The Bullish Case For Fortegra Financial

| About: Fortegra Financial (FRF)
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Fortegra Financial (NYSE:FRF) trades at an attractive valuation due to the current negative regulatory environment despite a low risk, diversified business model, recurring revenue stream, strong cash flow and significant insider ownership.

Company overview

FRF is a diversified insurance services company that provides distribution and administration services on a wholesale basis to insurance and financial services companies as well as insurance brokers and agents.

The three operating segments include:

Payment Protection. Provides credit insurance, debt protection, warranty and service contracts as well as motor club solutions to consumer finance companies, banks/credit unions, retailers, small loan companies, warranty administrators, auto dealers and vacation ownership developers. Competitors include The Warranty Group, Assurant, Asurion, eSecuritel and Global Warranty Group.

Business Process Outsourcing (NYSE:BPO). Provides administrative services to insurance and financial services companies including sales and marketing, electronic underwriting, premium billing and collections, policy administration, claims adjudication and call center management. Competitors include Aon, Computer Sciences, Direct Response Insurance Administrative Services, Marsh & McLennan, Dell (DELL) and Unisys (NYSE:UIS).

Brokerage. Sells specialty property and casualty and surplus lines insurance through retail insurance brokers, agents and insurance companies. Bliss & Glennon (acquired in 2009) is one of the top 10 wholesale brokers in the U.S. in 2012 by premium volume according to industry publication Business Insurance. Competitors include AmWINS Group, Arthur J. Gallagher & Co., Brown & Brown, and The Swett & Crawford Group.

Investment thesis

FRF declined ~21% YTD due to increasing uncertainty regarding new regulations by the CFPB, which negatively affects its clients. Just like DFC Global (NASDAQ:DLLR), the current valuation incorporates all of the downside risk and little of the upside potential.

FRF should trade higher once there is more clarity from the CFPB. However, the time to enter is during this uncertainty, not after it is resolved. The market does not reward investors unwilling to take a position until after all negative factors have been removed. That would actually be a great short opportunity (e.g. the magazine cover indicator).

FRF has a stable shareholder base

Investment firm Summit Partners owns a ~63% stake after acquiring ~91% in June 2007. This stake, along with that of the management/board, significantly reduces the float and should drive rapid price appreciation once the regulatory fears subside.

FRF has a diversified and attractive business model

Diversified. FRF reduced its exposure to any single business by executing a growth through acquisitions strategy (acquired 13 businesses since 2008). Its focus on niche markets with a limited number of competitors and exclusive contracts (in the payment protection segment), along with significant economies of scale, drives high margins and high barriers to entry. FRF continues to expand to reduce geographic and customer concentration (see "Risks" section below).

LBO characteristics. Recurring fees, low capex requirements and long-term client relationships (over 80% of clients have been clients for more than five years) provide a stable revenue stream and strong cash flow. FRF would be a perfect LBO candidate if not for the previously mentioned Summit Partners stake and anti-takeover provisions.


Low risk. In the payment protection segment, clients generally retain underwriting risk through retrospective commission arrangements or fully-collateralized reinsurance companies. In the BPO and brokerage segments, FRF assumes no insurance underwriting risk. This factor alone merits a premium multiple.

Ratings agency helps prove investment thesis

On 7/18/13, A.M. Best affirmed the financial strength and issuer credit ratings for the FRF insurance subsidiaries and cited "sufficient risk-adjusted capitalization, positive net operating performance, positive trends in total premium growth and that the group distributes a large portion of its credit insurance products through consumer finance companies that benefit from the general tightening of lending standards."

Positive outlook despite regulatory uncertainty

On the 1Q13 conference call, management cited a strong pipeline in each of the business segments and potential additional cost savings*, which should drive higher top and bottom line growth. In 1Q13, revenues rose ~25% to $89.9 million and adjusted EBITDA rose ~15% to $10.9 million.

*In January 2013, FRF consolidated its fulfillment, claims administration and information technology functions and expects to save ~$4 million annually.

Despite significant acquisition-related debt, FRF has financial flexibility

FRF has ~$34 million of availability on the revolving credit facility. In August 2012, FRF reduced interest expense by replacing the existing credit facility with a new $125 million senior secured credit facility.

FRF uses strong cash flow to repurchase stock

In 4Q11, the board approved a $10 million repurchase plan. FRF repurchased 508,080 shares for $3.9 million in 2012 and 471,554 shares for $2.6 million in 2011. Management discussed the possibility of a "larger buyback" on the 1Q13 conference call.

FRF is strong technically

FRF recently broke out of a steep downtrend and pulled back to the rising 20 DMA, providing a perfect low risk, high reward entry point. While many trendlines are subject to the eye of the beholder, this one is not subject to interpretation.

Risks

Investment risk. FRF is exposed to interest and credit risk given the significant fixed income investment portfolio however this risk is mitigated by high credit quality and asset-liability management.

Exposure to insurance cycle. The market for P&C insurance (and premium rates) is cyclical from a capacity and pricing perspective. The brokerage segment would be negatively affected by lower premium rates as commissions are a percentage of premiums. Since late 2006 P&C rates have generally declined although the market began to firm in 2012.

Dependent on discretionary consumer spending/credit availability. The payment protection segment would be negatively affected by reduced purchases of items requiring protection such as mobile phones as well as less access to credit.

Increased regulation. The CFPB created by Dodd-Frank is increasing its scrutiny of the marketing of payment protection products, which may result in reduced sales.

Customer and geographic concentration. The BPO segment generates a significant portion of its revenue (~63%) from one client (National Union Fire Insurance Company of Pittsburgh). The brokerage segment generates ~two-thirds of its business in California.

Intense competition. FRF expects competition to increase in each of its businesses.

Conclusion

The target price of ~9.10 is based on a 7.5x EV/EBITDA multiple, which is more than warranted given the previously mentioned company specific positive factors.

A tight stop loss should be placed below the 20 DMA at $6.83. The time frame is one year.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.