Hallmark Financial ($HALL) — Initiation (6/30/21)

Hallmark is a small-cap insurer with a few lines of business. Here’s the quick summary of what’s happening:

  • Good business / average business situation — one segment is a long-term star (specialty lines) while the others have a spotty track record (personal and standard commercial).
  • A third “really bad” business has led to stock price cratering — company saw massive losses in commercial auto and has since exited that line.
  • Good business separating via IPO process.
  • Stock trades at less than 0.5x book value.
  • Huge opportunity for upside as the crown jewel is separated and recognized by the market.

Background

The stock has been more than a dud over the years. Hallmark has been public since the early 1990s with no success — S&P 500 outperformed by >1000%. It saw a period of stability following the financial crisis and then a major run from $10 to ~$20 in 2019 before collapsing to $3 after problems in their commercial auto segment. The stock has since settled in around $4-5 per share.

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For starters, this chart gets me excited… maybe not the portion dating back to 1990 but at least from 2010 on. Investor expectations for positive outcomes in this business are zilch.

Starting with what they do…

From the company’s 10-K — here’s how they describe their business segments:

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Hallmark has a long and lumpy track record of profitability, stable book value, and a few years of setbacks (i.e. losses). They endured a long stretch of no / minimal growth in book value per share — 2% annual growth from 2009 to 2019 before a 35% drop in 2020.

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We’ll soon find out that the “binding primary auto” business line is the main reason for the “setback” dating back to at least 2015!

So what happened in 2020?

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Hallmark experienced some trouble in its binding primary auto line; leading to a complete exit of that business line. This was large enough to leave a dent — it took out nearly $70m in book value during 2020 from a $263m starting balance… a nearly 27% hit to equity!

2020 revenue fell only $7m from $486m to $479m but Hallmark reported a $114m pre-tax loss for the year — thanks to a $46m goodwill impairment and $51m in additional reserves for losses (again, due to binding primary auto).

2020 income statement

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These losses have put a dent in equity and massively increased reserves for future payments. Most insurers have equity to assets in the 30-40% neighborhood while Hallmark is sitting at 12% at 1Q21.

Hallmark Balance Sheet

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In March 2020, Hallmark announced the planned exit and winddown. The exit announcement for the binding primary auto business contained some very interesting tidbits:

  • This business line was $114m or 13.5% of 2019 gross written premiums
  • Will fully runoff by 2Q21
  • But this last quote was the big deal…
  • Over the past five years, Binding Primary Auto has been responsible for over 100% of the Company’s aggregate adverse prior year reserve development.
  • Unfavorable prior year developments were $45.8m in 2020, $60m in 2019, and $16.5m in 2018 — $122.3m or $6.72 per share! All attributed to the “bad business” that has since been wound down…
  • Reinsurance deal (while expensive) should protect the company from larger losses

Binding primary auto reinsurance economics

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So Hallmark’s exposure is the $21.7m loss corridor — of which they’ve incurred $6.7m as of 1Q21 — and then anything over the $240m mark. Meaning they have another $15m or ~$0.80/share in remaining exposure to reduce book value.

Why own it…

Specialty Insurance separation. The big news is that Hallmark is planning to separate its valuable Specialty Insurance segment via an IPO. This will send cash back to the RemainCo (which will consist of the much smaller standard commercial and personal lines) and open up a market for the specialty business to trade in-line with peers (i.e. a much higher multiple of book value / earnings).

Quality business buried under a bad one. Specialty insurance segment grew net written premiums at a 35% annual rate from 2015-2020 and held a combined ratio of 84-94% during that timeframe — an average combined ratio of 88.6%. So we have a growing and profitable business here.

Segment fundamentals

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Fundamentals compare favorably against peers. Here’s a slide from Kinsale ($KNSL), which is seen as the best-of-the-best in this industry, touting their 30% growth in net premiums and 84% combined ratio. Kinsale is a specialty insurer trading at a hefty valuation of >30x earnings.

Kinsale ($KNSL) peer group slide

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Specialty insurance earnings potential. The IPO has not yet been priced and therefore we don’t have any data on actual earnings, but I’ll attempt an estimate. Earned premiums for the pro-forma specialty segment were $278m in 2020 and the average combined ratio over the past 6 years was 88.6%. This works out to $31.7m in operating income (before investment income) or $1.74 per share.

Valuation upside for specialty company. Kinsale trades at a ridiculous multiple of written premiums and probably doesn’t make for a good comparison. $ARGO is a competitor going through a similar turnaround story and State National was a recent takeover by Markel. Both of these seem like good comparisons. ARGO trades at ~0.6x gross written premiums and SNC was acquired by Markel for roughly 0.7x GWP. For reference, other high-performing competitors trade at multiples well over 1x GWP. Hallmark’s specialty business had $500m in trailing GWP as of 1Q21. At 0.6-0.7x would imply a market cap of $300-350m or $16.50 to $19 per share.

Upside left in the stub parent. With the same figures from above, let’s say $1.70 in EPS for specialty in a new public company and $7.25 in book value per share (using same ratio of specialty assets to total assets applied to book value). At 10x earnings = $17 for specialty company which works out to 2.3x book value. Hallmark will retain ~50% of that new public company or $8.50 per share in addition to the remaining insurance businesses. Plenty of room for upside / improvement at the stub company here.

How to play this situation…

This is a unique setup in that Hallmark is IPOing the specialty insurance unit instead of a spin-off…

Current shareholders will not receive shares in the separate company, rather, Hallmark will continue to hold shares of the new specialty business on its own balance sheet. They plan to hang onto ~50% of shares.

Stub Company. HALL shareholders will own the personal/commercial lines that have hovered around underwriting breakeven. Commercial lines averaged a 95% combined ratio from 2015-2018 and personal lines had only 1 year of sub-100% CR over the past 6 years. Operating expenses are high and perhaps the company can achieve underwriting breakeven or better.

Pro-Forma Stub. Say they can only manage breakeven underwriting after the specialty division is gone = $0 operating income. Investment income has historically been $15-20m and the stub is ~27% of the consolidated company so call it $4m in pre-tax earnings [$0 operating income + $4m investment income] = $0.20/share in pre-tax earnings… Not great but then consider the 50% ownership of specialty co on the balance sheet — My math in the previous section indicated potentially $16-19 per share at the IPO or $8-9 back to the parent! So you have maybe $0.10-0.20/share in net earnings and $8-9 in a valuable specialty business with growth potential? Seems like an opportunity for a strong re-rate.

How I’m playing this. I currently own a small position in Hallmark and will await the IPO/prospectus results for the specialty business. If inexpensive at the time of IPO, I’ll probably want to buy shares in the IPO. Either way, I think HALL shares have a good chance for an upward re-rate as this nears completion.

The risks…

Debt. Obviously Hallmark’s balance sheet is in disrepair. Although binding primary auto is gone (mostly), it left a wake of loss reserves. The IPO is a great solution to this problem. While a spin-off would be nice, the IPO brings in fresh capital to an undercapitalized business. My guess is that the debt will probably go to the specialty company given their ability to service it.

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IPO Process. The biggest disaster scenario would be low/little appetite in the IPO of the specialty business causing Hallmark to withdraw the offering. This would result in cash outlays for the offering without getting it done. Given the historic performance of that business and comparable companies, I think the odds of this are pretty low…