National Interstate: Squeeze-Out Tender Materially Undervalues The Company

| About: National Interstate (NATL)

National Interstate's (NASDAQ:NATL) majority owner is tendering for the 48% of shares it doesn't already own.

This is a bad deal for the minority, which misprices the company. There is no reason an informed shareholder should tender to the Controller absent a complete disclosure regarding current and prospective loss development in a very large runoff book of business, called Vanliner, which I believe is carried on the balance sheet at a value well above what the liabilities can be settled at.

More directly: liabilities are overstated and book value is understated, leading to a transaction which is not fair in price, process, intent, or result.

Background to the Deal

The target is National Interstate Corporation, $570mm market cap, of Ohio domicile ("Company", or "National").

The purchaser is Great American Insurance Company, a non-public subsidiary of American Financial Group (NYSE:AFG), which owns a controlling stake of 51.7% ("Controller", or "AFG"). National's Founder is the second largest shareholder, at 9.2%.

National is a leading underwriter of interstate passenger-transportation exposures, such as scheduled bus lines and charter operators. The tail on exposures is short-to-mid term, with about three years after accident-year required for loss development to be fully known.

National is an extraordinarily competent underwriter. Book value per share compounded from $4.70 in 2004 to $18 today. Company distributed a $2 special dividend in 2012, although payout ratio is low.

For 2013, Company collected $34 per share of earned premiums. Insurance-related float stands above $33 per share. National generates a huge amount of earned premium and float relative to its $18 of book.

And Therein Hangs Our Tale

In 2010, Company acquired a moving and storage property and casualty company called Vanliner. In the transaction, National took on $380mm in insurance-related liabilities, or $20 per share.

National also entered into an 100% collar agreement with the seller, such that both losses and gains from running off the book of existing Vanliner business would be settled between the parties. The seller compensating National for losses, and National remitting gains.

The collar runs until year-end 2014. (See page 35, Company 2012 10k)

And there has been significant net favorable development.

If you work the disclosed loss development triangles, I think the runoff Vanliner business has returned $39mm in favorable settlements through years 2010-2012 (almost $2 per share). Company discloses $29mm ($1.50) per share in the deep footnotes. (See Note 13, pages 85-86, Company 2012 10k)

But the favorable development doesn't reach the income statement because of the collar!

Yet, there is no incentive to settle the liabilities on favorable terms with the claimants until the collar expires at the end of 2014. Since the Vanliner liabilities were so large ($20 per share), I believe there's much more favorable development still to come once the collar is gone.

The collar and accounting treatment is unique and buried deep. So the superficial exhibit looks like a bloated balance sheet generating meager underwriting profits. This is just not true.

To Recap, I Believe There is:

1. Evidence the Vanliner liabilities were meaningfully overstated at the time of acquisition.

2. No incentive to settle what remains of the $20 per share of liabilities before December, 2014, when the collar expires.

3. An unconventional income-statement treatment which results in a very weak-looking exhibit, when the underlying economics are materially better.

4. Weak-to-no disclosure or acknowledgement of issues contributing to (3), above.

The Controller Makes His Move

On February 5, 2014, AFG initiated a two-step transaction for the remaining public shares, consisting of a tender to 90% followed by a back-end merger. Terms were $28 per share in cash.

On February 14, the Founder filed a 13D representing that his request to form a special committee and hire legal and financial advisors was rejected by a majority vote of board, such majority consisting of directors affiliated with the Controller.

On the morning of February 18, AFG raised its bid to $30 per share in cash, representing it was both best and final.

What Should Happen Next

Shareholders should not tender and hang tight into the December, 2014 timeframe. I believe book value per share will begin to approach float- and premiums- per share once the Vanliner liabilities are settled. On terms very favorable to continuing shareholders.

Controller is using an unfair informational- and timing- advantage to push through an opportunistic transaction on unfair terms.

National Interstate owes its minority shareholders a complete and current disclosure on the Vanliner liabilities, so that they can conduct a proper, informed valuation. Otherwise, tendering into the bid is just trading with someone who has much better information than you and has selected the timing of the trade.

A deal like that is unlikely to be favorable to your wallet.

Disclosure: I am long NATL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.