing act between low-beta, secure investments, and a superior return on investment. Through the means of specialization, Arch Capital has been able to selectively generate cash flows with low intrinsic risk and maximal potential return. Confluently, with the firm's more stable revenue generators- reinsurance and mortgage insurance- Arch Capital represents the ideal low volatility, high return stock for investors.
Arch Capital's resilience and specialization are best described by its net premiums segmented into end markets; while the company broadly divides its activities into insurance, reinsurance, and mortgage insurance, there is a high degree of revenue diversity even within these verticals. For example, Arch Capital's insurance business- the largest by net premiums written- serves a heterogenous clientele, including professional insurance lines, property and energy, travel, construction, E&S, etc. The latter proves the firm's commitment to exotic insurance products for specialized cases, fortifying the business through diversification and niche-expertise alike.
The aforementioned philosophy of risk aversion and diversification extends into the firm's AUM deployment, seeking a mix of investment types and investment grades. Through these means, Arch Capital essentially ensures a level of yield capture alongside portfolio security.
Wall Street Consensus
Analysts largely support my positive outlook on Arch Capital, projecting an average 1Y price increase of 16.60%, to a price of $81.79.
Even at the minimum projected price of $67.00, a 4.49% decline, Arch Capital faces relatively low volatility, a product of analyst confidence in the insurer's operational model.
Risks & Challenges
Regulatory Complexity & Pressure
With an ever-evolving global presence, and activities across complex insurance products, reinsurance, and mortgage insurance, each business Arch Capital operates within is laden with regulatory burden. As such, failure to adequately comply with regulation or regulatory systems putting downward pressure on premium pricing capabilities may materially harm cash flow generation.
Inverse Interest Rate Demand Convexity
While rising interest rates continuously put downward pressure on Arch Capital's AUM portfolio, they also serve to dampen demand for Arch Capital's products, particularly specialized lines. Although the firm seems to be experienced a reversion to normal demand levels, continued demand reductions may reduce long-run net incomes.
Conclusion
Arch Capital continues to demonstrate its outsized ability to balance risk management and investor returns, with specialized insurance lines and strong capital deployment leading to accretive, long-run growth.
For further details see:
Arch Capital Focuses On Specialty And Security For Stable Upside Potential