Sunday, January 18, 2009

This Stock Tip Needs More 'Splainin

This might be a little unfair, since Barron's Rountable is caveat emptor and no one should expect a full blown analysis for the $5 cover price.  

However, Archie MacAllaster, who had a rather dismal year, recycled one of his 2008 picks - Hartford Insurance Group - HIG.  Archie didn't mention that it was a 2008 pick [but Barrons, to its credit, did show a table of all the 08 picks with their predictably awful results].   
Next, Hartford Financial Services . It was trading for 17.09 Friday [Jan. 2] [And 13.90 Jan 18th] . The range has been 85.11 to 4.16. How about that?  [How about the fact that he recommended it at $82.95?] The yield is a little under 8%. Book value is $41 a share. Earnings in 2007 were $8.25 a share.
Fair enough -- if it was a buy @ $82, its a steal at $14, no? Here is the main problem - his next sentence.
Recently Hartford raised its 2008 earnings estimate to $4.70 to $4.90 from about $4.30 to $4.50. I think they'll make better than $5 and maybe $6 a share in 2009.
True -- Hartford did confirm these earnings estimates. Here is a slide from their pitch:

Note the $.62 cents from a decrease in prior period P&C reserves.  Nothing inherently wrong with booking it, but the timing of a reserve release is to a large degree, arbitrary.

The problem with this picture, is that one might think that with rather robust earnings of close to $5/share that the Hartford would be able to maintain or strengthen its capital position.  It would be obvious, in fact.  But obviously wrong.

Here is the "money" slide from the HIG presentation:

HIG lost $11.6 billion in capital (pre tax) that isn't recognized in their earnings estimate.  The recognized portion - the $3.5 billion, is part of net earnings, but the $11.6 is shown as 'Other Comprehensive Income'.

It's a pretax number, but it is big.  And it is a reason that The Hartford is selling for 40% of book value.  

Archie makes a couple more comments:
The company has given itself all kinds of flexibility.
How so?
MacAllaster: They raised a couple of billion dollars in Europe. They bought a savings bank in Florida. They got some money from the TARP. They won't have any financing problems. Hartford will be 200 years old in 2010. It has $350 billion of assets, and in five or 10 years will have a much bigger net worth than today. Meanwhile, you're buying it around four times earnings.
They don't have all sorts of flexibility because they don't have that much capital to support what Archie refers to as $350 billion in assets.  

Fortunately, they have $311 billion in assets @ September, 2008 AND almost half of the assets are in separate accounts.  That leaves $12 billion in capital to support the other half of the assets.  The $12 billion includes whats referred to as DAC or deferred acquisition costs, which are prepaid expenses.  It also includes a tax asset, which will require profits to be useful.  Plus some goodwill.

That means they are a bit leveraged with the $12 billion supporting over $150 billion in assets.  The $12 billion includes the deferred tax asset and the prepaid expenses and goodwill, which pretty much account for all their capital.  

They don't have "all sorts of flexibility" but are rather are a little light on capital with a market that has turned against everyone but short sellers.  They should be getting the TARP money, but it isn't finalized yet.  And if it is, that fat 8% dividend may disappear as part of the deal.

The accounting for insurers tends to be inherently complex.  You have three sets of books (GAAP, Statutory, and Tax).  GAAP gives capital a haircut in the balance sheet but doesn't run it through income.   

I actually think HIG has a lot of merits as an investment.  However, anyone that naively thinks that a firm quoted as making a profit has not lost capital is missing critical fundamentals.  

A straight tip is fine, but throwing in the "earnings" without more explanation and referring to a capital stressed firm as "having all sorts of flexibility" is a bit much.  

What you get with Hartford is a heavily leveraged bet on the financial markets.  If they stabilize and prices increase, it will be a huge winner.  If we see more deep declines in asset prices, HIG has big capital issues. 

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