A Story of Fortune and Impending Disaster:
Say you move into an old house and rummaging through the basement, you find 6 famous Picasso paintings worth $1mm each, wow, fortune! Now say you form a company selling these paintings, ramping up each year:
- 2011, 1 painting sold - income: $1mm
- 2012, 2 paintings sold - income: $2mm
- 2013, 3 paintings sold - income: $3mm
Wow it's a growth company! Maybe the stock of this company trades at a market cap of $21mm or ONLY 7X last year's $3mm income! So cheap: low multiple WITH growth in this environment: BUY BUY BUY say the stock salesmen!
But Today, the Basement is Out of Paintings...
HCI Group Inc. (NYSE:HCI): About To Experience Extreme Earnings Headwinds
THE FLORIDA HURRICANE INSURANCE MARKET
Every once in a while there is a big hurricane in Florida and a lot of houses get knocked down and insurance companies go bankrupt. Rather than letting its people go homeless, Florida a long time ago set up a state-run insurance company called Citizens that would absorb the policies of these failed insurance companies and the taxpayer would foot the bill. It has roughly 25% market share of the homeowners insurance in the state, by far the largest provider - the other large insurance companies like State Farm left because they didn't think it would be profitable to do business over the long run.
HCI FOUND SOME PAINTINGS, THEY ARE ALL GONE NOW
HCI was created by very clever people that realized they could "take-out" policies from Citizens and become the insurer for thousands of customers all at once rather than the expensive way of knocking door to door selling or advertising. Over the last 3 years, they pioneered the approach of cherry-picking the most profitable policies from Citizens (effectively transferring the highly profitable policies from the taxpayers to HCI shareholders). Citizens was OK with this arrangement because they are a government agency and were run by government bureaucrats, not typically a shrewd profit-maximizing group. By taking-out these juicy policies, HCI boosted its profits enormously and metaphorically "sold the paintings" that it kept rummaging out of Citizens basement.
A NEW SHERIFF AT CITIZENS TURNS THINGS UPSIDE DOWN
In 2013, Citizens hired a new Chief, Barry Gilway who has been called an "insurance industry dynamo" and promised to shrink Citizens and reduce the burden on the taxpayers of Florida. He has been hard at work: first in August 2013 he created a competitive bid to take out a huge chunk of 400,000 policies (~1/3 of the total) across 10 companies. This meant no more cherry-picking the best policies, they were given away wholesale. The nail in the coffin though is the creation of a clearinghouse so every single policy will be competitively bid for and treated as a commodity. No cherry-picking the best policies ever again, ever (they spent $45mm building the system to make sure each one would be bid competitively).
This is not going to happen - THIS HAS ALREADY HAPPENED - IT STARTED JAN 27, 2014.
HCI APPEARS TO BE THE MOST HIGHLY VALUED INSURANCE COMPANY AND EPS COULD NORMALIZE DOWN -75% OR WORSE
Banks and insurance companies are inherently in the most commodity product of all: money. Without some structural advantage like a better brand, service, or sales channel, most financial companies earn average returns on equity - around 10%. Unlike Microsoft (NASDAQ:MSFT) or Apple (NASDAQ:AAPL), a financial company's capital base IS the engine to generate the earnings so book value is important and a single year's earnings are meaningless to valuation.
HCI Trades today at 2.7X Price / Book Value vs. the industry average of around 1.0X P/BV. The industry is growing slowly, in line with GDP and I believe HCI is about to start shrinking given it now cannot easily acquire and grow its policy count and attrition will decrease it.
Normalized earnings for HCI on its $160mm of equity would be 10% ROE * $160mm equity = $16mm per year net income (over 11mm shares) = $1.45 EPS - DOWN 75% from $5.63/share in 2013.
Even the best insurance companies in the world like Progressive (NYSE:PGR) or GEICO [now part of Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B)] that are growing rapidly and have deep competitive advantages trade for a lower valuation than HCI. HCI would have to drop by 20% to $31/share just to have the same 2.2x P/BV valuation as Progressive!
COMPENSATION IS ASTRONOMICAL FOR BOARD AND MANAGEMENT
HCI insiders were clearly intelligent enough to capitalize on this take-out opportunity and are now intelligent enough to milk it while they can. According to the proxy filed April 25, 2014, The CEO was compensated $15 Million in 2013! More atypically - the board of directors (who set the CEO's compensation) each received nearly $900,000 each in compensation, approximately 10 times higher than the average similarly sized company! I have never seen directors receiving (multiple) BONUS payments? Why do the board members deserve ~$900k each?!
CEO INCENTIVE PLAN IS BASED ON EARNINGS DECLINING -41% IN 2014
In 2013, HCI had EBIT of $106.5mm according to CapIQ. According to a January 8-K filing, the CEO's incentive compensation target is for the earnings to grow by MINUS 41% in 2014 vs. 2013:
The company…must have earnings before interest and the provision for income taxes of at least $62.5 million, a -41% decline!
If that performance goal is met, Mr. Patel will qualify for a cash bonus equal to 3.25% of EBIT
COULD ONE HURRICAINE WIPE OUT SHAREHOLDERS?
Insurance is taking cash now for a future promise that you must deliver on or someone will be out of a home. Right now HCI has the lowest loss ratio (% of payout vs. % premiums collected) of ANY public insurance company in the industry at 27.8% - vs. 50-60% being typical. How does HCI manage to insure people that so rarely make claims?
Do they know how to sell flood insurance only to people at the tops of mountains? NO - they are just taking extreme risks by being concentrated and I believe under-reinsuring the risk (which increases costs). AM Best, the "Moody's" of insurance ratings, won't even give HCI a rating and Weiss Ratings gives HCI a "D" for significant weakness that could negatively impact shareholders.
I called HCI numerous time and left my phone number over the past few weeks trying to get their insight on these topics, as each one appears to be to be potentially "catastrophic" to HCI's earnings. Unfortunately they never returned my calls or emails so hopefully they can address these risks on the upcoming earnings conference call in a transparent manner.
Additionally, we question a number of significant risks:
- Is HCI's reinsurance capacity adequate given the lack of risk-waterfall disclosure for related party Moksha Re, formed by HCI's CEO and SVP?
- Why is HCI investing in Florida waterfront real estate which has highly correlated risks to the insurance business? Won't a storm concurrently damage both businesses, compounding losses?
- Why has HCI taken on so much debt - $126 million (vs. $160mm equity) as of the last filing - while keeping such a high cash balance and not investing it?
Disclosure: I am short HCI. 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.