I have written about Old Republic International (ORI) a few times, with the last valuation pegging it around 11 per share. While the underlying concept remains the same, I believe the risks to investing in ORI are higher and there is still a large lack of visibility into certain aspects.
The company recently announced earnings for the 2nd quarter of 2012 (and first half 2012), which was in my view mostly negative. The company does have a different presentation than in the past as it now separates its run-off businesses from its on-going business (RFIG and CCI being the run-off businesses). As it relates to the on-going business the company saw good top-line growth, with revenue increasing 12.8% year over year. Premium growth was strong with the General Insurance segment growing over 10% and the Title segment growing north of 23%. From the General Insurance standpoint the trends seem consistent with Traveler's (TRV) most recent earnings release (mainly from a pricing standpoint as it is clear they don't compete in all the same business lines).
Although the revenue and premium growth was strong, the General Insurance segment saw a significant increase on the costs/claims side. Per the conference call and earnings release this was largely driven by the workers compensation line, which is driven primarily by a poor economic environment and more specifically, a poor employment environment. The really bad part about this is that it means we shouldn't expect a significant improvement without seeing an improvement in the employment picture. That said, the company still expects this to be a profitable line for the year.
Putting this all together for the General Insurance resulted in a decline in operating income by about 28%. However, the Title segment had a very strong performance which allowed the non-RFIG/CCI segment to only show around a 2% decline in operating income. The company did show good results on the investment gains (both realized and unrealized), but I typically focus more on the operating results.
Turning to the run-off businesses it is critical to understand how these are structured both operationally and legally. For reporting purposes the company has basically rolled up the CCI (credit indemnity) business with the Mortgage Insurance (MI) business, as both these lines are and have been in run-off (meaning they are not writing new business). However, just because these are combined for reporting purposes, doesn't mean they have the same legal structure or risks.
The MI business is something that the company has been very clear is "walled off", meaning basically the exposure won't force the company to contribute new capital. Additionally, the MI division isn't and hasn't not been contributing dividends up to the parent, which means it isn't really needed to maintain the dividend to shareholders. To look at this another way, if true, being walled off would mean that the worst case scenario is that the division could only go to zero, and not below.
During the quarter the RFIG run-off business had operating losses of $160M, compared to greater than $180M in the prior year. As part of these results the mortgage part of the business was better than it has been, but still running at large operating losses. As this is mostly in line with what we have seen and not really a new event, I prefer to focus on the one point that really surprised me…the losses from CCI. During the quarter CCI generated an operating loss of almost $50M USD, much greater than any other quarter previously, including last year. The increase in the losses from CCI was largely attributed to both an increased in expected legal costs as well as a decrease in expected salvage values. While the overall RFIG performs was improved (i.e. a lower operating loss) I am more concerned seeing this large spike in CCI losses and the potential for future exposure.
Risk and Uncertainties
ORI is a company with a lot of risk, but we knew that in previous quarters. The previously understood risks and main focus for most investors was the impact of potential receivership for the MI subsidiaries. The first concern around this was what the company would do about their debt as this action would be considered a breach of their debt covenants (i.e. default). That is, would they have a liquidity event that requires them to raise expensive financing, dilute the shareholders in a common stock raise, and cut the dividend, or other worse alternatives (or some combination of all). Some are also concerned if the business is truly walled off or if it could somehow require a new contribution of capital (and/or a cut of the dividend).
This quarter it seems there was an added level of uncertainty given the losses from CCI. In my previous analysis I had assumed that the impact of CCI would be minimal based on the relatively small level of premiums that the exposed subsidiary (the primary one in terms of exposure) was generating as well as the typically small level of costs being attributed to CCI. However, with this recent spike in costs, it isn't clear what the new run rate is, or the worst case exposure.
The primary exposure for the CCI business is the Old Republic Insurance Company (ORIC in the company filings), which is the named defendant in a more than $300M USD suit by Bank of America (BAC). However, the company hasn't really said this is walled off (they have said they won't contribute more capital to RFIG), but we also haven't been provided how much capital is exposed inside of ORIC or how much in dividends to the parent company they contribute or contributed (remember, ORIC is a General Insurance legal subsidiary, but they do move the CCI results to RFIG for reporting purposes). I find this lack of information very difficult to come up with a worst case scenario.
Taking all of this into account I have adjusted my valuation significantly. Considering that the company has about $3.6B USD in book value for the on-going business (not run-off) and that this business is running at a profit, it would seem there is value in ORI. If we assume that the mortgage exposure is truly walled off, then we need only to take account for the intercompany related exposure, which is about $200M USD. That basically leaves CCI to be dealt with, but as mentioned above we don't have the best visibility to do that. What I am assuming is that we could use the exposure of the main lawsuit (Bank of America) and even another $120M USD as judgment (which is annualizing the 2012 operating loss) to chop off the book value. Even with these adjustments you end up with a value of almost $3B, or about $11.7 per share. You can see in my previous article I would be comfortable to use a multiple of .8 to be applied to the book value, which would get you a valuation of around $9.3.
Comparing that to today's price of sub $8 per share, it would seem to offer a compelling value. Even with this potentially good value, all investors need to keep their eyes on the risks. It could be the impact of CCI is underestimated in my analysis and it could be that the MI business requires some capital injection. Even if the analysis is correct the timing of certain events could cause a perfect storm. That is, if there was some settlement or judgment with the Bank of America lawsuit at the same time as the MI business going into receivership, it would put extreme stress on the company's liquidity and be a difficult/expensive problem to solve. Even though the on-going General Insurance business can cover the dividend I see more risk in the dividend based on the CCI results than I was previously aware of, which is just another point to watch. In summary, I believe the share price has probably dropped further than is warranted, but I also believe ORI is a riskier and less valuable investment than I previously believed.
Disclosure: I am long ORI.
Additional disclosure: This article should not be taken as investment advice, and is for informational purposes only.