The Aspen-Endurance Merger Is Unattractive For Both Companies

| About: Aspen Insurance (AHL)
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Summary

The proposed Aspen-Endurance Holdings merger doesn't offer benefits for shareholders of either stock.

A detailed study of the valuation of the deal shows limited benefit, but substantial risk for Aspen.

Strength in the reinsurance sector means there are better opportunities beyond Endurance.

Endurance Specialty Holdings (NYSE:ENH), a company with a market capitalization (before acquisition talks) of $2.39 billion proposed to by Aspen Insurance Holdings (NYSE:AHL) a company a with a market capitalization of $2.62 billion (before acquisition talks). The fact that Endurance is the smaller of the two may immediately make investors skeptical. Aspen soundly rejected the deal and drew up a "poison pill" to protect its company. This poison pill is set to activate as soon as somebody buys 10% of Aspen stock, and would allow current shareholders to purchase new stock at half of the market value. However, the poison pill wouldn't allow the 10%-holder to purchase new securities. This would effectively dilute the acquiring shareholder, which would mean that Endurance Holdings could not start buying Aspen's stock in order to demand a deal.

Shareholders might feel that it would be unethical for Aspen's management to take the decision away from them. As the owners of the company, they would have a point. This is obviously controversial and this poison pill decision needs to be evaluated on a case by case basis.

However, Aspen was likely upset by the smaller company dictating their terms. It likely follows that Endurance did not want to acquire Aspen; rather, Endurance wanted to merge-but Aspen rejected the idea, forcing Endurance to employ this tactic.

Investors should think of the deal as a merger - rather than as an acquisition - with Aspen shareholders holding 35% of the new company, Endurance shareholders holding 44%, and new investors holding 21%. Endurance was forced to push the issue because Aspen would not listen to their merger proposal. Endurance obviously felt that the deal was too good to ignore and issued a hostile takeover bid. Aspen has since posted two detailed letters on their website that quantitatively and qualitatively explain the negative effects of a merger.

Despite the hostility in the transaction and the rejection by Aspen's board of the directors, this report will analyze the pros and cons of the acquisition. At the end of the day, should Aspen accept the merger?

(1) Is the deal actually for $47.50 per share?

Endurance offered $47.50 for each share of Aspen, 20.6% higher than the $39.37 price that Aspen traded at on April 14 (before the deal was announced). However, the deal would not all be in cash, so the $47.50 value could fluctuate. This number was based on Endurance's $53.82 share price on that day. On May 5, Endurance's share price was $50.77, which means the premium has already decreased for shareholders. The calculation works as follows: one Aspen share receives $19 cash, or 40%. The remaining 60% is multiplied by 0.8826, a number Endurance has based on their $3.2B valuation of Aspen. The 60% multiplied by 0.8826 comes to .52956 Endurance shares. Therefore, the shareholder that initially owned one Aspen share would now own $19 + (0.52956 X ENH's current market value); given ENH's current price of $50.77, that would equal $45.88.

Thus, the premium of the deal has already dropped. Endurance stated on April 14 that the deal valued Aspen at 1.16 X diluted book value per share. As of today, the deal only values Aspen at 1.0767x diluted book (given Aspen's Q1 results and updated value of $45.88). The premium is not quite as substantial as Endurance claims.

Furthermore, Chairman of Aspen Chairman Glynn Jones highlighted this concern and stated that "Endurance stock as consideration in a combination is not appealing." Clearly, Glynn Jones is right, and receiving payment in stock holds substantial risk for shareholders. The key takeaway: purchasing in stock is generally okay, but when the premium is only around 15%-20%, the shareholders being acquired can see their premium evaporate.

(2) How would the combined company look?

The key to the deal is examining the combined company. In order to do this, we need to understand the deal thoroughly. Currently, Endurance has approximately 44.7 million shares outstanding. The proposal involves issuing Aspen shareholders $19 in cash and 60% stock for each 1 share. The deal also involves issuing $1.05 billion of new ENH stock, at what we can assume was priced around $51 (given that ENH likely provided the new investors with a slight discount to their price).

$1050 to new shareholders divided by $51 (Current ENH share price)

20.59

Current amount of ENH shares outstanding

44.70

(60% is in stock X 0.8826) then multiplied by 66.569 current Aspen diluted shares outstanding

35.25

Aspen - Endurance Shares Outstanding

100.54

100.54 shares multiplied by ENH's current share price would produce a combined market value of $5.1 billion. Currently, Endurance has $3.0 B of shareholders equity, including $430 million in preferred stock and $165.4 million in goodwill and intangibles. This brings tangible equity to around $2.41 billion. However, this will change given the purchase price paid for Aspen and the new stock issued. The key will be determining the tangible equity of the combined company. In order to do this we have to calculate the goodwill as a result of the merger. The first step is to calculate the purchase price.

$ 1,264.75

(1) $19 per share cash explained above X 66.569 million diluted Aspen shares Outstanding

35.25

(2) (60% is in stock X 0.8826) then multiplied by 66.569 shares outstanding

$ 1,897.19

(3) Is 35.2506 X $53.82

$ 3,161.94

(4) $3.16194 is the total value

Given Aspen's current tangible equity of $2.81 B, there will be $350 M ($3.16 B minus $2.81B) of goodwill or intangibles as a result of the acquisition. We can now determine the combined tangible equity of the new company as follows:

In Billions

Add: ENH's tangible book value

$ 2.41

Add: Stock issued by ENH to AHL shareholders

$ 1.90

Add: Stock issued by ENH to new shareholders

$ 1.05

Less: goodwill

$ 0.35

AHL - ENH combined tangible equity

$ 5.01

(The calculation can be reconciled to $2.41 B of Endurance tangible equity, plus $2.81 of Aspen equity, minus $1.265 B of cash paid to Aspen shareholders, plus the $1.05 B issued by ENH to new shareholders.)

(3) The transaction is dilutive to ENH Shareholders

Now that we understand what the combined company will look like, the next step will be determining whether the acquisition is worthwhile.

As discussed previously, there will be 100.54 million combined shares in the new company, and $5.01B of combined tangible equity. The diluted book value per share (DBVPS) of ENH/AHL will be $49.93 ($5.01B / 100.54).

Presently, ENH has a DBVPS of $57.53, meaning the deal would lower its DBVPS by 13.2%, already making it sound like a painful deal for ENH shareholders. It is indicating one of three things: (1) ENH management does not have much faith in their current company and is trying to pursue an acquisition to diversify; (2) ENH's management are not valuation analysts and do not understand how detrimental it is to dilute DVPS by 13.2%; or (3) the combined company will be very accretive to their value.

Before we move on to point 4, let's take a look at what fellow reinsurer Axis Capital said about deals that dilute DBVPS during their most recent conference call:

"We get paid for growing book value, at the end of the day that's the only thing that...I think that as a general guideline, acquisitions can have a quote a one year dilutive impact as you go through pay fees, sometimes it takes you a year or two to achieve all the efficiencies…if they are dilutive in the first year, if you can make it up by the second year or so, but a transaction which is long-term dilutive is really hard, it's hard to reconcile."

It is hard to imagine how a deal that dilutes ENH's current DVBPS by 13.2% could be made up in a year.

If we were to assume that the combined ENH and Aspen could earn an ROE of 15% for years 1 and 2, and that the current ENH could only earn 8%, then the combined ENH's DBVPS would be $66 at the end of 2 years ($49.93 X (1.20%)^2). Given ENH's current DBVPS, that would be growth in book value per share of 14.7% ($66 / $57.53). If ENH was able to grow at 8% per year for the next 2 years, then its DBVPS would be $67.10 - which is above the deal value.

The facts are that ENH proposes only 11-13% ROE for ENH, and states that this is just a 1% increase over its current value.

Thus, the deal would be dilutive for ENH shareholders for the next 16 years.

5.473566

Multiplier of 1.12^15

4.784589

Multiplier of 1.11^15

$ 306.09

Multiplier of 12% ROE X $49.93 DBVPS

$ 305.54

Multiplier of 11% ROE X $57.53 DBVPS

Finally, in year 16, the deal would add value for ENH shareholders. Certainly this would seem to suggest that the deal is not a very good one for ENH shareholders. It follows that it is a poor choice for Aspen shareholders as well, because it means they would own stock in a company that is willing to substantially dilute its shareholders.

(4) How much will the combined company make?

Endurance estimates an 11-13% ROE in 2015, based on page 11 of their investor presentation. If we add back goodwill, it brings shareholders' equity to $5.36 B ($5.01 B + $350M); this multiplied by 12% (midpoint) comes to $643 million of earnings. The company states that this would be 1% above standalone ENH. However, the company estimates annual synergies of $100M (since reinsurers have tax rates near 0% we can ignore taxes). Therefore, the non-synergy earnings of the company come to $543M.

It is important for investors to scrutinize this $100M. Glynn Jones has stated:

"Endurance claims that a combination would result in 'over $100 million of annual synergies,' but its discussion is superficial, its claims are unsubstantiated and the types and sources of synergies are unidentified. Importantly, we believe this claim assumes no disruption or loss of business to the combined company... If anything, we appear to have understated the dis-synergies."

If we assume that there are no synergies in the deal, the combined company would have an ROE of around 10.8% ($543 M / $5.01B), which is similar to what ENH currently estimates for itself as a standalone company.

It appears that ENH would be taking on a large amount of risk to make the same amount of money.

(5) How solid is ENH?

Aspen speculates that ENH is not a very solid reinsurer, which helps to explain why ENH wants to merge with AHL in spite of the fact that the deal appears to make no quantitative sense.

Aspen states 3 weaknesses of ENH's business:

(1) its over-reliance on crop insurance, a business which is troubled, low-margin, recently volatile and exposed to major risks;
(2) the lack of progress in its other insurance businesses, which are in a nascent stage, and;
(3) its weak reinsurance business.

Moreover, Endurance's earnings in recent years have been driven disproportionately by prior-year reserve releases.

This is one of Aspen's key points. Technically, the fact that an insurer's earnings are driven by reserve releases could simply mean that it reserved too strong in prior years. And a company not releasing reserves could be a result of not reserving strong enough.

Excluding this less likely scenario, what it actually says is one of two things: (1) the insurer is worse at estimating its future losses -meaning there could be large swings in either direction - or (2) the company is managing its earnings. Excluding reserve releases, the company earned only $23.3M in underwriting income last year, instead of its reported $245.7M. In 2012, the company would have lost $64M in underwriting. This compares to $50.3 M in profit and an $18.7M loss. In AHL's first 2014 quarter, its combined ratio ([Estimated Losses + Acquisition costs + General and Admin] divided by net earned premiums) was 92% excluding reserve releases, while ENH's was 94%.

It is clear that ENH's earnings are likely to be of a lower quality than those of Aspen.

(6) ENH is not diversified

Warren Buffett has stated that diversification is an excuse for laziness. However, when it comes to reinsurance, a company should want to have a certain level of diversification.

ENH states that its policy is not to incur a loss of more than 25% of its shareholders equity. However, it does not break down the calculation for losses. At least I have not found one. All the other reinsurers provide sample calculations of losses. The fact is that 36% of ENH's business relates to agriculture, which translates to a large amount of risk for a volatile reinsurance category. ENH cites diversification as a key reason for the merger. ENH states that "a key strategic rationale for this transaction is the enhanced scale and diversification evident in the combined company." It appears that the only company of the two likely to benefit from diversification is ENH.

(7) The deal is not attractive to Aspen Shareholders

If the deal is accepted, Aspen shareholders will own $1.265B of cash and 35.25 million ENH shares. The deal would give AHL shareholders a premium of $45.88 (calculated acquisition price) / $42.72, or 7.3% premium to book value. Aspen expects to make above 10% ROE going forward, and to grow in 2014 and 2015. ENH's combined company expects a 10% ROE with the stock trading at a 2% premium to book (based on May 5 closing price of ENH). Without synergies the ROE of the combined company is lower. Aspen stated in their Q1 conference call that ROE should be 11% in 2015. Why would Aspen want to merge with Endurance? There are deal risks, integration risks and after all of that worse returns.

(8) It is too risky for a deal that doesn't add much value under optimistic scenarios and loses value under realistic ones

As shown throughout the calculations, it is very debatable whether the ENH deal actually adds any value for Aspen shareholders. They would get themselves involved in a complicated transaction that appears to have little to no synergies. Furthermore, the price that the new ENH shareholders will pay is unknown - meaning there could be further dilution.

(9) Conclusion: go long all reinsurance, except for Endurance

While the deal isn't awful for Aspen shareholders, it certainly appears to be awful for ENH shareholders. Given this, it makes one wonder how secure ENH's business is, if ENH is willing to pay such a high price to diversify. For these reasons, I don't think the merger should go through, and I would not be a buyer of ENH stock. Despite the run-up in Aspen's share price, AHL is the more attractive of the two companies. However, AHL is no longer the most attractive reinsurer to buy. Given its run-up in share price, there are now other more attractive reinsurers. Nevertheless, Aspen remains attractive as a standalone company and is substantially undervalued.

The fact is that every reinsurer is presently very undervalued. It makes no sense that the majority of them trade around tangible book value when they are earning ROE of 10%. Furthermore, these companies' ROE's are highly leveraged towards rising interest rates. For these reasons, I am long the entire reinsurance sector. And I expect all reinsurers to substantially appreciate in value going forward. Be that as it may, I would be hesitant to buy ENH, given management's tactics to substantially dilute its shareholder base. I feel that these tactics indicate a lack of goal congruence between shareholders and management at best, or a business that has substantially higher risk than it states at worst.

The key is always in making the right choice. Still, picking any random reinsurer would result in a strong investment for anyone, given the unwarranted discount of the sector by the market.

Please check with your financial advisor before making any investment decisions. Disclaimer: Do not base any investment decision upon any materials found in my article. I am not registered as a securities broker-dealer or an investment adviser either with the U.S. Securities and Exchange Commission (the "SEC") or with any state securities regulatory authority. I am neither licensed nor qualified to provide investment advice. The information contained in our report is not an offer to buy or sell securities.


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.