Citizens, Inc. (CIA) is a life and health insurance company that sells policies both domestically and abroad. Harold E. Riley, the 84-year-old founder, chairman of the board and CEO, owns 100% of the company's Class B stock and 5% of the publicly traded Class A stock. Because Class B stock elects the majority of the board of directors, Mr. Riley is the controlling owner of Citizens. His son, Rick D. Riley, is currently the Vice Chairman, President and Chief Corporate Officer, so it looks like the Riley family will continue to control the company for the foreseeable future.
While in theory I do not mind investing alongside controlling shareholder-owners, in this instance, Citizens' ownership structure helps to solidify the bear case for the stock. The likelihood of a change in strategy seems remote given the current institutional imperative, so I can extrapolate prior results into the future with greater confidence.
In this article, I will argue that the company's current valuation is too rich relative to past performance and its likely long-term performance going forward. Furthermore, there are issues with the company's balance sheet and earnings capacity in the short term that the market appears to be ignoring. This sets up an interesting asymmetric risk-return investment to the downside: if things go well for the company, then there is little reason to expect the stock to appreciate much in price. If things go poorly as I expect, then there will be double downward pressure on the stock as earnings and book value decline even as the valuation multiple deflates.
Citizens is currently selling for $6.37 per share with no dividend. With a book value of $5.38, the company has a p/b ratio of 1.2. Even when paying only a slight premium to book value, investors should demand strong evidence that the company can deliver high returns on equity without taking on unnecessary risk.
Citizens does not provide that evidence. In the last quarter, the company's combined ratio for all of its insurance operations was a bit more than 100, indicating that the company was operating at an underwriting loss. When this happens, insurance companies must rely on their investment portfolios for income. And while this is unattractive prospect for insurance companies in general, we shall see that this is especially bad news for Citizens.
I am a long-term investor, so I do not mind temporary hiccups provided that a company is capable of eventually generating excellent returns. Time arbitrage is one of my favorite strategies. The problem is that there is no evidence that Citizens has a durable competitive advantage or that the company is able to profitably invest the earnings it has decided to retain rather than pay out to shareholders:
NOTE: The burst in EPS in 2010 was due mostly to mark-to-market gains on the company's securities portfolio as financial markets stabilized. More on that below.
During a typical year in the last two decades, Citizens generated about a 5% ROE. Given that the company operates in a competitive commodity industry and is unable to consistently grow earnings across a pricing cycle, paying any premium to book for the company's equity is unjustified. I'd rather put my money in high-yield bonds to generate a higher return without the price volatility of a small cap stock.
It Gets Worse
While Citizens' business results are unimpressive and the stock seems pricey at first glance, a closer look at the balance sheet raises even more red flags. Of the $264M in shareholder equity on the balance sheet, $179M of that is intangible assets, including goodwill, deferred policy acquisition costs, and cost of customer relationships acquired. The latter two correspond with expenses such as commissions already incurred to obtain policies that are now in force. Accounting rules allow for insurance companies to pay up front to drum up business but capitalize the cost over the expected life of the policy. While this accounting treatment makes sense because policies are expensive to originate but cheap to service, it means that Citizens is selling at a hefty 3.8 times tangible book. There is not much margin of safety in that multiple, and this over-weighting of intangible assets suggests that a p/b of 1 should not serve as a price floor for the stock.
When we delve even deeper into how tangible book value is recorded, the picture looks uglier still. Insurance companies have two choices regarding the classification of investment securities on the balance sheet, amortized cost or available-for-sale. The amortized cost method evenly discounts the value of the security until maturity corresponding with expected interest payments. This approach reflects the fact that insurance companies often match the duration of their securities with the expected duration of their policies. When amortizing a security's cost, changes in market price do not translate into changes in shareholder equity on the balance sheet, provided that there is no credit impairment.
Available-for-sale marks the value of securities to market. In this method, companies record any unrealized capital gains or losses as increases or decreases in shareholder equity. These paper gains or losses are categorized as Accumulated Other Comprehensive Income (AOCI).
Citizens currently holds about 80% of its fixed income portfolio as available-for-sale, which means that the rise in bond prices in the last several years have been recorded as a gain in tangible assets on the balance sheet. And while this practice is quite common and totally above board, it renders GAAP book value much more sensitive to changes in bond prices than if the company used the amortized cost method. If and when bond prices fall, AOCI immediately takes a hit and shareholder equity will dissolve. What the bond market giveth, the bond market taketh away.
Although this arcane issue is trivial for many insurance companies because AOCI is a small portion of tangible assets, it has ballooned to 34% for CIA:
In Q1 2010, AOCI was $10M and non-AOCI tangible shareholder equity stood at $45.7. At the end of last quarter, AOCI was $28.9M and non-AOCI tangible shareholder equity was $56.1. Thus two-thirds of the growth in tangible book value during the last three years was due to rising bond prices rather than underwriting profits or reinvested interest income. This means that for book value to continue growing at the same low to mid single digit annual rate going forward, bond prices must continue to rise. This is a dubious prospect. On the other hand, if bond prices begin to fall, book value will decline.
Capital Losses and Lower Yields
Since the beginning of Q2, the 10-year treasury rate has been creeping upwards, threatening to erode AOCI as bond prices fall. Management is well aware of this interest rate risk and has taken the only step it can to deal with its exposure. Whereas in Q4 2012 62% of the fixed maturity portfolio had durations greater than ten years, that number was sharply reduced during last quarter to 25%. Now fully 39% of the portfolio is in securities with durations less than one year, up from 3% in the prior quarter.
And here's the heart of the problem: In order to lock in some profits on its long-term bonds that have already been booked as AOCI while lowering interest rate exposure, the company must settle for lower-yielding short duration issues. This will push down the average yield on the portfolio going forward, which is bad news for a company that tends to operate at an underwriting loss. So not only should we expect AOCI to decline somewhat in the coming quarters, we should also expect downward pressure on earnings. Because the company's fundamentals are already deteriorating, it is quite possible that Citizens will be pushed into the red in Q2 and Q3:
The Bottom Line
Competition in the life insurance industry is cutthroat, and companies without sustained competitive advantages should not trade at premiums. Because Citizens, Inc. lacks a sustained competitive advantage and is unlikely to change course in the near future, it does not deserve its premium valuation. Furthermore, the company's GAAP book value and earnings capacity are set to decline in the short-to-medium term. This will create a double set of downward pressures on the stock as earnings and book value decline while valuation multiples compress.