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Hartford Insurance Group (HIG) recently reported 2Q EPS of 1.73, down 12% year over year. After reviewing their financials and reading the conference call, I think HIG is attractive as a value stock, based on a P/B of 1.1 and TTM P/E of 9.4. The dividend, 2.12, yields 3.3% at a recent price of 63.65. Book value per share grew 7.87% per year from 1998 to 2007, so there is a long term trend of creating shareholder value. Add the dividend yield and returns approximate 10% per year: and, starting at the current P/B of 1.1, there is ample room for price appreciation.
Hartford is a major player in both P&C and Life Insurance. They have done a good job on retirement products, variable annuities, and expanded rapidly in Japan. Demographics should favor them as more baby boomers start looking for secure retirement investments. Also, higher gas prices should improve personal automobile insurance results due to fewer miles driven.
Why so cheap? Reading the conference call, many analysts were concerned about the size of mark to market losses. HIG expects to hold most of their asset backed securities to maturity and as such has taken the mark to market losses in Accumulated Other Comprehensive Income (AOCI), a balance sheet item, which affects GAAP Shareholders Equity but does not impact reported earnings. The GAAP book value per share is 55.51, the book value excluding AOCI is 64.68.
This difference, 9.17 per share, is partly the result of changing interest rates but to a large extent reflects the market's perception of the risk involved in assets that have been marked to market. HIG's process is to review the assets monthly as reports come in and project future losses under various stress case scenarios. After John Thain's performance on the issue of holding vs. taking fire sale losses, can we give Hartford CEO Ramani Ayer complete credibility? He was on CNBC yesterday, presents himself well, and is confident that HIG will not have to realize any unnecessary losses by any kind of a fire sale. On a personal level, he was a speaker at a luncheon I attended in 1995 or thereabouts, made a good impression then, and now in 2008 I am looking at an impressive ten year record for HIG in terms of increasing book value per share. So, I am willing to go along with 64.68 as management's best estimate of book value and use it as a metric for determining value.
HIG also has a 1.5 Billion capital cushion compared to the most restrictive rating agency standard for an AA rating. That fact supports their contention that they can hold to maturity.
Another key question is the P&C price cycle, which is in a soft market phase, and HIG's ability and willingness to exert price discipline. In personal lines, HIG sees the same trend Allstate reported, that most companies are taking small incremental increases as needed, which will sustain profitability. In commercial lines, prices are down 7% but Hartford has accepted some reduction in new business. For P&C, the combined ratio, excluding catastrophes and prior year, is 90.7, which is favorable. They are improving their estimates for combined ratio and reducing their estimates for written premium, indicative of pricing discipline - they are unwilling to write business at a loss in order to maintain or gain market share.
My guess is that the current investment climate will make the industry more careful to maintain underwriting profits, since investment returns are questionable because of the credit crisis. Under this scenario, the soft market would be less pronounced.
Asbestos liability: Hartford has large reserves for asbestos liability, from time to time they increase them. The last real news I saw on asbestos was that courts were making it progressively more difficult for lawyers to get away with drumming up claims based on trivial exposures, so I think the danger of large additional reserves is remote.
Another issue is that Hartford will be taking a DAC charge in the third quarter. Deferred Acquisition Costs is an asset item, which is amortized into expenses over the life of the business involved. Hartford reviews their assumptions during the third quarter every year, and expects to take a charge of between 330 and 640 million. That would reduce EPS by 1 or 2 dollars for the quarter, but future expenses due to amortization would be reduced. To me, this is a timing issue and if it makes a bump in the third quarter numbers I would not be unduly concerned - it might present a buying opportunity.
Over the past ten years, HIG's market price has varied form a P/B of as low as .9 in 2003 to 2.7 in 1999. It has traded above 1.5 every year over that period. Using GAAP book value, I get a target on that basis of 82 per share. Because I lean toward management's view on the mark to market, that very little of it will eventually be realized, I think the 82 target is on the low side: if mark to market losses revert over time, that would give me a target of 97. Using EPS, I think Hartford can do 8 a year reliably and at a P/E of 12 that would be 96.
I recently started a position on HIG and plan to add to it over the rest of the year, believing that I may get better prices if the current bear market in financials persists.
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