Heritage Insurance ($HRTG) — Initiation (11/1/21)

Price: $6.50 Market Cap: $183m Valuation: 0.4x P/B Category: Option

$HRTG 10yr chart
$HRTG 10yr chart

Heritage is a small-cap insurer with a $180m market cap and the stock is down 34% YTD and 65% since 2018!

Background…

Heritage is / was a coastal-based property and casualty insurer covering personal and commercial residences. Back in 2015, this business was 100% exposed to Florida so they’ve done a good job of expanding the coverage base. The coastal exposure is seen as a negative due to extreme weather events popping up frequently and unexpectedly which can wipe out huge chunks of book value if unprepared. Earnings tend to be flush when weather is light and they get hammered when extreme weather rolls in…

Insurance coverage distribution

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Here’s a quick overview of how the company progressed from an exclusively Florida insurer to a multi-state coastal insurance company:

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Financial overview…

The 2020-2021 periods have been particularly heavy on the weather and Heritage is feeling the financial impact. For example — revenue has grown 17% from 2018-2020 but loss expenses have ballooned nearly 60% by $136m!

2018-2020 P&L

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Through 1H21, loss expenses are up another 35% YoY sending Heritage into a net loss of close to $10m. To pile it on, they announced another $51m in weather-related losses coming in Q3!

1H21 P&L

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Lately it seems like this company is getting dumped on but historically they’ve had good earnings, good revenue growth, and combined ratios in the 90-95% territory:

2015-2019 selected financial data

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To sum it up — this is a profitable albeit cyclical insurance business with periods of good (or even great) earnings in less weather-driven years vs. heavy losses during periods with extreme weather events.

What about how they’ve spent their cash?

Since 2018 (i.e. 3.5 years) — management spent $48.8m on repaying debt, $28.2m on share buybacks, and $23.5m on dividends (current yield is ~3.7%). There were no acquisitions during this period.

On top of that, cash on hand has grown from $153m to $447m! (They’ve left no / little hints as to how that cash will be deployed in the future.)

Valuation…

Obviously, the weather-related losses shouldn’t last forever — but it’s (nearly?) impossible to predict when these will or won’t happen. The latest weather events have sent the stock and book value down. Price to book is down to ~0.4x, way below the 5-year average of 0.9x.

5yr P/B ratio and BV per share

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So book value is likely to fall again in Q3 after the latest series of weather losses. But probably not to the full extent of the $51m announced losses.

Heritage has also done most of the hard work in comparing themselves to other coastal insurers for us…

HRTG comps

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The problem with this table is that Heritage has made a few acquisitions over the years and carries some intangible assets… When comparing price-to-tangible values, the stock looks more in-line with peers.

My Comps

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Few quick comments here —

  • I consider $UVE to be the true peer as $UIHC and $FNHC are both far more levered and have struggled with growing book value; they deserve to trade at a deep discount
  • Heritage has had better book value growth over the past 3 years but trades at a deeper discount to book
  • Heritage / UVE have/had comparable ROEs and assets/equity lately
  • Despite the higher levels of debt, Heritage is carrying $447m in cash vs. $425m equity / $2.35bn total assets / $183m market cap — this is a huge safety net for paying claims or deploying cash

Leading up to the pandemic, both UVE/HRTG were historically trading at close to 1.6-1.8x tangible book value — this would fetch a $12+ share price without any further growth.

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Looking at the situation another way — Heritage typically earns a 90-95% combined ratio in non-cat years. On trailing net premiums of $578m that would be $29m+ in underwriting income. Tack on ~$14m investment income (2% of $700m investment portfolio) and another $14m for other revenue (policy fees and rental income on owned property) and you have $57m EBIT. Interest takes away $8m and 30% in taxes leaves us with $34m net income or ~$1.20 per share. My $12 target price would be 10x earnings which is still quite a bit lower than the 14x+ multiple during the 2018-2019 period.

How I’m playing this one…

Heritage is a classic beaten up cyclical stock (with good reason). The main culprit (extreme weather-related losses) shouldn’t last forever and when profitability returns, so should a normal multiple of earnings and book value.

I don’t consider this a great business and I’m not sure I’d want to hold onto it even at a “reasonable” multiple. It does look like a good trade to re-rate heading into 2022 (barring any major hurricanes!).

This one falls squarely in my Option bucket with good upside in a return-to-normal scenario but a very hard to quantify downside scenario. I like the fact that Heritage has built up considerable cash on the balance sheet as a buffer. But with Q3 earnings set to be another major loser, it may take some time for this one to play out… I expect to start seeing the re-rate in early 2022.