Life Partners Holdings, Inc (NASDAQ: LPHI) operates in the secondary market for life insurance, known as “life settlements,” by facilitating the purchase and sale of life settlements. It has generated average returns on equity of 49.6% over the last nine years, and has done so with minimal debt on its balance sheet. Furthermore, over the last three years, it has generated free cash flow of $28.6 million on average versus its market cap of just $83 million, for a stunning yield of 34%.
First, what is a life settlement? This is an area of life insurance the existence of which few people are aware. Suppose someone with a $2 million life insurance policy contracts a terminal illness. Life insurance pays out only upon death, but this person needs or wants money immediately. The policyholder then turns to the secondary market, selling the future payout for a discounted amount immediately. The purchaser receives a low-risk investment that pays out upon the death of the insured person. It is worth noting that this is a negative-carry investment, as the purchaser is now on the hook for paying premiums until the insured dies.
LPHI acts as agent for purchasers, identifying and examining potential sellers, pricing policies and facilitating the actual transaction. The company has developed proprietary software for analyzing and pricing transactions, using its track record of more than $2.8 billion (face value) of transactions covering 6,400 policies (spread over 131,000 purchasers) to help hone its strategies. The company also has developed relationships with various brokers, estate planners and other parties across the United States in order to help identify potential sellers. This is important, as 99% of its revenues come from sales found via brokers, two of which accounted for nearly 27% last year.
It appears that the Life Settlement industry is highly cyclical. According to the company, steady growth from the early 2000s to 2007 gave way in the recession to a stunning decline in transaction volume.
In reports issued in 2010 and 2011, the insurance research group, Conning & Co. (the “Conning reports”), estimated that the life settlement industry completed $11.8 billion in face value of transactions in 2008, but dropped to $7.6 billion in 2009 and $3.8 billion in 2010. Based on our own research from other providers, publicly reported data and estimates based on historical data, we concur with Conning’s estimate that the total amount of face value of transactions completed by the life settlement industry in calendar 2010 shrunk to about $4 billion. The 2011 Conning report suggests the decrease in the life settlement market results from a lack of capital due to the lingering distress in the credit and investment markets following the 2008 and 2009 financial crisis, increases in life expectancies, and investor concern regarding liquidity. We concur with Conning’s forecast that the life settlement market overall will remain flat or decline during 2011.
One of the main contributors to the decline in transactions had to do with, according to the Conning reports (with LPHI concurring), a lack of capital for investment resulting from the financial crisis. This is a good sign, because risk capital will rebound over time. It would be a far worse scenario if the industry was in secular decline. I do not believe this is the case. Some policyholders will always want or need to raise cash, and beyond the life settlements industry, the only real alternative is for a policyholder to go to the insurance company itself and opt to receive the cash surrender value of the policy. According to the company:
A 2009 market analysis indicated that the average life settlement trades at 15% or more of policy face value while insurance companies pay a cash surrender value that averages 4% of face value.
Thus, by offering far higher rates than the only viable alternative, it appears that there should be demand for the services of this industry for the foreseeable future. According to LPHI, there are twenty companies operating in the life settlements market, of which LPHI is the second largest player with 14% market share (up from 7% in 2009). Also worth noting is that LPHI is the only company in the market that does not utilize leverage in its business model.
So why is LPHI trading at such a small multiple of free cash flow? After all, the company is conservatively capitalized, has consistently earned extremely high returns and has grown its market share significantly throughout the recession. Perhaps this is our clue:
WACO, Texas — January 20, 2011 — Life Partners Holdings, Inc. (NASDAQ GS: LPHI) confirmed today that the SEC is conducting an investigation into the business of its operating subsidiary, Life Partners, Inc. The Company’s confirmation follows press reports of the previously non-public investigation. The Company said that it is cooperating fully. The Company said in addition that it does not know how long the investigation will go on, nor does it know how it will ultimately be resolved.
Also, this public spat with its auditor which led to that auditor resigning, is a cause for concern (more here). Another worrying sign is that the CEO issued this warning to Shareholders in dealing with short sellers, which is usually reserved for managers unwilling to deal with real problems but desperate to improve their stock price.
While I am impressed with the company’s performance, I see too many red flags here so I will stay out.
What do you think of LPHI?