As some readers may recall, I bought shares in small NZ insurer Tower Limited (Australia) (ASX: TWR) just over a month ago. The company released its annual report to the market this morning.
Here's what you need to know (all figures in NZ Dollars):
- Revenue down 2.2% to $315 million
- Gross Written Premium (GWP) down 0.8% to $303 million
- Net Profit After Tax (NPAT) down significantly to a loss of $22.3 million (loss of $6.6 million in prior year) due to impairments plus higher Canterbury claims expenses
- Underlying Profit After Tax down 34% to $28.3 million due to higher claims costs and lower investment revenue
- Full-year dividend suspended to preserve cash (more on this below)
- $13 million deterioration in capital position due to Kaikoura earthquakes
The Canterbury saga
Due to many factors, the NZ insurance industry (including the Earthquake Commission) response to the Canterbury Earthquake in 2010 has been tough. The industry still has a couple of thousand claims outstanding (Tower has 564) and new claims are still rolling in, plus a number of claims get reopened after settlement due to disputes.
That's why Tower announced today that it wants to spin off its Canterbury quake claims into a separate run-off company called, appropriately enough, RunOff Co. Tower is of the view that Canterbury claims are holding back the company's value, as well as consuming too much executive attention and RunOff Co will have a dedicated exec in charge.
To create RunOff Co, Tower will have to raise capital to cover RunOff's obligations. How it raises capital has not yet been decided. Once the businesses are separated, RunOff will 'run off' its obligations until they're all gone, and then close. Tower will carry on business as usual, and recommence paying a dividend post separation. Shareholders are expected to vote on the separation in March next year.
The business
Richard Harding and his team have made the best of a bad situation, and I thought this report represented a decent step forwards. Tower's claims costs grew at a slower rate than the rest of the industry. Tower also improved its customer retention, grew the core NZ business, and delivered a significant increase in profit in the second half.
Note the red circles. Many things can affect Underlying NPAT, but it looks as though the new-ish CEO Richard Harding has been able to arrest a business in decline and return it to growth.
The risks
Tower has Net Tangible Assets of NZ$0.96 (A$0.91) per share, well above its current share price. Its financial position has deteriorated somewhat, especially with the anticipated impact of the Kaikoura earthquake. Tower now only has a little leeway above the regulatory minimum, before it would be forced to take on debt.
The above chart excludes the anticipated $13 million impact from the Kaikoura earthquake, as well as the $50 million in available debt funding, should that be required. Needless to say, shareholders will hope there are no earthquakes or severe cyclones in the near future.
Where's the value?
Looking beyond the balance sheet and the write-downs, there is a clear case for Tower delivering value over the next 18 months or so. Some of the ways the company has identified to improve its operations are appallingly simple, and should have been implemented years ago:
- Launching new 'simple and easy' products and simplifying product portfolio (Tower currently has 444 products in its NZ business alone)
- Identifying problematic phrasing in products and removing it
- Repricing policies (some have not been repriced for years)
- Adding ability to buy insurance online (Tower has zero online capability)
- Over the medium term, a new IT system would result in significant simplification and reduction of costs (albeit potentially expensive to develop and implement)
- Other initiatives like finding preferred partners (think mechanics and panel beaters) for automotive claims, etc, in order to keep costs down
Looking at the above Tower sure doesn't sound like an inspiring investment. However, it's also important to note that the above problems are low hanging fruit for management to pick.
Fellow insurers Suncorp Group Ltd (ASX: SUN) and Insurance Australia Group Ltd (ASX: IAG), in particular, have to dig deep and get creative to generate any operational improvements. Tower hasn't tackled the easy issues yet, although it has made some progress, and resolving them should prove rewarding in terms of the quality of its business.
Foolish takeaway
Tower is an ugly duckling – but that's why it's trading at 6 times its underlying Net Profit After Tax. Vocus Communications Limited (ASX: VOC) is valued at 14 times its underlying NPAT, even after its 21% dive today. Tower's cheap, but the biggest question in my mind is whether its balance sheet still has enough leeway in it to prevent the investment from getting ugly – and on that, I am undecided.
