After significant research, I've just purchased shares in embattled small-cap insurer Tower Limited (Australia) (ASX: TWR). Tower shares have been hit by a number of concerns including increased claims for the Canterbury earthquake and massive write-downs to its IT systems. Investors are concerned about its solvency as well as the growth of larger competitors like Insurance Australia Group Ltd (ASX: IAG), and Suncorp Group Ltd (ASX: SUN).
As part of my research I asked a fellow Foolish contributor for insight and his first comment was "what a piece of junk". Certainly Tower is no market darling, but that's why I think it's cheap and undervalued.
Addressing the chief concerns
- After retaining Deloitte, Tower has substantially increased its claims provisions for the Canterbury earthquake. The current figures should now be substantially more accurate, reducing the likelihood of future claims
- Tower has no debt, plus approximately $22 million in available solvency in the form of cash on hand plus solvency capital, plus a $50 million undrawn credit facility to cover excess claims
- Tower appears to have been poorly run in the past, as witnessed by its high management costs, lack of policy growth, and outdated IT systems
Where the value comes in
New CEO Richard Harding has spent the last 18 years working in insurance and held senior and CEO roles for the past 10. In his 15 months at Tower, he's delivered modest positive policy growth, written down the antiquated IT systems, plus slightly reduced management expenses (I'm not sure by how much, since Tower lumps together management and sales expenses).
Secondly, Tower appears fairly unlikely to go broke even if the provisions for Canterbury claims increase, as I expect they will. Tower has an excess of solvency capital that is meaningfully above minimum regulatory requirements.
Third, Tower sells for a ~20% discount to its Net Tangible Assets. This discount will decrease as the company spends cash, but asides from claims I can't see many big near-term expenses for the company. The IT systems write-downs shortened the company's software lifespan to 3 years (previously up to 10 years) from April this year.
Fourth, Tower has an attractive presence in under-insured and growing Pacific Island markets. With policy growth in NZ and the eventual upgrade to the IT systems (the recent interim results have a good chart on page 19 about this) the company has scope to improve its existing operations.
Fifth, 7 weeks ago (prior to the increased claims expenses) Tower received an unsolicited lowball offer that valued the company at $1.32 per share. I'm certainly not counting on it but the possibility of a takeover is like a free lottery ticket.
Sixth, Tower has announced its intention to keep paying dividends at the same level as last year. I'm not a big fan of this, but the final dividend will be around 7% when it's paid.
What would make me sell?
- An increase in claims provisions or lawsuits (more than $20 million) that stretch the company's finances beyond the point I'm comfortable with (also bearing in mind we're coming into cyclone season in the Pacific)
- Loss of the lawsuit against the company's recently appointed Canterbury quake reinsurer, depending on impact on Tower
- The departure of CEO Harding, as the idea that Tower is underperforming and can be turned around by a seasoned executive is core to my thesis
- Inability to generate respectable positive growth in the NZ market
- Prices of around $1.30 or above and/or a takeover offer
- Turnaround taking more than ~18 months or so to come to fruition
Tower's progress so far has been a bit 'two steps forward, one step back' but another 18 months should be enough time to get insurance operations back in order, as well as finalise more Canterbury claims which will relieve investors. Two key risks are liquidity issues, as bad news could easily see sellers overwhelm the small pool of potential buyers. Additionally, there's a risk that I've been too cute with my thinking, and that my thesis involves too many unpredictable variables to turn out the way I intend.
