National Financial Partners: Finally, a No-Brainer to Buy

| About: National Financial (NFP)

Over the past year, we have built a good track record on Seeking Alpha around identifying mispriced stocks that have had significant moves following our article. Given the scarcity of secular investment ideas in financial services, we wanted to highlight a stock that has fallen off of investors’ radar screens. With a 20% free cash flow yield, a recent recapitalization after two-plus years of deleveraging, and exposure to emerging secular and political themes, we believe National Financial Partners (NYSE: NFP) could double or triple from current levels. While many stocks are “cheap” today, very few have the catalysts and tailwinds of NFP. We believe secular themes will drive solid performance for each of NFP’s three businesses. Its life brokerage business, historically its largest, will benefit significantly from the inevitability of a higher tax environment in the United States. NFP is a unique beneficiary of the problems that higher tax rates will create, and represents one of the few ways to invest in this theme without taking significant balance sheet risk. As investors, we have diligently waited for NFP to finalize its deleveraging plan. With borrowing of $173 million repaid entirely over the past seven quarters (primarily funded with organic free cash flow), and the July refinancing of its convertible debt, NFP is finally in a position to deploy its considerable free cash flow ($124 million the last twelve months and growing) for the exclusive benefit of the shareholders.

It appears that very few investors have followed NFP over the past two years. Currently, six Wall Street analysts follow the stock (with only one buy recommendation), but nothing more than maintenance notes have been published on the company for the past few years. From what we can tell, management has not marketed to investors since September 2008 (Lehman Brothers Global Financial Services Conference). Over the past two years, management has been in a bunker mentality, deleveraging and stabilizing the business. In an informal pool of investors who we believe knew the company well between 2004 and 2008, only a small percentage were aware of the company’s developments, and several were unaware that NFP was still public. We believe that will change, as management is currently scheduled for three investor conferences in September 2010 alone, the first time management will tell investors the “new” NFP story. In addition, we believe the recent reorganization into three reporting segments simplifies the company and will provide investors with a transparent and exciting story.

NFP’s valuation is usually associated with a distressed company. However, NFP assumes no underwriting risk, and has no direct exposure to interest rates, credit markets, or equity markets. Further, the company generated $124 million of free cash flow in the trailing twelve months, has low leverage, has no debt maturity until 2014, and is experiencing accelerating organic growth (7.3% in the second quarter). Based on management’s public comments (which appear to have occurred on conference calls with little attendance), we expect management to ramp acquisitions and begin to return cash to shareholders. These initiatives could be accretive to current consensus estimates by around 25% (as we discuss below). With earnings per share accelerating and $100 million of debt capacity, these actions should significantly improve NFP’s multiple. NFP is currently trading at 4.5x consensus estimates for 2010, a nearly 70% discount to the insurance brokerage industry. It is our belief that the combination of a sound thematic story, beneficial shareholder decisions, and a void of institutional ownership, NFP will likely double in the next six months. Our assumptions rests squarely on the fact if NFP simply trades at 10x earnings, which still represents a 30% discount to the group, the stock would trade well above $20 per share and STILL maintain a substantial double-digit free cash flow yield.

NFP Background

NFP is an independent distributor of financial services products to high net worth individuals and small to medium-sized businesses. NFP was formed in 1998 and went public in September 2003 at $23.00 per share. NFP was a classic roll-up strategy. The company acquired life insurance brokers, high net worth financial advisors, and benefit consulting firms. Today, NFP has a national distribution network of 148 firms, which would be extremely difficult to replicate and represents a core asset for the company.

Under NFP’s acquisition model, NFP acquires 100% of the equity of the broker. The principals become independent contractors for NFP and continue to run day-to-day operations. Principals are tied to NFP for the long-term, and are typically subject to five year non-compete and three year non-solicit agreements if they were to leave NFP. Under a typical agreement, NFP acquires around 50 percent of the firm’s operating cash flow before compensation to the owners. NFP retains a senior position in these earnings (principal takes earnings hit before NFP) and has incentive programs to encourage growth.

Like so many companies, NFP stumbled in the midst of the financial crisis. It became too reliant on large commissions from universal life policies and leveraged the balance sheet to buy back stock right before the meltdown. In the fall of 2008, NFP management stopped making acquisitions and has been restructuring, reducing expenses and deleveraging. The refinancing in July 2010 was the final piece of the company’s deleveraging and restructuring plan. What was once a darling of Wall Street is now poised for a comeback.

NFP recently reorganized into three reporting segments: Corporate Client, Independent Client and Advisor Services. We believe this realignment will make it much easier for investors to understand the drivers of NFP’s businesses, and below is a brief snapshot of each.

The Corporate Client segment, which represents 40% of revenue, is mostly corporate benefits brokerage and consulting to middle market companies. This segment competes with the benefits consulting businesses of insurance brokers Brown and Brown (NYSE:BRO), Arthur J. Gallagher (NYSE:AJG), and Aon Corp (NYSE:AON), as well as benefit consultants like Hewitt Consulting (HEW). The corporate client segment is a relatively stable business with high-teens margins. The segment grew 4% organically in the second quarter 2010. Importantly, NFP should be a beneficiary of health care reform. Given the complexities of the reform, businesses are relying more heavily on the expertise of consultants and brokers. Our view on the market was reconfirmed with Aon Corp’s July 12th acquisition of Hewitt. While Hewitt is typically involved with larger clients than NFP, the 40% premium paid and healthy valuation (17x earnings and over 8x EBITDA), confirms that one of the larger players believes there is tremendous opportunity in the post-health care reform world.

The Advisor Service segment, which represents 20% of revenue, provides an integrated platform of proprietary technology, brokerage and investment advisory services to roughly 1,000 independent financial advisors, who manage over $8 billion in assets. We believe the advisor business is a hidden gem within NFP. It is a business that was built from the ground up (no acquisitions) and is growing north of 25% annually. This growth has been driven by the attractiveness of the platform and migration of financial advisors to the independent channel. This business is the lowest margin business given high payouts to the financial advisors. However, we believe NFP has the opportunity to double the margin in this business over time as it scales. The closest comp to NFP’s Advisor Services segments is LPL Investment Holdings, which is on file to IPO later this year. NFP has a long runway for growth as it currently serves less than 1% of the roughly 114,000 independent advisors in the US. In addition, its recent partnership with Charles Schwab (NYSE:SCHW) should provide it access to roughly 19,000 RIAs.

Independent Client segment – Unique Beneficiary of Higher Tax Rates

The Independent Client segment, which represents 40% of revenue, sells life insurance and financial planning to the high net worth market. Life insurance brokerage was historically the company’s largest business. It was also the hardest hit during the market downturn (for example, NFP’s retail life business declined 27% in 2008 and 31% in 2009). NFP’s life brokerage business is a unique business with no public comps. Today, it remains the largest independent distributor with many prestigious insurance companies, including John Hancock (NYSE:MFC), Sun Life (NYSE:SLF), Pacific Life, ING, AXA, MetLife (NYSE:MET) and Principal (NYSE:PFG).

We believe it is universally accepted that high net worth individuals will be facing significantly higher taxes over the next few years (we will not argue the merits here). NFP should be a unique beneficiary of higher tax rates. Higher tax rates drive the need for estate planning, financial planning and life insurance, all of which represent areas where NFP is a recognized leader. In 2011, the Bush tax cuts expire and the estate tax resets. The estate tax is an example of a tax hike that could drive material volumes to NFP. In 2009, a “death tax” rate of 45% was applied to estate assets over $3.5 million. In 2010, there is no “death tax” (it’s a great year to die, at least for one’s heirs). Under the current law, the exclusion drops to $1 million and the tax rate rises to 55% in 2011 and beyond. According to the Spectrem Group, there are less than one million “ultra high net worth households” in the U.S. but almost 8 million millionaires. The number of people exposed to the death tax will rise materially (over 700% according to Spectrem’s figures). This should drive significant volumes for life insurance brokers. Every life insurance broker will have a call into their clients selling the need for estate planning, tax planning and deferral strategies, and pushing the benefits of life insurance. We believe it will drive significant demand for products like universal life insurance, whole life, trusts and other asset protection and tax deferral products. NFP has already begun to see the benefits of this trend (earlier than we expected). On August 4, 2010 conference call, management stated that they are experiencing “increased activity” in “larger cases” given the “prospect of a higher tax environment.” This could be a multi-year driver for NFP.

Recapitalization and Use of Cash Flow for Acquisitions and Buybacks

The table below highlights the company’s free cash flow generation since it began deleveraging. Over seven quarters the company redeployed almost all of its cash flow to reduce its $173 million bank line to zero (as it was set to mature in August 2011). The table below highlights this dynamic; with free cash flow roughly equaling bank debt repayments over this time period (it’s also important to note that the first quarter is seasonally weak for cash flow). We expect free cash flow to continue to ramp and believe that third quarter’s cash flow could be one of the highest in the company’s history.

$ in millions 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10
CFO - quarterly $36 $32 ($2) $34 $50 $41 $5 $37
CapEx - quarterly ($5) ($3) ($2) ($2) ($2) ($2) ($3) ($2)
FCF - quarterly $31 $29 ($3) $33 $49 $39 $2 $35
Bank debt repay - quarter ($47) ($45) $0 ($33) ($40) ($35) ($5) ($35)
CFO - LTM $88 $56 $114 $101 $117 $124 $130 $133
FCF - LTM $53 $23 $92 $89 $107 $117 $122 $124

Source: Company filings.

Following the substantial paydown of the bank debt, NFP’s management chose to continue in their capital management efforts. The last piece of their debt, a $230 million convert, was set to mature in February 2012. Instead of continuing to collect cash to pay off the convert, they decided to refinance it. In June and July 2010, they replaced the $230 million convert with a new $125 million convert and $125 million term loan. They also agreed to a $100 million revolver that remains undrawn. The refinance (with its effective convert price after the note hedge of $15.77) and resulting shorting of the stock created a large overhang on the stock, yet also a large opportunity.

We believe the refinancing is a significant positive for the company. The ONLY reason for management to complete the refinancing at this time would be to position the company to deploy its considerable cash flow in shareholder friendly ways (instead of continuing to pay down debt). The company remains on the low end of its “1.5% to 2%” debt-to-EBITDA range and has no need to pay off their only two pieces of remaining debt (the new term loan and the new convert). This implies that management will deploy its excess free cash generation in one of three ways: acquisitions, buybacks or dividends.

From 2003 to 2006, NFP acquired between 19 and 26 firms per year, deploying between $51 million and $110 million of cash per year for acquisitions. During that time period, management was able to add acquisitions without adding much leverage to the balance sheet. We believe management’s acquisition pipeline is currently ramping quickly, but management is unlikely to get too aggressive with acquisitions in the near-term. Based on public comments, we believe management may focus on sub-acquisitions and will not to issue equity in deals given the depressed valuation of the stock. If management deployed $65 million of cash for acquisition at 5x to 6x EBITDA, we estimate it would add $12 million of EBITDA and $0.16 per share to EPS, or 8% accretion to current estimates.

Year ($ in millions)






Number of acquisitions






Cash consideration






Stock and other consideration












Source: Company filings.

If management’s appetite for acquisitions remains below its considerable available capital of $230 million ($100 million bank line and $124 million cash flow), we expect management will return cash to shareholders in the form of buybacks or dividends. Given the current valuation, we believe shareholders will be better served by a repurchase program. With a $65 million repurchase program at $10.50 per share, we estimate a buyback would be $0.34 accretive or 16% accretive to current estimates. Combined with acquisitions, management could productively deploy capital that would be around 25% accretive to 2011 estimates and result in the stock trading at 3.9x earnings. We believe these are conservative figures. With $65 million of cash acquisitions and $65 million of share repurchase, NFP would still end the year with no debt on its $100 million bank line.

We believe investors who take a fresh look at NFP will be surprised by the cash flow generation of the business during the downturn and will be giddy at how well positioned the company is to benefit from emerging themes like higher taxes and accretive deployment of their cash flow. Stocks that benefit from powerful secular themes tend to trade at dramatic premiums to the market. Even if investors double their money in NFP from current levels, we are projecting a valuation of less than 10x earnings and a double digit free cash flow yield. We believe these types of opportunities are rare in today’s market, and investors who can get up to speed on the company are poised to benefit.

Disclosure: Long NFP