Purchase #10: Tower Limited
One of the things I struggle with most with my ‘Buy’ pieces is the overlap between explaining what the opportunity is – which is easy – and explaining the thought process and research that lead to me believing that it is an opportunity – which is hard. Doing both at the same time usually leads to a convoluted thought process, like with my (now sold) Mayne Pharma (ASX: MYX) investment. I do not want to publish 60-page screeds covering a stock because nobody will read them.
I will try producing one piece explaining in a very simple manner the investment thesis behind a company, and a separate piece explaining my thinking behind it. This is the former.
I have purchased Tower Insurance (ASX: TWR) as the 10th company for the 10foot portfolio.
Some stats:
- A$212m market capitalisation (337.3m shares on issue @A$0.63 share price)
- FY17 underlying profit after tax of NZ$18m (A$16.5m; P/E of ~13x)
- NTA of NZ$0.90/share as of 30 September 2017
The thesis:
Tower has been underinvesting in its business and has historically been – in my humble opinion – run like a country club. With a CEO-led business turnaround already underway, historical earthquake liabilities now covered, and reinvestment in business capabilities commencing, today’s price is in my opinion not correct. Trading at or below book value, the downside appears minimal while the upside appears meaningful without being stellar.
Tower historically has a cost ratio of ~42% which has moved to around 38% recently. Roughly speaking:
Insurance premiums (revenue), minus claims, minus admin costs = insurance (‘underwriting’) profit.
So a 3%-6% reduction in costs is significant in context, especially if premiums are also growing. Tower thinks a cost ratio below 35% is plausible in the near future, given the scope of improvements, and I think they could go as low as 32% with a proper IT system and >50% online sales (currently 30% of sales are online). IAG’s cost ratio by comparison is around 29%. Tower has a lot of low-hanging fruit and I think it is hard to overstate how much scope it has to improve its core business functions. Until ~18 months ago it did not have an online purchase option, for example.
Dividends are expected to recommence in the next 2-3 years and assuming profit is maintained, a 50% payout ratio would be around a 4% yield at a ~60 cents a share. In between dividends, lower costs, and GWP growth I think Tower is conceivably a 2-4 bagger over the next 5 years. That is not a forecast or a price target, just generally what I am looking for it to achieve. As with all stocks there are a wide range of possible outcomes.
The risks:
- Tower has a ~$40m dispute with Peak Re over reinsurance it purchased following the Christchurch quake. Tower basically passed big liabilities off to its reinsurer, who was not all that happy about it. Tower says it is in the right, and I believe them. However (if I understand correctly) if Tower knew with a high degree of probability that its future liabilities were likely to tap that reinsurance, then the contract may be void and Tower would be left with a hole in its balance sheet. Notably Tower hasn’t received the cash from Peak Re yet so protracted litigation here could lead to Tower having to raise more capital or delay paying dividends.
- Earthquakes, cyclones, etc. I think it is almost inconceivable that Tower will not be a much better business in 5 years, however this does not provide it much protection from freak weather events. Their risk pricing and reinsurance will be important and I hope to interview the CEO quite soon on these topics.
- Competitors Suncorp and IAG have about 70% of the market stitched up between them. I think Tower has viable sources of distribution, including via alternative platforms like Airpoints and TradeMe. I don’t see it getting squeezed out of the market, but it is a risk. I see Tower as a viable third competitor to majors that are already coordinating their pricing, according to the NZCC.
- Key man risks. I rate CEO Harding quite highly and his departure would be a concern. I also think that management and the board are unaligned with shareholders which is another key risk. To be fair, they have been very shareholder friendly so far, but on paper their alignment is not great. I have further comments on alignment in my longer piece (link below).
- Sale of cap raising shares. One of the reasons I kept this idea to myself for a while was because I expected a major wash out of shareholders following the recent capital raising at $0.39. That’s basically a 50% profit to anyone who subscribed (I am surprised that some people did not) and in between that and underwriter Goldman I expected major falls in the share price, given low liquidity. I didn’t want to declare I was buying the company at $0.60 and then have to sit through the public collapse in shares (+ the criticism) when it fell to $0.40. While that hasn’t happened to date, there is still a chance that it may.
Brief background:
(I have more extensive background in a lengthier piece here. Not all things from this piece will be in that one and vice versa, so if you are interested in Tower you should read both.)
Tower recently raised capital to cover liabilities from the Christchurch earthquake in 2011. CEO Richard Harding joined Tower in 2015 after a solid 6 years at TIO in the Northern Territory.
(Old TIO annual reports can be found here: http://www.territorystories.nt.gov.au/jspui/handle/10070/242199 )
Tower has poor computer systems and weak internals. One major shareholder described the company as having ‘low hanging fruit in every area of the business.’ Even so, Tower has seen improving retention, lower costs, and decent GWP growth over the past ~2 years under CEO Harding. With the Christchurch liabilities (hopefully) behind it, Tower is going to reinvest in a new IT system and a number of other initiatives including simplifying its policies and so on.
For example, Tower previously had three separate teams for selling, renewing, and updating a policy. The company does not have address-based pricing. Until recently Tower did not have an online sales option, did not have a preferred supplier network for vehicle repairs, and had over 300 policy types that had not been repriced or been updated for ‘years’. This is basic stuff (albeit not simple) that other insurers implemented 10 years ago.
The 2015 AGM speech from CEO Harding sums up a lot of what’s been happening. I think he’s the real deal, even if the Chairman’s responses to questions at the bottom were pretty toothless:
Note this link will download the 2.6mb PDF file directly to your device:
In short I think there is a lot happening and, despite the risks, Tower appears both overlooked and attractive. Here is a link to a substantially more detailed post on the company.
On 5 October 2017 I purchased 700 shares at $0.765 for a total of $550.45 after brokerage. ($0.786 /share)
On 14 November 2017 I purchased 900 shares at $0.625 for a total of $577.45 after brokerage. ($0.642 /share)
On 20 December 2017 I subscribed for 1600 shares at $0.39 from the capital raising for a total of $624, with no brokerage. ($0.39/share)
I now hold 3200 shares with a total cost of $1,751.90 for an average price of $0.547 per share including brokerage. This is currently approximately a 17% portfolio position, although as I mentioned in the recent quarterly I will be doubling the portfolio size. Following this it will be around an 8.5% stake.
I own shares in Tower insurance. I have no position in any other business mentioned. This is a disclosure and not a recommendation.
Comments: 3
I own them too.. also bought post bid rejection and cum 39c issue so not too much wrong there for now.
2-4 bagger is a stretch
TWR are cheap and can go up towards NTA but destined to always a sub scale player.
Hence not too much bagger-ing
Thanks for nice report on TWR opportunities management etc
Snej
I own them too.. also bought post bid rejection and cum 39c issue so not too much wrong there for now.
2-4 bagger is a stretch
TWR are cheap and can go up towards NTA but destined to always a sub scale player.
Hence not too much bagger-ing
Thanks for nice report on TWR opportunities management etc
Snej
Hi Snej, thanks, glad to see someone else in the market also sees the value in Tower. I am definitely not forecasting here because there is a wide range of possible outcomes. Basically I have seen an attractive situation and bought it – now I wait to see how it turns out.
I agree that a 4x is quite unlikely. However I think if you use some rough assumptions such as 3% GWP growth per annum, a 3%-6% reduction in the cost ratio, and a ~5% yield per annum (at my purchase price of $0.55) a 2 bagger in 5 ish years is plausible. If interest rates go higher and they can also claim market share, and I’m not betting on it, but historically their share has been around 10% (currently 5%), there is an outside chance of it growing further.