Description

CF Corporation (“CFCO”) is a SPAC formed by two leaders with long, successful careers of creating value through acquisitions and operations. The “C” in CF is Chinh Chu, who spent 25 years at Blackstone, most recently as a member of Blackstone’s Executive Committee and co-chair of Blackstone’s Private Equity Executive Committee. He led notable Blackstone buyouts including Kronos, SunGard, Freescale, Biomet and Celanese. The “F” in CF is Bill Foley who has led 3 publicly traded platform companies: FNF, FIS, and LPS which have collectively completed over 100 acquisitions and created over $50bn in public market value. Foley is the better known of the two partners and his companies have been featured in numerous write-ups on this website. It’s also worth noting that Blackstone has invested $300m in CFCO so Chu, Foley and Blackstone have collectively invested over $900m into CFCO.

CFCO has announced the acquisition of Fidelity & Guaranty Life (“FGL”) for $31.10/share in cash in a deal that is expected to close in Q4 of 2017. FGL is 80% owned by Harbinger, and announced a sale process in April 2015. Chinese insurer Anbang agreed to buy FGL in November 2015, but this deal was terminated in April 2017. Anbang gained notoriety in 2014 for buying the Waldorf Astoria in New York and trying to buy Starwood but has fallen quickly to earth and its leader Wu Xiaohui was apprehended by Chinese authorities in June 2017. I view this background as relevant because FGL has been on the auction block for over 2 years, so I believe FGL has not been that focused on optimizing day-to-day operations. In addition, I believe the broken deal process allowed CFCO to come in and acquire FGL at a reasonable valuation of 1.1x book value.

FGL’s largest product (71% of 2016 sales) is Fixed Indexed Annuities (FIAs). FIAs are a relatively fast-growing area in US life insurance as they offer purchasers guaranteed principal, some tax-deferred income plus some equity upside. From the insurer’s perspective, they are taking in policy holder money, investing it in high quality fixed income, paying out a modest amount of income (crediting rates) and taking some of the remaining spread and buying call options on the equity markets. The policy holders are given modest/capped upside to equity markets and crediting rates are typically reset annually so in my opinion, there isn’t a big risk of getting mismatched books compared other life insurance products. FGL has generated ROEs in the 9-11% range over the last few years but CFCO believes they can be improved to 15-19% ROEs over the next 2-3 years.

One of the largest FIA underwriters in the US is ATH, a company backed by private equity firm Apollo which generates a ~14% ROE. I believe that CFCO is essentially taking the ATH playbook and applying it to FGL. The 4 primary drivers for improving FGL’s ROEs are 1) lowering tax rate through an off-shore reinsurance structure; 2) earning better investment yields by using Blackstone as manager of its fixed income portfolio; 3) cutting $30m of expenses and 4) using CFCO as a platform for further accretive acquisitions.

I believe that the structure/tax rate change is the most impactful change as FGL currently pays a 36% tax rate and the pro forma rate will be <10%. I believe that lowering the tax rate does not have high regulatory risk given that it’s a structure that is already being used by ATH so regulators are already comfortable with the structure. This structure change also does not require any US companies to re-domicile, but rather uses an offshore reinsurance (which is quite common in the insurance industry). Note ATH has an effective tax rate of 6% and I believe CFCO should be able get to similar levels over the next 2-3 years. I estimate the investment portfolio (which currently yields ~4.6%) can earn 40bps higher yields and Blackstone’s oversight of the investment portfolio ensures strong oversight to help returns. Specifically, ~10% of the portfolio is invested in short-term low-yielding assets that can be re-invested in higher yielding areas (e.g. private debt and mortgages) and there is also an opportunity to invest a small portion (<5%) of the portfolio into private equity and alternatives over time. In the fiscal year ended 9/30/16, FGL’s operating expenses were 57bps of average invested assets, compared to the 25bps ratio of operating expense to average invested assets at AEL (another publicly traded company in the FIA space). If FGL were run at a similar expense ratio, this would imply $60m of cost cuts compared to the $30m I am estimating. I believe that Bill Foley’s experience in cutting costs at FNF, FIS and LPS adds credibility that the targeted $30m in cost cuts are achievable and may be conservative.

Starting with my estimate of FGL’s pre-deal 2019e pre-tax income of ~$270m, adding $30m of cost cuts and ~$100m of pre-tax investment earnings gets to an estimated ~$400m in pro forma pre-tax income. Assuming a pro forma tax rate of 8% and subtracting out new preferred dividend of $28m ($375m at 7.5%) results in pro forma net income of ~$340m. Using 220m diluted shares outstanding results in EPS of ~$1.55. Public comps ATH and AEL trade at 10.3x-10.5x P/E, so I am using 10x for CFCO to derive a $15.50 price target.

As for upside from acquisitions, I am normally skeptical of acquisition-driven platform companies but given Chu and Foley’s backgrounds in building companies through acquisition I am willing to give them the benefit of the doubt. Post deal close, I estimate CFCO has $200m of cash available for further acquisitions and such acquisitions have an incremental ~20% ROE once the acquired books of business are brought onto CFCO’s tax efficient and scalable platform. Assuming CFCO’s excess cash is deployed into acquisitions, this would add an additional ~20c/share in EPS or $2/share to the target price, resulting in a total potential price target of $17.50/share.

Note there is an investor presentation at http://cfcorpandfidelity.com/ which gives more detail on the background of CFCO and the plan to improve returns at FGL.

Catalyst

Closing of FGL acquisition, initiation of analyst coverage, execution on plan to improve ROEs at the acquired company.