Time Arbitrage With Primerica

Includes: C, PRI
by: Derek Pilecki, CFA

There is an opportunity to time arbitrage the stock market by owning shares of Primerica. The market is not assigning any premium to the expected low-risk growth at Primerica over the next 5 years. The growth is expected because of a complicated reinsurance transaction that shrunk the size of Primerica’s block of term life policies. Over the next few years, Primerica will replace the term life policies that were removed with new policies. This will translate into attractive earnings growth, but Primerica trades for 1.1x book value and under 9 times this year’s estimated earnings per share. Buyers of the stock can earn an attractive return assuming no multiple growth by relying on the expectations for earnings growth in the coming years.

Last July, I wrote a bullish article about Primerica. I saw an opportunity because the company’s balance sheet was restructured prior to its April 2010 IPO. The bottom-line on the balance sheet restructuring was to insure a high growth rate for the first 5 to 10 years as a public company. Through March, the investment thesis played out as Primerica reported 4 quarters of better than expected earnings as Wall Street has missed the high revenue growth rate. The stock rose from $20 last July to $26.

In April, Citigroup announced that it was selling a second tranche of Primerica common in a secondary offering. The secondary offering has beaten up Primerica’s stock as the market has struggled to digest the additional supply of shares. This recent decline is an opportunity to buy shares in a company with solid earnings growth prospects at a low valuation. At these levels, I believe there is assymetrical risk / reward in the shares of Primerica.

Here’s my investment thesis on Primerica:

  1. Basic business model is simple and low risk – Primerica’s business model and balance sheet is simple for a life insurance company. The company only writes one type of insurance policy for its own balance sheet: individual term life insurance. Term life insurance is a simple product with low volatility. Because Primerica has a large direct selling salesforce, it does not compete on price. Primerica also sells third-party mutual funds and other insurance products underwritten by other insurance companies. Selling financial products for other companies is a low-risk business and has a high return on equity because it does not require Primerica to hold additional capital.
  2. Wall Street is underestimating company’s growth because of unique reinsurance transaction with former parent prior to IPO. Prior to its April 2010, Primerica moved 85% of its existing term life portfolio to its former parent, Citigroup. All of the new business written by the Primerica salesforce is written on Primerica’s balance sheet, so Primerica will grow quickly in the first 5 to 10 years as a public company. Wall Street estimates do not seem to recognize the high revenue growth rate Primerica will post for the next 5 years.
  3. Current year EPS estimates are low and future year EPS estimates are very low – For 2011, consensus estimates for Primerica’s EPS are $2.33. In Q1, Primerica already earned 63 cents, so on a run-rate basis, it is earning $2.52 or 8% ahead of current estimates. Since coming public, Primerica has been growing its earnings 4 to 5 cents per quarter. If this 4 to 5 cents per quarter growth rate continued, the company could earn $2.76 this year, or 18% more than consensus estimates. In 2012, consensus estimates are just $2.58. They could earn as much as $3.40 next year.
  4. Opportunity for long-term investors to time arbitrage valuations in the 3-5 year range – Wall Street’s reliance on stock multiples on near-term earnings is an opportunity for investors with a longer time horizon. Here’s a sample sell-side comment about Primerica’s valuation: “We value shares of PRI by applying a 9.0x multiple to our 2012 operating EPS estimate of $2.57. The peer group is currently trading at an average P/E of 7.3x 2012 earnings.” This sort of statement implies that growth rates for Primerica are similar to peers when we know Primerica must have higher growth than peers because of its balance sheet restructuring.
  5. Primerica’s business has a higher ROE than perceived by market – At 15.5% ROE in the 1st Quarter of 2011, Primerica already has one of the highest ROE’s in the life insurance industry; however, Primerica’s normalized ROE is even higher. The higher normalized ROE is disguised by the excess capital the company is holding and its temporary lack of scale from the reinsurance transactions. Primerica was IPO’d with excess capital that it intends to put to use as the company has high growth over the next few years. As of March 31, 2011, the company’s risk-based capital (RBC) ratio was above 600%. I think Primerica can safely operate at a 400% level, so the company has approximately 50% more capital than it needs or just under $500 million. This is a 4% drag on the current reported ROE due to this excess capital. The smaller balance sheet is also a drag on Primerica’s ROE because the company is not fully leveraging its expense base. As Primerica grows its term life insurance book, I expect the company to show operating leverage which will add to the ROE. For example in 2005-07, Primerica operated at a 38% operating margin. In Q1 2011, Primerica only reported a 28% operating margin. Once Primerica gets back to its normalized operating margin, I expect the ROE to increase another 4%. Between the excess capital and the temporary lack of scale, Primerica’s ROE could be as much as 8% understated. This would put the company’s ROE in the low-20’s, which would translate to a business with a much higher Price to Book value than the current 1.1x. A high natural ROE is important for a life insurance company because it generates capital that allows it to grow faster than peers, or it can use the capital to pay dividends or buyback shares.
  6. Primerica has excess capital and current high growth provides opportunity to reinvest capital into the business – Chuck Akre, a portfolio manager with the great long-term track record, says the best investments are the companies that generate a lot of cash and have opportunities to reinvest that cash back into their core business. I have not seen a company as well positioned to do this as Primerica. Because of the reinsurance transaction, Primerica has huge growth ahead of it as the salesforce adds the new term life policies to company’s currently undersized balance sheet. As new term life policies are added, Primerica must also support the balance sheet growth with capital. They get this capital from two sources: 1) the excess capital the company had at the time of the IPO business and 2) the capital being generated each quarter. The reinvestment of capital into their own insurance business gives Primerica an opportunity to compound the returns on their capital and reduces pressure on management to find other ways to invest the cash.
  7. The former parent (Citigroup) is a non-economic seller – Citigroup has divided its business units into what is effectively a good bank / bad bank model. In the good bank (aka, CitiCorp), Citi had put its ongoing businesses such as the global consumer bank, institutional securities, and its transaction processing business. In the bad bank (aka, CitiHoldings), Citi has placed businesses and securities it wants to exit. Among the businesses it has placed into CitiHoldings is Primerica. The management at Citi has shown a preference for fast exits from these businesses rather than waiting for an optimally price for their exit. This is an opportunity for public shareholders to buy shares from a forced seller.
  8. A high profile private equity firm has a significant stake and seats on the Board – Prior to Primerica’s IPO last year, Citigroup sold a 26% stake in Primerica to private equity firm Warburg Pincus. In addition, Warburg has two board seats. This is important to public shareholders in two ways. First, Warburg Pincus provides oversight of management. This will keep a reasonable lid on management compensation and focus their capital management on actions attractive to shareholders (share repurchases) versus empire building (acquisitions). A second benefit of having private equity representation on the Board is that Warburg will push to get their stake monetized at some point in the future. This may come from a secondary offering or it may come from an acquisition.
  9. Economic environment affects operating results only at the margin – Because of the reinsurance transaction and the nature of term life insurance, the current economic environment only affects Primerica’s operating results at the margin. As stated before, Primerica has baked-in growth due to the reinsurance transaction and can’t be changed much by the current economic environment. Also, the term life insurance business is a stable, low volatility business. Mortality rates are stable year-to-year, so benefits and claims do not have large variability. Since the average term policy lasts more than 10 years, the company knows where more than 90% of its revenues are coming at the beginning of the year. The current environment will affect recruiting and ease of sales for the current year, but it does affect overall results to a great degree.

These are the risks which concern me about Primerica:

Not everything is perfect with Primerica. I think they are manageable, but I wanted to highlight these risks to provide a balanced view.

  1. Recruiting and number of sales reps are down – Primerica’s recruiting is down with the economy as new recruits aren’t willing or don’t have the resources to pay for training and insurance licenses. Also, existing salespeople are not renewing as the annual licenses. This appears to be an easy cost to cut for somebody struggling with their cash flow, and they are not producing new life insurance policies. For now, I am monitoring this issue. It is affecting sales to some extent, but it does not change my overall investment thesis, yet.
  2. Purchases of life insurance are somewhat discretionary – Life insurance is an important purchase for a young family, but it is not crucial when times are tough. Primerica’s sales are sluggish due to the economic conditions. On the other hand, there is a little upside to sales when the economy improves.
  3. Low interest rates are a headwind for the industry – Low interest rates affect all life insurers and Primerica is no different. This is a current headwind for the business.
  4. Difficulty forecasting public company expenses – Because Primerica has only been public for one year, it is still difficult predicting corporate expenses. They had given guidance last year that expenses would increase due to becoming a public company, but it has taken a while for those expenses to become evident.
  5. Citigroup still owns a little more than a 20% stake and must sell – I believe the stock is currently depressed because of the secondary offering in April where Citigroup sold its second tranche of Primerica shares. Citi still owns more than 20% of the company, so there will probably be another secondary offering. It will most likely come in the Spring 2012. The good news is once Citi sells its last shares the overhang goes away. Plus, Primerica’s stock will become more liquid, so it will be easier for larger institutional investors to buy positions in the stock.

There is opportunity in Primerica because of the secondary offering in April. The company is positioned to deliver strong earnings growth. The business model is low-risk and provides high returns. The company’s current valuation does not factor in the expected high growth rate over the next few years.

Disclosure: I am long PRI, C.

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