Description

Axis was previously written up by Nassau on March 24, 2012.  The idea produced a total return of 41% (including reinvested dividends) in the 28 months between that recommendation through today’s close.  As we often see with the more solid, low-risk VIC ideas, the posting was unrated and the message queue was starkly barren other than updates from the author. 

Nassau’s main thesis was that you could purchase a very well capitalized, highly diversified hybrid specialty insurer with an enviable track record at 86% of book value even as the P-C pricing cycle was bottoming.  He suggested that diluted book value should hit $50 per share by the end of 2014 and that the market should price the shares between 1.1 and 1.2 times book based on comps.  As at June 30, 2014, Axis’ diluted book value per share is $49.69, makingNassau’s prediction a buyside bullseye in my view – accurate yet erring toward conservative.

My thesis is you can now buy a very well capitalized, highly diversified hybrid specialty insurer with an enviable track record at 87% of book.  After three years of improved pricing, I will concede that the P-C cycle is now probably closer to a peak than a trough, but I will also argue (below) that Axis’ breadth of offerings and unique underwriting culture dampens the impact of general industry pricing on their business.  Further, management has been aggressively adjusting its portfolio to deliver smoother, less volatile loss ratios over time. 

As the market appreciates these points and, even more importantly, the company’s strong commitment to returning capital to shareholders in the form of dividends and buybacks, Axis’ shares should trade between 1.1 and 1.2 times book.  Projecting forward Axis’ historical 13% CAGR in diluted tangible book value, I estimate book will be about $58 per share by the end of 2015.  If the shares trade at 1.15 times book, I have a price target of $66.50 per share.  Including dividends this equates to a total return of almost 60% in 18 months from today’s closing price of $43.15.

Investment Highlights

-         Proven performance history since 2002 inception at top of peer group

-         Thoughtful risk pricers and capital allocators

-         Currently executing aggressive share repurchases at discount to book

-         2.5% dividend yield

-         Managing toward even lower volatility lines which should increase multiple

-         Trading at 87% of book provides margin of safety and downside support

-         Highly rated, low duration investment portfolio

Business Overview

Axis’ operations consist of two global underwriting platforms, Axis Insurance and Axis Reinsurance, which operate out of Bermuda, theU.S.,Canada, Europe, Australia, Singapore and Brazil.

Insurance

Axis Insurance consists of the following major lines:

Property: provides physical loss or damage, business interruption and machinery breakdown coverage for virtually all types of property, including commercial buildings, residential premises, construction projects and onshore energy installations. This line of business consists of both primary and excess risks, some of which are catastrophe-exposed.

Marine: provides coverage for traditional marine classes, including offshore energy, cargo, liability, recreational marine, fine art, specie, hull and war. Offshore energy coverage includes physical damage, business interruption, operators extra expense and liability coverage for all aspects of offshore upstream energy, from exploration and construction through the operation and distribution phases.

Terrorism: provides coverage for physical damage and business interruption of an insured following an act of terrorism.

Aviation: provides hull and liability and specific war coverage primarily for passenger airlines but also for cargo operations, general aviation operations, airports, aviation authorities, security firms and product manufacturers.

Credit and political risk: provides credit and political risk insurance products for banks and corporations. Coverage is provided for a range of risks including sovereign default, credit default, political violence, currency inconvertibility and non-transfer, expropriation, aircraft non-repossession and contract frustration due to political events. The credit insurance coverage is primarily for lenders seeking to mitigate the risk of non-payment from their borrowers in emerging markets. For the credit insurance contracts, it is necessary for the buyer of the insurance (most often a bank) to hold an insured asset (most often an underlying loan) in order to claim compensation under the insurance contract.

Professional lines: provides coverage for directors’ and officers’ liability, errors and omissions liability, employment practices liability, fiduciary liability, crime, professional indemnity and other financial insurance related coverages for commercial enterprises, financial institutions and not-for-profit organizations. This business is predominantly written on a claims-made basis.

Liability: primarily targets primary and low/mid-level excess and umbrella commercial liability risks in theU.S. excess and surplus lines markets. Target industry sectors include construction, manufacturing, transportation and trucking and other services.

Accident & health: includes accidental death, travel insurance and specialty health products for employer and affinity groups, as well as accident & health reinsurance for catastrophic or per life events on a quota share and/or excess of loss basis, with aggregate and/or per person deductibles.

Reinsurance

Axis Reinsurance writes business both on an “excess of loss” basis (i.e., coverage begins after a deductible is breached) and on a proportional basis (pro-rata sharing of the loss).  The reinsurance segment consists of the following lines:

Catastrophe: provides protection for most catastrophic losses that are covered in the underlying insurance policies written by cedants.  The exposure in the underlying policies is principally property exposure but also covers other exposures including workers compensation and personal accident.  The principal perils in this portfolio are hurricane and windstorm, earthquake, flood, tornado, hail and fire. In some instances, terrorism may be a covered peril or the only peril.

Property: provides coverage for property damage and related losses resulting from natural and man-made perils contained in underlying personal and commercial policies.

Professional Lines: covers directors' and officers' liability, employment practices liability, medical malpractice, professional indemnity, environmental liability and miscellaneous errors and omissions insurance risks.

Credit and Surety: consists of reinsurance of trade credit insurance products and includes both proportional and excess of loss structures.  The underlying insurance indemnifies sellers of goods and services in the event of a payment default by the buyer of those goods and services.  Also included in this line of business is coverage for losses arising from a broad array of surety bonds issued by insurers to satisfy regulatory demands or contract obligation in a variety of jurisdictions around the world.

Motor: provides coverage to cedants for motor liability and property damage losses.

Liability: provides coverage to insurers of standard casualty business, excess and surplus casualty business and specialty casualty programs.  The primary focus of the underlying business is general liability, although workers compensation and auto liability are also written.

Engineering: provides coverage for all types of construction risks and risks associated with erection, testing and commissioning of machinery and plants during the construction stage.  This line of business also includes coverage for losses arising from operational failures of machinery, plant and equipment and electronic equipment as well as business interruption.

Agriculture: provides coverage for risks associated with the production of food and fiber on a global basis for primary insurance companies writing multi-peril crop insurance, crop hail, and named peril covers, as well as custom risk transfer mechanisms for agricultural dependent industries with exposures to crop yield and/or price deviations.

Other: includes aviation, marine and personal accident reinsurance.

Performance History

From its inception at the end of 2002 through the end of 2013, Axis has written $40.6 billion in premium, on which it registered a combined ratio (including corporate expenses) of 89% over the entire period.  Axis Insurance has never had an unprofitable year.  Axis Reinsurance has only lost money in 2 of its 12 years – 2005 (Katrina, Rita, Wilma) and 2011 (large international catastrophes).  As mentioned above, Axis has grown its book value per share adjusted for dividends at a compound annualized rate of 13.1% since inception.

The slide below illustrates Axis’ performance relative to its peers over period.

(Source:  Bernstein Strategic Decisions Conference, May 30, 2014)

Pricing

The pricing environment is clearly getting more competitive, especially within the property and catastrophe lines, but other areas remain attractive.  Growth in gross premiums written within the accident, health for Axis Insurance and agriculture for Axis Reinsurance reflect the company’s nimbleness across its myriad lines in finding opportunities for better pricing and moving out of areas of margin compression. 

The chart below illustrates how this flexibility generates more stable pricing for Axis as a whole relative to its individual lines:

 (Source:  Bernstein Strategic Decisions Conference, May 30, 2014)

Investment Portfolio

Axis’ investment portfolio consists of $12.6 billion of fixed income assets, $1.3 billion of cash/short-term investments, $1.0 billion of alternatives, and $745 million of equities.  The fixed income portfolio has a weighted average credit rating of AA- and an average duration of 3.0 years.  Incorporating the cash  and short-term investments and the swap hedge into the equation brings the portfolio duration down to 2.6 years.  The alternatives component of the portfolio consists of various hedge funds executing a range of strategies.

Investment income for Q2 2014 was relatively strong at $115 million representing a 1.6% total return for the quarter, driven mostly by performance in the alternatives category. 

Capital Allocation

While Axis’ 2.5% dividend yield is very attractive, we believe management’s strong commitment to repurchasing shares below book value really seals the deal on this investment.  During Q2 Axis bought back 3.1 million shares, or just under 3% of its current shares outstanding, at an average price of $45.59.  Thus far in 2014, Axis has been reducing its sharecount at a 12% annual rate.  We are big, big fans of aggressive buybacks below book.  They are instantly accretive, they show that management “gets it”, and, provided operational performance is maintained, they ultimately put a floor in the stock price. 

CEO Albert Benchimal shared management’s view on buybacks at the Bernstein conference on May 30, stating,

“We have been very shareholder friendly managers of capital. Interestingly enough, when we were founded in 2001, we started with $1.7 billion of

capital. Inception to-date, we've already returned to our shareholders through share repurchases and dividends some $3.7 billion of value -- of

cash back to our shareholders. And as you can see on this chart, from 2008 to date we've actually returned over 100% of our cumulative operating

income, 2008 to now in the form of dividends and share repurchases. The reason we're able to do that obviously, we started off with a very strong

capital base, but more importantly, we've been focusing very much on enhancing the capital efficiency of our business, more diversification, shaving

off some of the peak exposures to ensure that we can do more with the capital   base that we have. And just to give you a statistic, over the last two

years, we've grown our gross return premiums by over 15%.  During that same period, we've repurchased 15% of our shares outstanding. And we've been

able to do that and get the upgrade from AM Best from A to A+. So we did not do this stock repurchasing at the expense of capital strength, quite the opposite, we

did it in the context of a more balanced book of business, a more capital efficient book of business.”

On yesterday’s conference call, CFO Joseph Henry reiterated the company’s commitment to its buyback program, stating, “As we discussed with you previously, provided that market and financial conditions remain the same, we anticipate returning close to 100% of our annual operating earnings to our shareholders through common dividends and share repurchases.” 

Also on the call Benchimal responded as follows to the analyst question below:

Dan Farrell – Sterne Agee

Hi and good morning.  Just a question on the buyback looking into wind season in the near term.  In past wind seasons, but not all of them, you have slowed down your buyback.  I am wondering how you are approaching that strategically this quarter, particularly given where the valuation of your stock is currently?

Albert Benchimol – CEO

Dan, very good question.  As a matter of fact because of the fact that our stock price is trading where it is, we have decided to restart our share buybacks in Q3 and as soon as our quiet period is over we will do that. (Source:  Transcript) 

Operational Improvements

Some of the operational initiatives that management has mentioned recently include focusing the risk portfolio on less volatile lines (i.e., less cat), focusing on new distribution sources, and reducing operating expense.  On the latter point, management has set a goal to reduce operating expense by 4 to 5 percentage points by 2017.

While we are not incorporating the impact of these initiatives in our price target, the cost initiative alone could add $1 or more per share to Axis’ earnings power.  Further, a less volatile stream of earnings should ultimately confer a higher multiple on the company’s shares.

Comparables

                                                          Stock Price/             Div.

                                    Mkt Cap         Tang Book                Yield

Arch Capital                   7.2 B                      1.31                 0.00%

WR Berkley                    5.7 B                      1.33                 0.92%

Ace Ltd                         33.7 B                      1.39                2.29%

Endurance                      2.4 B                      0.98                2.45%

Aspen                             2.6 B                      0.88                1.85%

Axis                                4.5 B                    0.86                2.46%            

(Source: Bloomberg)

Axis is arguably among the best managed of the group and yet trades at the lowest price to book and highest dividend yield.  Note that that Endurance and Aspen represent the lower bound of valuations on this comp table and their valuations may be suppressed by Endurance’s recent failed attempt at a hostile takeover ofAspen.

Conclusion

Strong management, aggressive buyback, significant discount to book and value enhancing initiatives all conspire to make Axis a very attractive risk/reward on an absolute basis and particularly in relation to a generally overpriced equity market.

Catalyst