10foot Scuttlebutt: February 2018 edition

Back with another version of scuttlebutt, some stuff I’ve seen or thought recently. I am particularly keen to get thoughts and opinions on alternative investments & the UK fin services sector.

Buffett buys Teva

Has Warren lost the plot? He’s bought a stake in Teva Pharmaceuticals which has an at EV/EBITDA of 12ish and something like $32bn in debt. I first thought he was a) insane, and then b) that this might be validation of my Mayne Pharma purchase (buying pharma when there is blood in the streets, etc) but I realised he’s got something different in mind – job cuts. My guess is he’ll try and gut Teva, which is not nearly so expensive if you can fire half the staff.

There has been some interesting media coverage on the pharma industry recently, including one piece about pharmacy benefit management. It’s made me think Mayne might still be an opportunity, but equally, the media coverage only indicates how complex the situation is – I’m better off on the sidelines.

Bailed up by Bailador? 

Bailador Technology Investments (ASX:BTI) looks similar to Blue Sky Asset Management (ASX: BLA), except it’s wholly a venture-cap/technology style fund.  I was originally interested in it for its ~15% discount to NTA, as well as the underlying tech companies that were reportedly carried at modest valuations or cost.

However there were a couple of things I didn’t like. First it seems very difficult to get any sort of grip on its investment company performance or valuations as that part appears all quite opaque.

Second, Bailador appears to be externally managed, paying 1.75% & 17.5% to an entity controlled by Bailador management – talk about a conflict of interest! To be sure, I’ve seen them mark down at least one investment that wasn’t performing, but if you take a skeptical view (remember the incentives!) that could just be virtue signalling.

Third, related, Bailador has an illiquid portfolio that will probably go without generating cash for several years, as early stage growth companies don’t throw off cash, and sales of holdings should be very infrequent. To me this is problematic as shareholders will be paying annual (hefty) management fees – directly to management! – on an investment portfolio of opaque companies on basically a mark-to-model basis.

Bailador is currently paying a shade over $2m a year to management in management fees alone, and it has only $6m in cash. Portfolio companies seem to require additional investment semi regularly so I suspect Bailador will have to raise capital soon. It will be interesting to see if they are able to raise at NTA.

Sharpening the criticism a little, it appears Bailador will be raising capital at least in part to pay its ongoing management fees. On a positive note, upwards revaluations of some of its investments won’t trigger performance fees on unrealised gains (that is, performance is only payable on cash gains, such as from a sale).

Bailador management also receives director fees directly from subsidiary companies. That is, in addition to receiving management and performance fees, management receives ongoing director fees from portfolio companies. Money is being taken out of shareholder pockets via both the fund manager, and directly out of portfolio companies. Significant shareholdings notwithstanding, management is doing extraordinarily well out of this arrangement.

From the BTI 2017 annual report

This kind of company might be right for some, but it’s not my cup of tea.

Do alternative investments have a future? 

One of my many side projects aims to determine if Blue Sky Alternative Investments (ASX:BLA) is aggressively marking its portfolio (I have NFI*; disclosure is obtuse).

Still, judging by the AFR I’m pretty sure that their investment in Vinomofo is valued optimistically. Vino missed its revenue forecasts by $10m last year, but Blue Sky’s valuation for the Blue Sky Private Equity Vinomofo Fund increased by 3.6% from $4.342 million to $4.5 million while percentage interest remained constant. It was marked up a similar amount in the first half again today.

If I step back and ask myself where all the money looking for a home in a low yield environment is going, it’s not hard to envision some of it going into alternative assets. Plus if you look at BLA’s assets, it owns a decent amount of property and aged care investments (around 17% of net assets – and a lot more if you include student accommodation). I would guess that these investments almost definitely have their valuations inflated by lower interest rates.

Elsewhere BLA owns late stage venture-cap tech stocks, which are also pretty easy to mark to model, given that the underlying businesses are usually opaque and valuations can be pretty woolly e.g. multiples of revenue. I’m on the fence on BLA, but I do wonder how all of these investments would fare in a world where investors have a lot more choice (via higher interest rates). I suspect they would not be nearly so much in demand.

(*NFI = no fucking idea)

Big trouble in little Big Un

AFR has been belting it out of the park these past few months and there has been some really sterling coverage of Big Un (ASX: BIG) by Jonathon Shapiro recently.

Big Un shares dive 30% after financing admission

Big Un revelations as company goes into trading halt

I haven’t done the legwork on BIG but there are some concerning allegations in there. Customers are being filmed for free, one unhappy customer (if I understand correctly) was filmed for free, billed anyway, was unhappy with the service and had the video published by BIG anyway. The company financing BIG’s customers has a claim over Big TV’s assets, which makes the arrangement look a lot like a loan. I’m not familiar with the specifics of debtor finance but I thought it was normally secured solely against the customer receivables.

Reading between the lines I suspect that there’s a lot more to this story.

Given the point we’re at in the market and some of the shenanigans we’re seeing, I have been spending a fair bit of time looking at dodgy stocks with a view to finding one to short. I don’t short stocks (yet), and there’s no BIG shares available to borrow (I checked on the weekend) but if I found some I would have shorted BIG solely on the strength of the AFR’s articles and BIG’s Tipsly transaction. Buyer beware.

UK Fin Services

I’m keen on the UK wealth management space (and have been for a while – since I bought Just Group plc). I am still in the early stage of sieving a lot of companies, but I have a seemingly compelling thematic. UK pension contribution rates are currently around 3% and are rising to 9% in 2019. I also expect there will be additional inflows to the sector coming from the ongoing switch over from defined benefit to defined contribution pensions. I rate it at least a 50% chance that contribution rates go above 9% in the next ~5 years. In that context, prima facie, valuations of ~16x earnings at a bunch of asset manager + financial advisor firms look to be discounting the significant growth that could be coming.

I have not looked closely at any one co yet, as I am casting through a long list of firms trying to find something that is a) small enough to see significant growth, b) scalable, c) well run, and d) relatively future-proof.

Several firms appear kinda backwards here, including one called Brooks Macdonald (LON: BRK). I was interested in Brooks Macdonald and had it on my short list until I saw its fee structure. It charges 1.45% per annum (plus advisor fees, say 0.5%?) for a “Low Risk Portfolio Defensive Income” strategy that is up to 70% in bonds. Performance has been staunch – 13% per annum over the last 5 years (!!) and has more than covered the fees, although I do wonder how defensive it really is to get that type of return. Performance of other strategies has not been quite that good.

There are a few other things I didn’t like. Brooks MacDonald reports its returns gross of fees, and it charges 0.8% per annum (plus advisor fees) to customers in a passive defensive strategy that is 100% ETFs and around 50% Vanguard & similar index funds. Also, “Underlying charges may apply which will vary according to the specific assets within the portfolio.” Not only do you pay 0.8% to Brooks, plus 0.X% to your advisor, you also have to pay the fee for the funds that Brooks invests you in. So you pay a fee to your advisor for putting you in a Brooks strategy, then you pay a fee to Brooks for putting you in a basket of funds, then you pay the management fee for the funds themselves! I am not sure if I understand that correctly (it seems too wicked) but it really reeks.

This LSE-listed BRK gets a ‘no’ from me.

I own shares in Just Group plc. I formerly owned shares in Mayne Pharma but have sold them all. This is a disclosure and not a recommendation.

Getswift: Data Talks, Bullshit Walks

The title of this piece comes from an interview with Getswift (ASX:GSW) executive chairman Bane Hunter.  He’s spot on:

Hunter has a clear message for all startup founders seeking US investment:

Data talks, bullshit walks,” he says. 

He advises founders to “be conservative and over deliver when speaking to investors, because “everything you say is going to be recorded and measured”.

“When you come back 6-12 months later everything can and will be used against you when you raise,” Hunter says.  

I’m looking at Getswift’s latest quarterly. At first glance there’s a fair bit of ‘walking’ going on. Or to quote another prominent elder statesman figure, Marshall Mathers:

It’s quicker to count the things that ain’t wrong with you, than to count the things that are.

  • Cash flows lag revenue and the difference has blown out this quarter
  • Cash flows fell despite ‘geometric’ revenue growth
  • Interest payments don’t correlate with cash balance. (Getswift paid $15k in interest expense despite having no debt and $26m in the bank.)

 

I can think of 4 possible explanations, and I’m going to throw around a few ideas:

  • Getswift could be booking revenue on free trials that goes unpaid when clients discontinue. This could explain revenues running ahead of cash flow but does not explain interest expense.
  • Getswift could be recording revenue at its ‘headline’ delivery fee (26-29 cents per delivery) but only getting paid cash at the fee rate it’s negotiated with clients (much lower than the headline rate – ~13 cents or so). This matches the below table, and could explain revenue and cash flow but not the interest expense.
  • Getswift could be running free trials, recording revenue and financing the subsequent receivables (via debtor finance) to show cash flow. This could explain the revenue/cash flow difference (lenders won’t finance 100% of receivables) as well as the unusual interest expense.
  • Getswift could be counting the interest on its cash balance as ‘receipts from customers’. That would be pretty unconventional but the numbers roughly fit. That could explain cash receipts but not the interest expense.

 

Sure, that’s just speculation on my part, but there are some meaningful discrepancies here – and how would you know otherwise? Company disclosure is less than zero.

Quarterly revenue vs cash flow:

Quarter Revenue Cash receipts from customers Delivery #s Fee per delivery (revenue basis) Fee per delivery (cash basis) Net cash difference (compared to prior quarter revenue)* Cumulative cash difference LTM
Q218 $321,000 $160,000 ~1.2m $0.27 $0.13 -$95k -$70K (8% of Getswift’s LTM revenue hasn’t turned into cash)
Q118 $255,000 $175,000 ~0.996m $0.26 $0.18 +$23k
Q417 $152,000 $128,000 ~0.73m $0.21 $0.18 +$11k
Q317 $117,000 $54,000 ~0.5m $0.23 $0.11 -$8k
Q217

(IPO 9 Dec)

$62,850 not stated ~0.34m $0.18 not stated

(note that figures above have been rounded off and are not precisely correct)

*To see if there was a payment lag I subtracted cash flow from revenue in the prior quarter. For example Q218 cash receipts are $160k, vs Q118 revenues of $255k. Even if actual cash payment falls through into the following quarter, there is still a huge hole not being filled.

A more concerning implication is that, if you assume that 100% of the revenues booked lead to cash flow, up to ~$80k of this quarter’s receipts from customers could be due to last quarter’s revenue. Last quarter, Getswift had $255k revenue but only $175k receipts, i.e., $80k was unpaid. If that $80k got paid through in this quarter instead, then Getswift only earned $80k in receipts from customers in Q218. Overall cash flow also declined vs last quarter. I can only guess that Getswift is accruing revenue that it does not earn.

Getswift is reporting ‘geometric’ revenue growth but cash flows persistently fall short. This is surprising because Getswift’s revenue recognition policy from the 2017 annual report states:

“For contracted customers, the revenue is recognised on a monthly basis, when the group is able to reliably estimate the underlying value of service provided for the period. This is determined based on the number of task deliveries and SMS values tracked.”

However “For pay as you go customers, the revenue is recognised at the point when the cash payment is received from the customer.”

Under the PAYG model, there should be virtually zero mismatch between cash flow and revenue. Ergo most or all customers must be ‘contracted’. However, Getswift confused the issue in its ASX announcement last week.  The company said:

“Regardless of any POC (proof of concept) period, because the contracts are pay as you go, clients that wish to no longer use the platform simply cease using it and this is then reflected in our periodic reporting of delivery transactions and revenue.”

This does. not. make. sense. If the contracts are pay as you go, Getswift should record the revenue when the cash comes in and there should be zero mismatch with revenue. Is it contracted or not? I cannot be sure what to conclude from this, but to me it looks like a yellow flag from a company that is rapidly becoming a byword for poor disclosure and overly optimistic statements.

Getswift turns Chinese

$26.5 million cash at bank at the start of the quarter (the big capital raise came right at the end of December and so likely did not contribute anything). Zero debt. $0 interest income. A net interest expense of $15,000.  Getswift is Chinese, apparently.

Where’s the cash? Where’s the interest income going?  2.5% interest on $26.5m = $663k per year. Divide by 4 to get a quarterly figure = $166k.  Getswift’s receipts from customers for this quarter was $160k.  Coincidence that those numbers are so similar?  You tell me. Surely they wouldn’t record interest income as receipts from customers? Surely they wouldn’t keep all their cash in a business account earning 0% when the interest income is so significant relative to receipts? Surely..

Last quarter Getswift recorded $64k in interest which is about a 1% interest rate, but roughly makes sense in context of its cash balance and the timing post- capital raise. I cannot reconcile this quarter’s figure at all.

Where it at?

Also worthy of scorn is Getswift’s raising of $75 million to “advance new product development initiatives and general working capital purposes.” Forecast R&D cash outflow next month is $1m. Forecast staff expense is $1.3m. This company has $96 million in the bank.

And working capital? At a software company? Wot?

Ohhhhh wait, yeah if you know your revenues are gonna run well ahead of cash flow, and you’re gonna spend money and not make any, then you need a lot of working capital. Perhaps that explains it.

This company does not make sense. When revenue runs ahead of cash receipts, cash receipts are declining, and the interest income on $26m in cash ($96m, now) suddenly goes AWOL, those are some pretty glaring warning signs. With zero transparency and numerous unexplained issues – not to mention those undisclosed material facts I keep mentioning – in my opinion Getswift is worth no more than its cash backing per share, 50 cents or so. Not only that, I think it’s totally uninvestable.

One thing I would dearly like to ask management and Getswift’s corporate advisors is “at what point does this transition from poor disclosure and optimistic forecasts into a legal and regulatory issue? Cos I’m pretty sure you’re about to find out where the line is.”

With a totally non-independent board, I think that’s a question that needs to get some serious internal airtime.

I have no investment position in Getswift, and will not be taking any investment position. I have no relationship with Getswift, its management, staff, or corporate advisors whatsoever. This is a disclosure and not a recommendation.

A lengthy screed on Tower Limited

I’m revealing my undisclosed 10th purchase a little sooner than expected: It’s Tower Insurance Limited (ASX: TWR). I expect a 3-5 year holding period from here, subject to business performance. Conditions are also not quite as favourable as I had hoped for, so I have taken a smaller position with a view to increasing if a better opportunity arises.

This post is a longer follow-up to my Buy thesis on Tower. There are some overlaps, because I want to have all of my sources in one place.

One thing that you should keep in mind is that I wrote this post at the time of the purchase, so some comments – about management’s shareholdings, or Goldman Sachs’ fees, for example – are outdated. I have kept them there because it reflects the information I had at the time I purchased in late 2017. Do your own research.

Tower Insurance 

  • A$212m market capitalisation (337.3m shares on issue @A$0.63 share price)
  • 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

 

Tower is a New Zealand insurer that spent the last 10 years selling off all its businesses and returning capital to shareholders only to get caught short of capital following the Christchurch earthquake in 2011. Now it’s stuck with antiquated IT systems and had to raise substantial additional capital from shareholders. Reading between the lines, you can see historical hints of underperformance, technological problems, and underinvestment in the business at the very same time as management is focusing on their dividend and returning capital to shareholders.

That was before the appointment of ex-Territory Insurance Office (TIO) CEO Richard Harding in 2015, who I think has done a solid job turning things around (ongoing collapse in the company’s share price notwithstanding). Prior to Tower, Harding was the CEO of TIO, the NT government insurer, for around 6 years. He led it through a period of improvement in operating profit prior to its sale to Allianz in 2014.

Old TIO annual reports can be found here: http://www.territorystories.nt.gov.au/jspui/handle/10070/242199

Like other insurers, Tower still has unresolved claims from the Christchurch earthquake in 2011. IAG discreetly raised capital for this in 2016 but Tower postponed doing so due to two takeover bids. Bids for Tower were launched at $1.17/share (by Fairfax of Canada) and $1.30/share (Vero/Suncorp Group) in 2016. The first bid was invalidated by the higher bid, and the Vero bid was rejected by the NZ Commerce Commission because it would result in Suncorp and IAG having a duopoly.

10foot goes activist

As part of my initial look at the stock, I spoke to some of the shareholders in Tower. They weren’t keen on saying much (as I am anonymous) but I got the impression that they had basically capitulated and wanted to sell the company in the takeover and wash their hands of it. I also sent an early version of this post to some small cap managers and their general response was “yeah it’s an insurer, no thanks.”  That could mean that this purchase is not smart – be aware that several smart investors turned this idea down – but I took it to mean that there was close to zero interest in Tower and a possible opportunity where nobody was looking, so to speak. I saw that some NZ brokers named it as their top pick for 2018, so it’s probably going straight to zero.

(That’s a joke.  Actually there is one brokerage firm that has had fantastic – detailed and practical – coverage of Tower, and that’s Forsyth Barr. They are often quoted in the media links I provide below.) 

In another world I might have gone all Bill Ackman on Tower – invest billions, watch it plunge 70% over the next few years, then get sued for insider trading – but as a certified small fry I was able to avoid that temptation. I do hope to get an interview with CEO Harding for this blog and I will be approaching Tower to that end very shortly.

The thesis:

Tower has a lot of unrecognised opportunities in its core business and today’s price – ~13x earnings and ~1x book is not the right one.

For example, 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’. The unresolved Christchurch earthquake claims were also weighing down the business and the share price.

Following reinvestment, Tower should see significant improvements in every area of the business, especially operating costs and risk pricing. I also reckon retention and policy numbers should improve. Tower has been growing policy numbers and reducing management expenses for the last 2-3 years even with its weak business systems, which I think is remarkable given the challenges it has faced. For example, Tower previously had three separate teams for selling, renewing, and updating a policy.

I direct you to this old AGM speech from CEO Harding that sums up everything that’s been happening.

Note this link will download the 2.6mb PDF file directly to your device:

https://www.tower.co.nz/~/media/Files/Tower/investor-centre/annual-shareholder-meeting/2016-ASM-Address.ashx?la=en

The Tower opportunity: 

With low-hanging fruit in every area of the business, expected improvement to earnings should more than compensate for the capital raising over time, and Tower is currently undervalued in my opinion.

Given the extent of the improvements and historical growth in policy numbers, market share, and reduction in costs, and the benefits Tower expects to achieve from these, I estimate fair value for Tower is around A$0.90 following business improvement. I estimate the company may (in time) pay a ~7% dividend at my overall purchase price of $0.55, based on a 50% payout ratio. These estimates are just part of a wide range of possible outcomes so do not rely on them.

The nullification of the Christchurch liabilities (management was going to spin them off, but they didn’t mention this in the recent results) should ease the process of re-rating.

I think the downside on Tower is limited and the upside is meaningful without being outstanding, especially if dividends recommence in the next 2-3 years as I expect. Management said they may recommence dividends as early as FY18. There is reasonable probability of a blue-sky scenario in which Tower claims market share, controls claim costs, and reduces operating expenses further than expected, but I am not counting on that. Further takeover bids, e.g. from Fairfax, are a possibility.

The balance of probabilities

What is the actual chance of Tower succeeding/failing as an investment?

In general terms, I think it is nearly inconceivable that Tower will not be a better company in five years. The improvements are very intuitive, albeit not simple to implement, and have been demonstrably successful at other insurers. However, whether these improvements actually lead to improved profitability and market share is the key question. I obviously think that they will, but Tower is playing catch-up to larger and more sophisticated competitors, which is not generally a winning premise. This is something to keep in mind. There is also the tail risk of catastrophic cyclones etc. I think the risk of a weather-induced bankruptcy is remote following the capital raising, but is definitely an important consideration.

One argument is that it doesn’t really make sense for Tower to be a standalone listed co as it is small and its cost ratio is so high, but I disagree. I think there is definitely a role for a third player in the Kiwi market and if Tower wasn’t there somebody else would take that position. On a non-business front I also think it would be a real shame for an iconic Kiwi brand like Tower (150 years of history) to be sold off to a foreign multinational like IAG or Fairfax.

The transformation process:

Tower currently has 30% of its sales online, up from 9% just 18 months ago. I think something like 70%-80% online sales is a plausible target (who makes a phone call to buy insurance these days?), and Tower says that it is aiming for more than 50%. This should result in lower costs, better service, and wider margins. There is a scoping study underway for the new IT systems and costs are currently uncertain. IT systems are expected to be deployed by the end of 2018, but I think Tower is kidding itself – I’ve never ever seen an IT system delivered on time, on budget, and without problems. Still, the opportunity from a new IT system appears worth the risk:

I never heard anything more about that investor day.  (Tower half year prezzo FY16)

If you know anything at all about software, you can clearly see the benefits of pulling it all together into one system instead of currently 4 systems and ‘dozens of ancillary systems’. The AGM speech I linked earlier has comments on the software system too.

I originally budgeted for a capital raising of 100m new shares at $0.50 to $0.60 – what I actually got was 166m new shares at $0.42, worsening the opportunity due to dilution. I blame Goldman Sachs and Tower – but more on that later. Tower has raised enough capital to cover its Christchurch quake liabilities and more besides. It has 99% claims coverage (including Incurred But Not Reported claims) for this event, and there is an 80% to 85% statistical probability that this will be sufficient to cover all claims (because the claims expense is inherently uncertain). The stability of Christchurch claims is a key risk, given multiple years now of ever-escalating claim expenses.

Management also expects to be in a position to upgrade the IT systems, which was a vital part of the thesis. Ultimately I think management took the hard road by raising a lot of capital, and I applaud them for it as it suggests they focused on the long term value of the business. This is despite their lack of personal shareholdings – but more on that later too.

Tower currently has a ~5% insurance market combined share (up from 4.6% in 2014 and 4.7% in 2015) and has been growing GWP about 3%-4% per annum. Market share has been increasing in recent years, despite lacklustre capabilities, although it is obviously well down from historical highs of ~10% around 9(?) years ago. There are fewer ‘hard’ moats/ network effects that would prevent Tower growing its market share, especially since Tower already has some financial adviser networks, banks, and alternate distribution sources such as NZ Airpoints and TradeMe insurance. Tower is over 150 years old, and has top-tier brand recognition on par with that of IAG/Suncorp owned brands.

Insurance is a commoditised product, and two major competitors (IAG + SUN) control around 70% of the NZ market. I think that Tower could probably claim additional market share over time, as it proves itself a viable and attractive proposition for new customers, although the thesis does not depend on market share growth. Anecdotal reports suggest Tower is ahead of other NZ insurers in its focus on digital, which is encouraging to hear, although I have not relied on it. The NZ Commerce Commission recently commented on price coordination behaviour between the two majors and I expect this opens an opportunity for Tower to compete via differentiation of its brand/products/service.

Management/board lack of alignment:

The chairman is one of the more heavily invested board shareholders and he owns less than one year’s salary worth of Tower shares (albeit he may have purchased at a higher price). He also has more than 20 other directorships(!!). CEO Richard Harding is highly paid and doesn’t own a single share. There are no equity incentives in his remuneration agreement. I think this is probably because he was hired for his expertise and may not have wanted to invest with the Christchurch liabilities etc. Even so, I believe this lack of alignment led to the unfortunate terms of the capital raising (see below). I would like to see management start to purchase serious amounts of shares on market. Chairman Stiassny has reportedly done a good job, but equally I believe he should resign some of his other directorships and/or buy significantly more Tower shares. Tower deserves a more heavily invested board and management team.

(The CEO and Chair recently purchased more shares and participated in the cap raising in a modest way)

From the Tower FY17 annual report remuneration report.

Ordinarily these would be grave concerns, but I have formed a high opinion of the CEO given Tower’s progress over the past two years, and I have spoken with long-time Tower shareholders that have corroborated my impressions. Still, these kinds of turnarounds can benefit significantly from execs with the grit (read: threat to their wealth, or reputation if a founder) to go above + beyond.

Also, in my opinion, weak corporate governance at Tower historically led directly to its weakened state, and I think this is something that should be tightened up ASAP now that the business is looking to rejuvenate itself.

As an aside, if I could speak to Tower directly, I would say please stop saying that you are ‘focused on capital management’. The historical focus on capital management led directly to Tower being undercapitalised in the aftermath of the quake. Given the history here and the current situation (e.g. ongoing dispute with Peak Re, see below) I would vastly prefer to see Tower comfortably overcapitalised while the reforms take place. You can always manage capital downwards but you cannot easily replace it, as long term shareholders have discovered to their considerable chagrin.

An error in Tower’s historical financials?

I had a brief worry when I spotted what looked like an error in Tower’s historical claims expenses:

The 2015/2016 numbers are identical to the 2014/2015 numbers. (via FY16/FY17 annual reports)

I subsequently realised it was probably a typo and I contacted Tower IR who confirmed that it was. The data is in the wrong column, i.e., the ‘2013’ column is actually ‘2012’  etc. I believe them and intuitively this makes sense, although the possibility of an ‘error carried through’, for example in a spreadsheet, is one that every would-be investor should consider for themselves. Orocobre famously had 20% of their annual production vanish into the ether due to a spreadsheet error, so it happens.

Anecdotally I have been surprised by how many similar errors I’ve spotted in company reports (not just Tower’s) when I really look for it. I saw a similar thing with Automotive Solutions Group in early 2017 and I have seen over a dozen notable examples since. I guess they are complex documents and vulnerable to errors.

The Vampire Squid strikes again:

Goldman Sachs got an estimated 6% fee off the top of the capital raising. $4.5m of the $70.8m – $6 out of every $100 raised – raised goes to Goldman, and I think this is a black mark against Tower. The market is quite aware of Tower’s antiquated state, but not necessarily of the opportunities for improvement, and I think if presented in the right way, more holders could have been convinced to participate. My belief is that the capital raising was under-marketed and under-priced.

(Subsequently, it turns out that the capital raising was 12% undersubscribed, and with such little liquidity Goldman is going to earn its underwriting fee. I estimate they now own/owned about 4% of Tower)

The price at which capital was raised was also pretty ‘eh’ with NZ$0.42 being a ~40% discount to the last trade price. Vero may have had a role to play here by demanding a greater discount in order to support the cap raise, no doubt trying to average down its very high buy price of $1.40/share.

Still, in my opinion this is the first sign of management’s lack of alignment hurting shareholders – I doubt that a founder would have paid so much to an investment bank or issued these shares so cheaply. A founder may also have more viscerally grasped the need to pound the bricks and drum up interest in Tower. Perhaps Tower did this in New Zealand (where most shareholders live) but I did not see any evidence of marketing on this side of the ditch.

In Tower’s defence, it did a renounceable pro-rata rights issue (huge credit to them for this) and I think in general that the lack of self-promotion is a big plus to Tower. They have done the right thing by shareholders. This company strikes me as an old-school insurer with a focus on risk rather than sales, which is ideal. However, it could really have used a salesman in the lead-up to that cap raise.

While I am not super happy with how this part turned out, I don’t think management is in the wrong – they needed capital and it was a responsible decision to underwrite it. I just would have preferred to see a little more aggression when raising, and a little less going to Goldman. I mean, if fucking Getswift can raise $75m on the thinnest of premises, Tower – established business, already making progress, solid turnaround plan – should have absolutely cleaned up.

It’s Seduction 101:  You gotta make them want it.

Dispute with Peak Re

I think this was a pretty shrewd move from Tower. Tower bought expensive reinsurance from Peak Re to cover potential increases in the Christchurch quake claims. It looks as though Tower effectively passed some of their liabilities off to someone else – the reinsurance was subsequently quickly drawn on and Peak Re was not impressed. Tower’s claim is now in dispute. Peak Re hasn’t handed over any money, yet Tower has counted the funds from this claim as part of its balance sheet, leading to risks if there is drawn out litigation or the contract gets void. That would leave a ~$40 million hole.

Tower says it is in the right, and I also struggle to see how Peak Re will wriggle out of it. 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 got the cash out of them yet and as they say, possession is 9/10ths of the law, so protracted litigation here might lead to Tower having to raise more capital or delay paying dividends.

Here is an excellent media article explaining the situation from interest.co.nz.

Here are several more media reports that are well informed and explain the wider industry risks in NZ

https://www.interest.co.nz/insurance/85065/government-confirms-it-has-not-been-approached-tower-insurer-seeks-capital-ring

https://www.interest.co.nz/insurance/84820/tower-announces-plan-ring-fence-troublesome-quake-claims-says-industry-model-broken

https://www.interest.co.nz/insurance/91753/nz-initiative-calls-shareholders-and-policyholders-not-taxpayers-be-made-take-hit-if

https://www.interest.co.nz/insurance/84316/nz-economy-vulnerable-risk-reinsurers-charging-insurers-premium-uncertainty-caused

https://www.interest.co.nz/insurance/91753/nz-initiative-calls-shareholders-and-policyholders-not-taxpayers-be-made-take-hit-if

I don’t want to go too much into wider industry issues as they require a lengthy discussion. Generally I am of the view that

a) consumers alone can’t affordably insure their homes against earthquakes without something like the EQC. I expect government support to remain via one mechanism or another.

b) risk-based pricing for Tower will give it the ability to better price earthquake/flood prone areas – and also perhaps to price itself out of areas it does not want to insure, if that should become necessary.

c) I am not certain but I believe that Tower has moved away from ‘replacement’ policies towards ‘sum insured’ which should reduce complexity and cost of its claims when future events occur.

The risks:

AUD/NZD exchange rate is a risk but difficult to forecast. It is hard to foresee significant, sustained divergence over the long term. If anything I’d be bearish AUD with China etc.

IT simplification is rarely trouble free but in this case benefits are clear enough to run that risk. Tower’s IT systems are sub-par and long-term shareholders agree that there are opportunities for improvement in every area of the business.

The willingness of CEO and the board etc to stick around during the turnaround process is a key risk. I think that the CEO could stay but the board may leave as they clearly wanted to sell the company.

Board and CEO alignment is low as I noted.

Tower is an insurer. If anything I think its claims expenses and risk management processes will tighten significantly via the introduction of things like address-based pricing as I mentioned. However, its risk pricing assumptions are really unknowable, and additionally the company does carry ugly worst-case scenario risks. There could be a monster storm that flattens New Zealand and bankrupts the company.

Tower’s Pacific island business also seems quite vulnerable in this regard. It would be a nasty surprise to find that the company has been pricing insurance wrong or not reinsuring appropriately, and there is no real way of evaluating that for a fact. We are in the La Niña part of the cycle which is associated with higher rainfall which is worth keeping in mind. (I also think that the Islander businesses are a decent hidden opportunity over the ultra long term, but I am not ascribing much value to them presently.)

Legal dispute with Peak Re, as mentioned above.

The bottom line:

With all of the opportunities for improvement – assuming the company is pricing risk correctly and reinsuring adequately – I simply think it is very unlikely that Tower’s price today is the right one. It may not end up a huge winner, but I think it is a good example of an asymmetric opportunity with a limited downside, and I have made it one of my larger positions.

Data on my purchases is contained in my original purchase piece, here.

I own shares in Tower Insurance. I have no financial interest in any other company mentioned. This is a disclosure and not a recommendation.