XL Capital: UBS Still Bullish After Recent Run-up

I was planning to write an update on XL Capital (XL) after the company filed its first quarter 10-Q on May 8th, but decided not to when I realized that UBS P&C insurance analyst Brian Meredith had already stated very well what I wanted to say (and more) in his May 4th report on XL entitled, “Asset Valuation Nearing the Bottom?”

Here are the headlines from his report:

  • Investment marks appear to be nearing a bottom
    • Corporate bonds marked below 1930’s default rates
    • Marks appear to be positive QTD
  • Top line might decline less than guided, but increasing risk of large losses
    • Improving industry fundamentals – and confidence in XL – could spur growth
    • Greater emphasis on short-tail cat-exposed lines could increase loss volatility
  • EPS estimates reduced slightly due to lower yields on investment portfolio, mainly due to continued de-risking
  • Price target of $15 maintained based on 12-month forward BVPS

It takes guts and conviction to call a stock “cheap” after a 150% YTD run-up (stock was at $10.84 as of his report), and to call a bottom on an insurance company’s investment portfolio marks (ok, he hedged with the question mark, but so did I in my Feb 5th article arguing that the stock was poised to “pop”).

Anybody who has access to UBS research and some interest in the insurance industry would be well served to read Brian’s reports on P&C insurers.  He does exceptional work and has a great record.

As I mentioned in a “tweet” three weeks ago, I also maintain the $15 price target shown in my November 25, 2008 article, “Reinsurer Stocks: A Fear-Driven Market Creates Opportunity.”

(Disclosure: The author is long XL)

Disclaimer: This website is provided for informational purposes only. Nothing on this website is intended to provide personally tailored advice concerning the nature, potential, value or suitability of any particular security, portfolio or securities, transaction, investment strategy or other matter. You are solely responsible for any investment decisions that you make. Terms of Use: By using the site, you agree to abide by the Terms of Use, which includes further copyright information and disclaimers.

Jamba Inc. – New CEO Gives Company a Boost

The market’s valuation of Jamba Inc. (JMBA) seems to reflect a consensus view that this chain of 729 smoothie stores will not survive.  After a review of JMBA’s fourth quarter and full-year 2008 results, and several calls with management, I disagree. I predict that this company will not only survive but thrive.

The company still faces extremely weak retail sales traffic, and a consumer that is cutting back on discretionary, premium-priced items.  However, the company’s new CEO, James White, has a good understanding of what it takes to succeed in this environment, and is quickly reorienting the company’s offerings to deliver what today’s consumer wants – healthy, convenient, fun food at an affordable price.  His vision and passion, combined with intense focus and a sense of urgency, are exactly what the company needs right now.

In the analysis below, I discuss (click to skip to section):

  1. Current Valuation and Consensus View
  2. New CEO: Focused and Results-Oriented
  3. Strategy and Execution
  4. Risks and Opportunities
  5. Financial Projections
  6. Potential Future Valuation and Catalysts

Current Valuation & Consensus View

jmba-value-jpg3A recent share price of $0.47 implies an enterprise value (equity + debt – unrestricted cash) of $25 million – approximately 0.6x store-level EBITDA and about 3.3x adjusted EBITDA, based on my 2009 forecast.  For comparison, PEET trades at about 7.9x EBITDA, and SBUX trades at approximately 7.6x EBITDA.  QSR concepts SONC and JACK trade at about 6.7x EBITDA.

The common viewpoint seems to be that: (a) JMBA’s business model is not viable, and (b) the company will run out of money before management has time to figure things out.

In 2006 and 2007, the business model was indeed broken outside of California, and deteriorating in California.  A smoothie may provide a boost of energy, but it is not a cup of coffee.  Coffee drinking is a habit, often repeated several times a day.  Even regular smoothie drinkers are unlikely to average one per day, let alone several.  Yet prior management acted as if a smoothie could replace coffee and JMBA could be the next Starbucks.  They opened stores too close to each other, and in suboptimal locations.  New stores outside of California had AUVs well under $600,000 and even CA store AUVs were dropping (especially for stores not included in comp store figures at the time), but JMBA’s cost structure, at both the store level and at corporate, was geared toward a system with $800,000 to $1 million AUVs.  Cash flow margins for stores outside of CA were in the single digits.  California store margins were still over 20% for seasoned stores, but newer store margins were only in the teens.  New stores in general were not even getting close to management’s target of 20% store-level EBITDA and 40% cash-on-cash returns.  Meanwhile, comp stores in 2006 and 2007 were flat.

This broken business model and a flawed growth strategy – along with the purchase of stores from franchisees – caused JMBA to blow through its $100 million in post-IPO cash reserves and get in trouble, or at least too close for comfort, with its banks.  This forced the company into an extremely costly debt financing – with $25 million coming due in less than 18 months.

Looking back over the last year, what we see is a company that:

  • Is suffering double-digit declines in comp store sales because it sells the sort of expensive indulgence on which consumers are cutting back;
  • Has not been able to articulate a strategy to fix the store-level business model;
  • Cannot afford to build new stores;
  • Might not have a profitable enough business model to attract new franchisees; and
  • Has less unrestricted cash on hand than necessary to repay its debt, and no proven ability to generate cash from operations.

Yes; this is pretty scary stuff.  However, over the last several months, the company has reduced its costs, store labor and SG&A in particular, and closed a number of underperforming stores.  Under James White, who joined JMBA last November, the company has developed a more focused strategic plan, and will further reduce costs while growing its product offering and franchise system.  The combination of a store model that now works better at lower AUVs, and an increase in AUVs through menu expansion, should be effective.  The picture looking ahead shows promise.

New CEO: Focused and Results-Oriented

JMBA’s new CEO, James White, is an experienced brand builder, product developer, and foodservice operator.  He came from Safeway, where he ran an $8 billion retail brand P&L, which included responsibility for brand strategy, R&D, product development, and manufacturing (prior experience includes Gillette, Purina and Minute Maid). He built the “O Organics” line of products for Safeway, through which he developed an extensive rolodex of organic food contract manufacturers.  The line was so successful that Safeway began offering it to other grocery retailers last fall.  He also knows multi-unit foodservice.  Safeway’s in-store foodservice business – essentially a restaurant chain within a grocery store chain – is bigger than Quiznos.

He sees that the brand equity of Jamba Juice is more in the “Jamba” than the “Juice” and that Jamba can grow to be a leading healthy lifestyle brand with broad application and appeal.  But he is not letting these big ideas distract him from the necessary task of creating the maximum positive impact in the least amount of time.  To this end, he has the team focused mainly on four key initiatives:  retail food, franchising, wholesale food/licensing, and local store marketing.

Strategy and Execution

Retail Food – JMBA wants to build a retail food capability across all four day parts (breakfast, lunch, afternoon, and dinner).  Oatmeal has exceeded management’s expectations.  In the coming months, the company will begin rolling out items for other day parts, likely focusing on high-traffic metro area stores where oatmeal has had the greatest uptake.  The company is focused on food items that, like its smoothies and now its oatmeal, are superior to the offerings of competitors, have high margins, are relatively simple to execute in the stores, and are consistent with the Jamba brand’s promise of great tasting, healthy, convenient, fun, on-the-go foods.

I estimate that breakfast and lunch could add $45,000 to $75,000 of annual sales per store ($30-50k of food sales plus an additional $15-25k of blended drink sales from the incremental customer base).  Since food will probably not work equally well in all locations, I would assume that perhaps 75% of stores benefit.  Thus, the overall impact on company-wide same-store sales would be in the range of 6-9%.  I expect minimal impact in the first half of 2009, and very little impact until 2010.

Franchising – JMBA has halted new company-owned store development for now, focusing its current efforts on improving the performance of its existing stores and growing its franchise system.  As of December 31, 2008, 511 stores (70%) were company-owned and 218 (30%) were franchisee-owned.  The company is now targeting something closer to a 50/50 mix. As part of this effort, JMBA is seeking to “refranchise,” or sell back, certain stores to franchisees (so far, ~30 stores have been identified for refranchising, of which the first 10 were sold this month).  For new franchised locations, JMBA is increasing its focus on “non-traditional” locations such as airports, which have been very successful to date.  This shift to a more balanced company-owned/franchised mix will help preserve capital, and lead to higher overall profit margins.

I made some rough estimates of the economics of a new store for each of three types of locations: suburban strip centers, urban metro areas, and airports.  The figures show that the economics of airport locations probably work very well today, which explains why JMBA is focusing on these now.  The suburban and urban metro “traditional” stores are probably adequate for an existing franchisee who can share some labor among stores, but probably fall slightly short of the return required to attract significant numbers of new franchisees.  With food, these locations should provide sufficient returns for a robust franchising model (once franchise capital is generally available again).


Wholesale Food/Licensing – White wants to capitalize on one of the things prior management did well: build a strong brand.  JMBA has now hired a senior executive, Susan Shields, to lead a branded CPG effort.  It is focused on licensing, but could include products that are contract manufactured for, and sold by, JMBA or through a JV.  The company has had discussions with potential partners regarding fruit teas, fruit yogurt and parfaits, frozen smoothie bars and sorbets, breakfast and energy bars and packaged boosts.

A successful offering in any one of these packaged food categories could be a $50-$100+ million business, so it is conceivable that a wholesale food effort could deliver $3-5 million per year, or more, of incremental cash flow.  Also, while Nestlé has shelved the licensed RTD smoothie line launched last year, JMBA’s 2008 10-K states, “We believe Nestlé is fully committed to re-launching a Jamba ready-to-drink beverage proposition.”

Local Store Marketing – The company believes that it can reduce spending on traditional advertising and marketing, and more efficiently build store traffic by focusing on “owning the two-mile radius” around each of its stores.  This effort includes off-premise sales such as at schools, and community and sporting events.  It also includes store-level sales incentives, and a greater emphasis on working with non-profit groups for fundraising.

In the short term, this will probably only serve to reduce the decline in same-store sales.  Assuming that retail sales are only just now beginning to bottom-out, without a food program and any enhanced efforts to drive traffic, same-store sales would be negative at least through year-end.  A successful local marketing program should mitigate the decline this year and help drive positive comps next year.

This seems like a lot for a small company to accomplish at once, but according to management, the team is actually focused on doing fewer things, but doing them better, and with a stronger sense of responsibility and accountability.  For example, in the past, development of new food items and licensing opportunities were projects added to somebody’s “normal” work schedule.  Now these initiatives are being driven by people who’s jobs are at stake if these initiatives are not successful.  My sense is that this greater focus and accountability has created a sense of urgency, and a level of positive energy at the “support center” (i.e., corporate office), that has not existed in years.

Risks and Opportunities

A lot could still go wrong, and, as shown in my financial projections, management does not have a lot of cushion.  Some of the many risks to a turnaround include:

  • Higher unemployment rates expected this year could potentially drive overall retail sales and consumer spending significantly lower.
  • The roll-out of lunch items into certain retail stores, which should kick off this spring, might not go smoothly.  Management is making decisions quickly and will recalibrate in the field if/as necessary.
  • Competitors could respond to the food launch with enhanced promotions and other tactics.
  • Costs for fruits, juice concentrates, dairy and other food ingredients are volatile and could spike up due to demand or supply shocks.
  • Weather could have a negative impact on sales and food costs.
  • Gas prices could have a negative impact on sales and food costs.

Of course, there are many other risks, from food-borne illnesses to increased labor and benefits costs.  One can pick up the latest 10-K for the usual laundry list.

However, I believe that with its new leadership, this team can navigate through the current economic environment and execute a successful turnaround.  The current store-level business model works better than one might think, and the strategic shift from a smoothie chain to healthy lifestyle brand will add to both sales and profits.  At a minimum, things should get better.  If management delivers completely on both the tactical turnaround and the strategic changes, the growth will be dramatic:  The strategic shift will not only add to the sales and profits of existing stores, but also (a) substantially increase the number of potential retail sites, and (b) create significant interest in the franchise community.

Financial Projections

Below is a summary of the company’s financial performance in 2007 and 2008, as well as a forecast for 2009.  In the first table, I show annual sales dropping 7.5% to $317 million in 2009.  I assume that food costs average 26.5% of sales versus management’s target of 26%, and labor costs average 36% of sales versus a target of 34%.  The second table shows the 2009 quarterly forecast, and assumptions for same-store sales.  It also shows the resulting trailing 12-month store-level EBITDA and projected unrestricted cash levels.

Same-store sales are modeled assuming two-year cumulative comps, before any impact of new food items and other initiatives, down 15% in Q1’09, and down 14% for the rest of the year.  The new retail food initiative is assumed to add just slightly to comp stores later in ’09.  No sales are included for wholesale/licensed food.  Store growth assumes no new company-owned stores and 50 new franchised locations, per management’s guidance.  The pro forma impact of refranchising 10 Arizona stores is included, but no additional store sales are included.  There is no specific impact for local store marketing, although one could assume this is reflected in the 1-point improvement in compound comps after Q1’09.

These projections show JMBA with a seasonal loss in Q1 but significant positive cash flow in Q2 and Q3 this year.  Store-level EBITDA remains comfortably above the $35 million covenant level.  Unrestricted cash rises to roughly the amount of the company’s outstanding debt in Q3 of this year, then falls to $14.7 million in Q4 after seasonal losses.  Even if comps are roughly 5% down in 2010, the company should still generate enough additional cash to repay the debt when it comes due in September 2010 (although it would be tight).  Successful implementation of the company’s current growth initiatives should provide substantial upside beyond this scenario.


Quarterly projections are shown below:


Potential Future Valuation and Catalysts

It will be hard to get excited about Q1 results, but a performance in Q2 like that projected above should demonstrate that the company is on the road to recovery.  This could be a catalyst for a significant improvement in the company’s valuation.  Growth in enterprise value to 1.2x ’09 projected store-level EBITDA, or 6.7x ’09 projected EBITDA, would bring the equity market cap to $55 million, or $0.95 per share.  This is my six-month price target. My 12-month target is $1.30 per share (unchanged from December).

Short covering could accelerate this adjustment.  At current prices, there is very little volume.  With short interest of 2.3 million shares as of 3/31/09, “days to cover” was over 31 (see chart here).

An increase in market cap could create an virtuous upward cycle.  Currently, investors who want to own less than 5% of the company are capped at an investment of just over $1 million, which is just not meaningful for many institutional investors.  As JMBA’s valuation improves, the stock will become more relevant.

Another potential catalyst would be coverage by a major sell-side analyst.  Recent investments in JMBA by PE group CIC Advantage and value fund manager Royce & Associates may help renew interest in the analyst community.  A restaurant industry analyst from Piper Jaffray was on the last earnings call.  I would not be surprised to see them pick up coverage again once the company demonstrates more progress on its turnaround.

(Disclosure: The author is long JMBA)

Copyright © 2009 by John G. Appel. All rights reserved. You may link to any Content on this website. You may not republish, upload, post, transmit or distribute any Content without prior written permission. If you are interested in reprinting, republishing or distributing Content, please contact John Appel via the e-mail address shown on this website to obtain written consent. Modification of Content or use of Content for any purpose other than your own personal, noncommercial use is a violation of our copyright and other proprietary rights, and can subject you to legal liability. Disclaimer: This website is provided for informational purposes only. Nothing on this website is intended to provide personally tailored advice concerning the nature, potential, value or suitability of any particular security, portfolio or securities, transaction, investment strategy or other matter. You are solely responsible for any investment decisions that you make. Terms of Use: By using the site, you agree to abide by the Terms of Use, which includes further copyright information and disclaimers.
www.aptacapital.com John Appel

XL Capital: Short Interest Poised to Drop – Will the Stock Pop?

XL Capital (XL) is a company that the market loves to hate. Its stock price has plummeted by 94% over the last twelve months, mainly over concerns about its investment portfolio.  (For a more in-depth discussion of XL’s past troubles, please see my article from November 25th, “Reinsurer Stocks: A Fear-Driven Market Creates Opportunity.”)  The stock could tick up a bit in connection with the unwinding of hedges related to forward share purchase contracts that settle on February 17th.  The company’s fourth quarter earnings call on February 11th could also bring positive news that lifts share prices, perhaps accelerating the hedge unwinds, and potentially leading to further short covering.

Short interest in XL stock is the highest of all commercial lines insurance companies as a percentage of float, at 9.3%, according to a recent Credit Suisse report. One might be tempted to view this as a sign that many investors believe the stock is headed to zero soon.  However, there is more to this story.

Most of these short sales are likely to be hedges rather than speculative plays.  XL has entered into forward sale agreements on up to 47.4 million common shares.  Much of the current short interest of 30.5 million shares is probably related to hedges of these agreements.

Equity Security Units

The forward purchase/sale agreements are part of $1.32 billion of outstanding “Equity Security Units” comprised of:

•    $745 million of 7% Equity Security Units sold on December 9, 2005 (prospectus), and
•    $575 million of 10.75% Equity Security Units sold on August 5, 2008 (prospectus).

Each unit consists of a portion of a note and a contract to purchase a like amount of common shares at a minimum price.  The minimum price to be paid by holders of the 7% units is $65 per share.  Quite a premium compared to today’s price of under $3 per share!

The Equity Security Units are a bit complicated, but essentially what happens is that on the “settlement date,” the unit holders are required to purchase shares of common stock at some price between the minimum price and a maximum threshold price.  At the same time, the related notes are remarketed.  That is, they are reoffered for sale at a new interest rate intended to bring the price (net of a small remarketing fee) back to par.  If the notes are successfully remarketed, the unit holders use the proceeds of the remarketing to fulfill their common stock purchase obligations.  If the notes are not successfully remarketed, XL can use the notes to fund the common stock purchases.  Thus, from XL’s perspective, the worst case is that the units act like convertible debt that converts on the settlement date.  The best case is that the notes remain outstanding after a successful remarketing, and the purchased common stock is incremental new capital.

Partial Hedge Unwind Coming

The settlement date for the 7% units is February 17, 2009.  The unit holders will be required to purchase an aggregate of 11.46 million common shares for $65.00 per share, or $745 million in total. (XL hired Goldman Sachs to remarket the notes.  To the extent they are successful, the common share purchase will constitute incremental capital.  If Goldman is not successful, the notes will effectively “convert” into common at $65 per share – adding to common equity but not total capital.)

The chart below shows that less than half of the 7% units were hedged while the common stock was trading well above the minimum forward price.  As the stock price broke through $65 per share, short interest grew, reaching about 12 million shares as the price passed through $40 per share.  At that point, the 7% units were probably fully hedged.  Short interest popped up by over 10 million shares, to approximately 25 million shares, when the 10.75% units were issued.  Short interest approached its current level of 30.5 million shares last October, as the stock price fell below $10 per share.


If all $745 million of stock purchase obligations related to the 7% units are hedged with short sales, short interest should decline by at least 11.5 million shares near the contract settlement date of February 17th.  The stock could see some upward pressure as these short sales are covered, although the impact would be small, as the covered shorts would represent just over 1x average daily trading volume.

Earnings Call

The impact from short covering could be eclipsed by reactions to the company’s fourth quarter earnings announcement on February 10th and analyst call on February 11th.

XL’s shares reached a low closing price of $2.68 last December after the company announced that mark-to-market and impairment losses on its investment portfolio as of December 10th would be consistent with amounts for the prior quarter, or approximately $1.1 billion, and, as a result (i) analysts cut prices targets significantly, and (ii) S&P, Moody’s, and Fitch cut XL’s ratings again.

The main reason for the negative action by sell-side analysts was concern that additional investment losses could lead to a need to raise dilutive capital.  As for the ratings cuts, these actually seemed to be driven less by potential balance sheet issues (although these were cited, of course) than by a concern that the company’s financial problems could have damaged its reputation to the point that it could lose a meaningful amount of business at January 1 renewals and beyond, or that it would need to under-price business to retain it, or both.

After rising to $4.69 per share on January 9th, the stock has retested its $2.68 December low.  At this price, which is only about 0.15x book value, the bad news is once again priced in.  It would take a large negative surprise to drive shares down significantly, and anything short of disastrous news should send shares higher.

It does not seem likely that investment losses will exceed last December’s guidance.  Market prices for many classes of securities held by XL – such as high-grade corporates and securities backed by subprime loans and commercial real estate loans – were higher at year-end than at the time XL provided guidance.  Thus, investment losses might come in slightly better than expected.  However, it is more likely that any benefits from lower rates and tighter spreads are offset by additional marks on other asset classes, such as investments in hedge funds.

It is difficult to predict XL’s Q4 revenue and operating profit, and to know how well XL fared in January renewals.  However, there is no indication that XL’s business has fallen off substantially. According to Business Insurance (article), XL’s policyholders are not abandoning the company (although they are watching things carefully), and XL is being offered the opportunity to bid on new business.  However, Business Insurance implied that D&O coverage could be one area where XL may be more vulnerable.

This is consistent with what other insurers have been saying on recent earnings calls.  Some companies have mentioned that risk managers have not been as willing to move business as they had expected.  However, ACE Ltd. (ACE) said that its D&O business has benefited from a significant “flight to quality.”  It is not clear if this has come at the expense of AIG, XL or both.

So far, financial results announced by competitors have been mixed.  However, 2009 guidance has been consistently positive.  Pricing appears to be more rational overall, and has firmed slightly in most lines of business.  Expectations are for further improvement throughout the year.

According to the company’s website, the median analyst estimate for Q4 EPS is $0.35 and the median estimate of book value per share is $21.65, about flat with the prior quarter.  Bloomberg shows consensus estimates of $0.43 for adjusted EPS and $19.36 for BV/shr.  The latter BV/shr figure is more consistent with management’s December guidance on investment losses.  Book value could be reduced further by the impact of a stronger dollar.

On the February 11th call, management should be able to make a convincing argument that the franchise is still very much alive, and that profitable growth will be forthcoming in 2009.  If the company surprises on the upside, positive movement in the stock could be enhanced by some short covering beyond the unwinding of hedges on the 7% Equity Security Units.

(Disclosure: the author is long XL, as well as ACE, AXS, PRE and VR)

Copyright © 2008-2009 by John G. Appel. All rights reserved. You may link to any Content on this website. You may not republish, upload, post, transmit or distribute any Content without prior written permission. If you are interested in reprinting, republishing or distributing Content, please contact John Appel via the e-mail address shown on this website to obtain written consent. Modification of Content or use of Content for any purpose other than your own personal, noncommercial use is a violation of our copyright and other proprietary rights, and can subject you to legal liability. Disclaimer: This website is provided for informational purposes only. Nothing on this website is intended to provide personally tailored advice concerning the nature, potential, value or suitability of any particular security, portfolio or securities, transaction, investment strategy or other matter. You are solely responsible for any investment decisions that you make. Terms of Use: By using the site, you agree to abide by the Terms of Use, which includes further copyright information and disclaimers.

Jamba Juice Should Bear Fruit by Mid-2009

Smoothie chain Jamba, Inc. (JMBA) lost $113 million in 2007 and an amazing $258 million for the twelve months ended October 7th, driving its market cap down to $36 million from over $500 million. Institutional investors have taken their losses and moved on.  Insiders and individual investors now own nearly 90% of the shares.  Mainstream sell-side analysts no longer cover the company because it is just too small – in terms of market cap – to matter to their clients.

Thus, it is likely that few people recognize that JMBA is profitable at the adjusted EBITDA level, and fewer still are likely to have gone through the exercise of translating management’s guidance into projections for 2008 and 2009.  This is just the sort of stock for a value investor who likes to do their own research and analysis.

The chart below shows adjusted EBITDA for 2007 and the latest 12 months ended October 2008, along with my forecasts for fiscal years 2008 and 2009 based on management’s publicly disclosed guidance.


Q4 Forecast

In Q4 of this year, store revenue is forecast down 5% versus last year to reflect double-digit negative comps, offset somewhat by sales from new stores.  Cost of sales is 27% versus management’s target of 26% for next year, due in part to the launch of oatmeal.  Labor is down slightly versus last year to reflect closed stores, offset by higher hourly rates.  Occupancy and store operating costs are down slightly from last year to reflect closed stores.  The resulting adjusted EBITDA loss is not far from the $12.18 million loss realized in Q4 ’07.

2009 Forecast

The 2009 forecast is based on the assumption that comp store sales are down 10-12% in Q1, down 8-10% in Q2, and flat during the second half of the year.  Costs and expenses are based on management’s guidance on the last earnings call.  If management can hit their targets for 2009, the company will generate nearly $20 million of cash flow – more than enough to meet its capital expenditure requirements.  Given the company’s cash balance of $28 million (excluding restricted cash) as of September 30th, management will have some cushion in the event that actual results do not meet these projections (although I expect this cushion to be reduced by losses in Q4 ’08 and Q1 ’09).


JMBA has taken numerous actions to reduce costs, which should bear fruit next year.  In 2009, the main challenge will be revenue growth.  The projections do not reflect any significant changes to the status quo.  We will not have real visibility into management’s plans to grow the company until we hear from new CEO James White (probably on the Q4 earnings call).

Even if one discounts management’s guidance, the company should be cash flow positive next year.  However, as management said in the last earnings call, JMBA is not expected to turn the corner until mid-year.

Due to the seasonality of the business, the soft retail environment and generally compressed consumer spending, I expect that Q4 ’08 and Q1 ’09 will show significant operating losses, which will limit upside potential in the stock in the short term and may take the price down.  As seasonal growth and a lower cost base begin to drive cash flow in late Q2 of next year, the stock price should begin to improve.  My current price target is $1.30 per share, although this is somewhat in flux until JMBA’s new CEO provides insight into how he views the business and what his plans are to grow and improve it.

(Disclosure: The author is long JMBA)

Copyright © 2008-2009 by John G. Appel. All rights reserved. You may link to any Content on this website. You may not republish, upload, post, transmit or distribute any Content without prior written permission. If you are interested in reprinting, republishing or distributing Content, please contact John Appel via the e-mail address shown on this website to obtain written consent. Modification of Content or use of Content for any purpose other than your own personal, noncommercial use is a violation of our copyright and other proprietary rights, and can subject you to legal liability. Disclaimer: This website is provided for informational purposes only. Nothing on this website is intended to provide personally tailored advice concerning the nature, potential, value or suitability of any particular security, portfolio or securities, transaction, investment strategy or other matter. You are solely responsible for any investment decisions that you make. Terms of Use: By using the site, you agree to abide by the Terms of Use, which includes further copyright information and disclaimers.

Reinsurer Stocks: A Fear-Driven Market Creates Opportunity

Catastrophes both natural and man-made have been hitting reinsurance companies, but the outlook is good.  Shares of all the reinsurance companies were pummeled in October, with the combination of Hurricanes Ike and Gustav hitting underwriting profits while the capital markets carved a mark-to-market chunk out of investment portfolios.  Things seemed to improve around Halloween and into November, as signs of “hardening” premium rates began to emerge.  But shares have recently retested their lows as the dysfunctional capital markets – especially for mortgage- and asset-backed securities – overshadow improving fundamentals for the group.  This has created opportunity for the intrepid value investor.

* Does not include AIG, BRK, and XL.

I evaluated a dozen reinsurers based on factors including:

  • underwriting and overall profitability;
  • historical and expected premium growth;
  • financial strength ratings;
  • fixed income portfolio make-up, duration and average ratings;
  • financial leverage; and
  • capital adequacy.

Table 1 lists these companies in order of total capital, along with relevant market value multiples, some key performance metrics, and my per-share valuation of each company based on fundamental analysis (except for AIG (AIG) and Berkshire Hathaway (BRK-A), which I include for comparison but don’t value).  Table 2 provides information on their investment portfolio quality.  Table 3 shows debt-to-capital ratios and a ratio I use a rough indication of capital adequacy: the ratio of cash and investments to loss reserves.

Table 1 – Reinsurer Market Multiples, Key Metrics & Target Price
* Medians exclude Berkshire Hathaway and AIG. See endnotes for an explanation of terms and calculations.

The companies that trade (as of 11/24/08) at the steepest discount to my estimated “fundamental” values are ACE Limited (ACE), Axis Capital (AXS), PartnerRe (PRE), Validus (VR), and XL Capital (XL).  Below is a brief discussion of each company:

Table 2 – Fixed Income Portfolio Quality
* Medians exclude Berkshire Hathaway and AIG. See endnotes for an explanation of terms and calculations.
  • ACE Limited, founded in 1985, is a Zurich-based leading global property & casualty, life, and accident & health insurance company and reinsurance company with operations in more than 50 countries.  Its ACE Tempest reinsurance operations are well respected but comprise less than 10% of ACE’s consolidated net written premiums.  Reinsurance net written premiums are down over 22% YTD, but its prospects for growth are good, as ACE has the scale and reputation to capture significant business from AIG at January renewals.  ACE has the best YTD combined ratio of the group.  The quality of its fixed income portfolio is about average for the group, and its make-up and duration are consistent with its insurance business mix.  As of 9/30, ACE had $5.5 billion of asset-backed securities (“ABS“) and non-agency mortgage-backed securities (“MBS“) in its portfolio, including $2.3 billion of commercial mortgage-backed securities (“CMBS“).  Given that spreads have recently skyrocketed for these securities (see chart, below), ACE is likely to report more unrealized investment losses in the fourth quarter (a 100 basis point yield increase equates to a +/-350 bp price reduction on a portfolio with a 3.8 year duration, or over $1 billion on ACE’s $36 billion fixed income portfolio). These unrealized losses should have little real impact because ACE should not need to sell its structured securities (at least not in this market), but it seems that investors need little incentive to punish a stock these days, so value investors should see further buying opportunities.
    CMBS Spreads
    click image to enlarge
  • Axis Capital is a Bermuda-based specialty P&C insurer and reinsurer, founded in November 2001.  Reinsurance is the majority of its business.  Property, professional lines and catastrophe are its largest business lines, representing 26%, 21% and 16% of gross premiums written.  These businesses should all see firming rates in 2009.  Its fixed income portfolio is higher rated on average than most at AA+ and the average duration is shorter than most at 2.9 years.  It includes $1.7 billion of ABS and non-agency MBS (including $860MM CMBS).  The relatively short portfolio duration means that an increase in credit spreads not only will have less effect, but also is more likely to be offset by yield curve changes.  One potential portfolio risk is the $636 million of hedge funds, credit funds and CLO equity tranches, for which marks vs. cost are not disclosed.  However this exposure is only 13% of book value.  AXS is very well capitalized relative to its current book of business, and its debt-to-capital is the lowest of the group at only 9%, so the company is quite well positioned to grow.  S&P gives it an “A” rating but a “positive” outlook – the only “positive” for the group.  Its management team is strong and seasoned, and its level of capitalization and other metrics are more representative of an A+ company, so it is likely that its relatively short operating history has been the only thing holding it back from an A+.
  • PartnerRe, based in Bermuda, was founded in 1993 and is the 10th largest global reinsurer, with lines of business that are well diversified by risk category and geography.  Premium growth YTD was driven by opportunistic business in the agriculture sector; other lines of business declined consistent with the group (when adjusted for one-time items).  A principal reason for the decline was greater risk retention by ceding insurers.  With insurer balance sheets constrained and little ability to reload in the current capital markets environment, risk retention by primary insurers is less likely to impact growth in the next year or two.  The company is well positioned with its “AA-” S&P rating.  PRE’s combined ratio was an attractive 91.4% despite hurricane losses in Q3, which speaks to the company’s underwriting discipline and ability to generate profitable growth.  PRE’s investment portfolio has only $825MM of ABS and non-agency MBS, although widening credit spreads on its $1.3 billion of finance sector corporate bonds (banks – $600MM) will also have an impact.  Unrealized losses will hit earnings, not just comprehensive income, because PRE elected “fair value” treatment under FAS 159 this year (ACE, AXS, VR and XL continue to flow unrealized losses through comprehensive income, except that ACE made the FAS 159 election for its equity securities).
  • Validus Holdings, based in Bermuda, was formed in December 2005.  Through Validus Re, it is a leading writer of property catastrophe insurance and also writes marine, energy and other specialty, short-tail lines.  VR writes direct insurance through Lloyds syndicate member Talbot, which it acquired last year.  VR was initially capitalized by private equity groups Aquiline Capital, Vestar Capital Partners, New Mountain Capital, and private equity affiliates of Goldman Sachs and Merrill Lynch.  The company went public in July 2007.  VR is very well capitalized for the size of its current business, with cash and investments of 2.7x loss reserves, and debt-to-capital of only 13.7%.  Its “A-” rating from A.M. Best is typical for the Bermuda “Class of 2005” and more indicative of its limited track record than its financial health and operations.  Its combined ratio YTD is still 93% even after Ike and Gustav took it up to 122% in Q3.  ABS and non-agency MBS of $653MM is 34% of book value but the average rating for the total portfolio is “AAA-” and the duration is a low 2.2, which is consistent with its short-tail focus and should provide some cushion against widening credit spreads.  Growth was flat last year (pro forma for Talbot) but VR is very well positioned to grow next year.
  • Table 3 – Leverage and Capital Adequacy
    * Medians exclude Berkshire Hathaway and AIG. See endnotes for an explanation of terms and calculations.
  • XL Capital, based in Bermuda and founded in 1986, is a diversified P&C insurance, life insurance and reinsurance company with 77 offices in 27 countries.  Its reinsurance businesses are ranked among the 12th largest globally.  XL’s situation shows how confidence is much easier lost than regained, and is a good example of how, in today’s environment, investors sell first and ask questions later.  XL’s price/book multiple is lower than AIG’s, and from its stock price trajectory, one would think that XL was headed for the same explosive fate, but without a bailout.  However, XL’s current operating performance, and even the rating agencies that give XL a “negative” outlook, paint a much more positive picture.  The rating agencies say XL has “strong” capital adequacy.  XL’s debt-to-capital ratios in Table 3 do not reflect that $745MM of debt converts to equity on 2/11/09. On a pro forma basis, debt/capital and debt+pfd/capital are a very reasonable at 17% and 27% respectively.  Its fixed income portfolio has an average rating of “AA,” on par with the group, and an average duration of 4.1 years, the same as PRE and lower than Everest Re and Odyssey Re.  XL’s ABS and non-agency MBS is slightly higher than the group as a percentage of book equity, at 77%, but lower than RenaissanceRe (RNR) and Endurance (ENH) as a percentage of total cash and investments.  Its CMBS portfolio is now at $2.4 billion, after $800MM was sold in Q3, bringing it close to ACE’s $2.3 billion level.  Its 10% decline in premiums written this year is about the same as for Everest and RenaissanceRe, and less than Berkshire’s 25% decline or ACE’s 22% drop in reinsurance premiums.  Besides, sacrificing growth for pricing discipline is a virtue.  Its combined ratio of 97.7% YTD is better than Everest (RE), Odyssey (ORH), Endurance and AIG, and about the same as AXS.  None of this explains the 85%+ drop in XL’s share price this year.  There must be more to the story….

A Closer Look at XL

1. Guilt by Association with Credit Default Swaps

Most of XL’s problems stem from the financial guaranty company, Syncora (SCA).  Formerly known as Security Capital Assurance, Syncora was a subsidiary of XL Capital until XL brought its ownership below 50% through secondary market sales following Syncora’s 2006 IPO.  Last year and earlier this year, XL Capital had a real mess on its hands because Syncora was facing serious issues with credit default swaps – very much like AIG – and XL Capital was on the hook for some of the risk.

In addition to the Syncora issues, XL had it’s own challenges, including the integration of several acquired businesses, strengthening its enterprise risk management systems, and de-risking an investment portfolio that had become too heavily laden with mortgage-backed securities.

In March of this year, XL announced that it was bringing in a new CEO, Mike McGavick, to turn things around.  Mike had a great track record of success at CNA and at Safeco, which he substantially turned around in less than a year.  A number of his moves at XL look like they come straight from his Safeco playbook: move quickly and get the financial pain out of the way; look to pay down debt through asset sales; invest in systems in order to wring efficiencies out of poorly-integrated acquired businesses, and ruthlessly drive down costs wherever possible.

CDS = “Collateralized Death Spiral”

Mike’s most immediate challenge was Syncora.  As the credit quality of the debt underlying Syncora’s credit default swaps eroded, it faced the same death spiral – ratings cuts, collateral calls, security sales, capital drain, ratings cuts, collateral calls… – that hobbled AIG.  XL was only a minority owner of Syncora, but as of 6/30/08 still had exposure through guarantees and reinsurance to a whopping $65.7 billion net par value of pre-IPO contracts.

Even though XL’s actual exposure under these contracts was estimated to be only $1.0-$1.5 billion, write-downs related to Syncora were damaging its financial statements – and its reputation.  In July, Chubb was reported to have taken XL off of its approved list of markets for facultative reinsurance.  S&P, Moody’s and Fitch all gave XL a negative outlook, citing its Syncora exposure.

XL needed to get out from under the Syncora cloud fast (and Syncora needed cash), so on August 5th, XL paid $1.8 billion plus 8 million common shares to erase over 98% of this risk through a settlement agreement with Syncora and certain of its counterparties (XL also transferred its remaining Syncora shares to a trust for Syncora CDS counterparties).  This payment was funded with part of the $2.9 billion in new preferred stock and equity units issued this year, so the company’s cash balance was still improved versus the beginning of the year.

XL has put its Syncora exposure behind it, but it has been much harder for the company to undo the damage to its reputation.  It didn’t help XL that at the same time that it announced the earnings hit for the Syncora settlement, it reported over $1 billion in mark-to-market losses on its fixed income portfolio.  Most of the losses were non-cash – approximately $825MM was unrealized losses due primarily to increasing credit spreads.  However, the combination of these charges was enough to trigger rumors that the company was on the brink of insolvency.  These rumors prompted management to host its earnings call before its third quarter numbers were finalized, and to release detailed data on its portfolio.  So far, investors seem unconvinced.  What XL needs is more third party validation.

A.M. Best upgraded its outlook from negative to stable following the Syncora settlement, and said that with McGavick at the helm, Syncora behind it, and its latest round of new capital, the company now has the resources befitting a strong insurance franchise.  However, S&P, Fitch and Moody’s still have a negative outlook.  Chubb has not, as far as I can tell, put XL back on its preferred insurer list.

S&P and the rest actually say some very positive things about XL, but until they change their official outlook, it is likely that investors will focus more on the negative headline than the positive story.  In maintaining its negative outlook, S&P cites “a track record of inconsistent earnings performance; material, though reduced, exposure to large catastrophic losses; susceptibility to further declines in the investment portfolio; and business-integration challenges borne from the relatively rapid building of a very strong and diversified global competitive position.”  However, S&P also makes a number of positive comments:

Pro forma Sept. 30, 2008, capital adequacy is strong and incorporates both the market valuation of XL’s investment portfolio and expected Hurricane Ike and Gustav losses that, though material, were within our expectations. …

We expect XL to produce a strong, steady earnings stream from its ongoing core operations at a level equal to that of similarly rated peers, despite soft market pressures. An accident-year and calendar-year combined ratio of less than 100% and a pretax return on revenue (excluding realized gains or losses) of 15% will result from continued pricing discipline and operating performance, absent an unusually severe catastrophe year. Furthermore, financial leverage (debt plus preferreds including hybrids) will be no more than 40% of total capital when reflecting the February 2009 conversion of $745 million of senior notes into equity, and fixed-charge coverage (excluding noncash and unusual charges) will approach 5.5x in 2008 and 2009.

It seems clear that S&P’s reluctance to lift its “negative” outlook is based more on XL’s history than its present status, and that barring any significant missteps, the outlook will be upgraded.  However, it could take some time.  S&P implies that it will need to monitor results for the next “couple of years” before changing its outlook.

2. Investment Portfolio and Business Risks – Real but Declining and Manageable

Since the Syncora settlement did little to help XL’s stock price, I dug deeper into the two other logical issues: the investment portfolio and the risk portfolio.  S&P and A.M. Best both mention XL’s investment performance, and it is clear from my conversations with people in the industry that there are still concerns about what may be lurking in XL’s portfolio.

I looked at XL’s Q3 credit supplement, which provides a substantial amount of detail on the portfolio, including marks versus par and amortized cost.  I put together a summary of the data, which shows that fair values seem reasonable, especially when considering the true likelihood of nonpayment rather than temporary swings in treasury rates and credit spreads.  XL has $1.3 billion of subprime, Alt-A and second lien loans; however, even the AAA-rated portion of this ($800MM) is carried at 75% of par.  The A-rated portion ($300MM) is carried at only 41% of par.  The combination of actual credit impairments and today’s insane credit spreads justifies these marks, but it is hard to imagine that 25% and 59%, respectively, of these loans actually will not be repaid.  Its $758MM of non-ABS CDOs are carried at 64% of par.  Its CMBS are marked at 88% of par, even though default rates for commercial mortgage-backed securities historically have averaged less than 1%.  The only mark I question is carrying its $1.4 billion of consumer ABS at 99% of par.  XL management has acknowledged the concerns about its portfolio and has already reduced its levels of riskier debt securities and equities. Overall, the portfolio has its issues, but nothing that would justify XL’s current stock price.

One last thing I considered was XL’s exposure to D&O claims.  About 24% of XL’s business is professional liability, and a recent study by Advisen Ltd. ranks XL as the third largest writer of D&O coverage for financial institutions, with an 11% market share.  The rest of the top five are AIG (19%), Lloyds (17%), Chub (10%) and Travelers (6%).  The study predicts that settlements and defense costs for subprime-related D&O claims will be $27 billion, of which the insured portion will be $5.9 billion.  This would put XL’s share at $650 million, or 6.5% of book value.  This is material, but, again, not enough to explain the current stock price.

The Power of Rumor Over Reality

I spoke to some of my contacts in the industry to try and get to the bottom of this.  They talked about XL having a lot of “those toxic subprime” securities in the portfolio, and XL’s having been involved in the whole credit default swap nightmare – nothing new.  The good news was that I also heard that XL was “an important market” for them, and that they had not heard anything negative about XL lately. When I probed for details about XL, it became clear that nobody I spoke to had done any primary research.  Their views were driven by industry chatter, which in this case seems to lag, not predict, reality.

The time to make a negative call on XL was in late 2007 and the first half of 2008.  By the time the negative buzz reached its peak in October ’08, the vast majority of XL’s problems were already behind it.

XL has raised new capital; virtually eliminated its Syncora problem; made progress in de-risking its investment portfolio (including the $800MM reduction in CMBS mentioned earlier, plus a $500MM reduction in corporate credits and other actions); and hired a new “Chief Enterprise Risk Officer” from Goldman Sachs.  While XL is likely to have another significant round of mark-to-market losses in the fourth quarter, this will impact “comprehensive income” not net income.

The market has priced disaster into XL’s shares, but while I see challenges, I do not see any signs of impending doom.  Mike McGavick has the skills and experience to lead a successful turnaround and has already made real progress.  Meanwhile, premium rates for property, catastrophe and professional lines are already firming and the outlook is very good for XL in 2009.  The conversion of its senior notes to equity in February of 2009 may be a catalyst for significant appreciation of the stock, especially if XL fares well during January renewals.  Unfortunately for XL, unless credit spreads tighten dramatically by year-end (the Fed is certainly pushing in the right direction), it is likely that Q4 mark-to-market losses will offset, or at least temper, positive Q1 news.  One thing that would help would be if following Q4 results, one of the other rating agencies revises its outlook to “stable.”


“Total Capital” refers to book equity plus minority interests, liquidation preference of preferred stock, and debt. “Capital” refers to “Total Capital” excluding accumulated other comprehensive income (“AOCI“). “Book” and “Book Value” refer to book common equity excluding AOCI. Prices are closing prices on 11/24/08. “Unlevered Value” is equity market value plus minority interest, preferred stock and debt, less an estimate of excess cash for RNR and VR.  Premiums earned are for LTM ended 9/30/08.  Company ratings are S&P financial strength ratings, or, if there is no FSR, ratings for the P&C operating companies. Validus rating is from A.M. Best.  Portfolio average ratings are S&P except Everest, which is Moody’s.  Figures for ORH are pro forma for an additional $150MM of share repurchases at an assumed $45/share average price. For AIG, figures: (1) are pro forma for the issuance of $40B Series D Pfd Stock and associated debt repayments, (2) do not include non-cash addition to APIC recorded with Series C Pfd Stock, (3) reflect preferred stock on an as-converted basis, and (4) include $156B of “other long-term borrowings” at face value, not $39.1B reported fair value.

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