Bancinsurance 3rd Quarter Earnings

This was not a typical filing. I'm going to separate this discussion into two parts, the operational side and the legal side.

Operationally, this quarter was a blast. The news reported premiums were down, but a closer look shows that they are writing more premiums than ever- they are just ceding more to their Producer-Owned Reinsurance Companies (PORC's).

Now, these ceded policies do earn a nicecommission:

During the three months ended September 30, 2007 and 2006, ceded reinsurance decreased commission expense incurred by $1,571,611 and $300,420, respectively, and $4,456,986 and $1,061,833 during the nine months ended September 30, 2007 and 2006, respectively.

Overall, earnings were boosted by a low tax rate and hurt by a realized loss on an investment, the effects of which approximately cancel each other out. But "normalized" earnings for the quarter of about $1.6 million was a big improvement. During the quarter the expense ratio dropped to 31.4% from 44.6%, which was one of the expectations in the original analysis. Meanwhile, book value per share increased to $39.4 million, and the stock is currently trading at a market capitalization of about $30 million. So on a pure-numbers we see this is definitely cheap.

Now, the legal front is where some uncertainty arises. With respect to the discontinued bond program, this statement from the last 10-Q was still present:

Highlands has provided loss information to the Company with respect to alleged losses for bail bonds issued in the State of New Jersey and for federal immigration bonds. Highlands has indicated in filings that it has additional exposure for bail bonds issued in states other than New Jersey. Highlands has not provided sufficient information for the Company to quantify these additional losses. As of September 30, 2007, the Company is reserving to its best estimate of future Highlands losses based on the most recent loss information received from Highlands with respect to immigration bonds and New Jersey bail bonds only.

Meanwhile, on a slightly more positive note:

In October 2006, the Company commenced arbitration against Ernst & Young LLP (“E&Y”), the Company’s former independent registered public accounting firm, in accordance with the terms of the engagement letter between the Company and E&Y. In the arbitration, the Company alleges that E&Y improperly withdrew the Company’s audit reports for the 2001 through 2003 fiscal years. The Company is seeking monetary damages in excess of $21 million. E&Y has counterclaimed, seeking to recover in excess of $475,000 from the Company for unpaid invoices and additional costs. An arbitration panel has been constituted and the hearing is currently scheduled for December 2007. The Company does not believe the ultimate resolution of this dispute will have a material adverse effect on our financial condition or liquidity. See Note 14 to the Condensed Consolidated Financial Statements for subsequent events related to the E&Y arbitration.

....

In connection with the Ernst & Young arbitration disclosed in Note 10, on November 12, 2007, the Company and Ernst & Young tentatively agreed to a settlement of this dispute whereby the Company would release its claims against Ernst & Young and Ernst & Young would agree to pay the Company $20,000 and forgive its counterclaim of $475,000. Upon execution of a settlement agreement, which is currently anticipated to be sometime during the fourth quarter of 2007, the Company would record a pre-tax gain of approximately $0.5 million related to the Ernst & Young settlement.

This was surely settled though just to save them both from a big legal battle. The sum being paid was very insignificant, so we can not assume any particular strength to Bancinsurance's claim. I mention this as important because the following was also new in this 10-Q:

On October 23, 2007, the Company and certain of its current officers (Chief Executive Officer, Chief Financial Officer and Vice President of Specialty Products) received a “Wells Notice” (the “Notice”) from the staff of the SEC indicating that the staff is considering recommending that the SEC bring a civil action against each of them for possible violations of the federal securities laws. The Notice provides the Company and each officer the opportunity to present their positions to the staff before the staff recommends whether any action should be taken by the SEC. The Company continues to cooperate fully with the SEC and intends to continue to do so in an effort to resolve this matter.

Pursuant to separate undertaking agreements dated November 12, 2007 between the Company and each officer who received the Notice, the Company has agreed to advance reasonable legal fees and expenses incurred by each officer in connection with the ongoing SEC investigation. The undertaking agreements require each officer to repay the amounts advanced if it is ultimately determined, in accordance with Article Five of the Company’s code of regulations, that the officer did not act in good faith or in a manner he reasonably believed to be in or not opposed to the best interests of the Company with respect to the matters covered by the SEC investigation. A copy of the form of the undertaking agreement is attached to this report as Exhibit 10.2 and the foregoing discussion is qualified in its entirety by reference to Exhibit 10.2. Under the Company’s code of regulations and Ohio law, the Company may also be required to indemnify each officer in connection with the SEC investigation.

That is something that I was hoping would not happen. You can read up more about Wells Notices (in general) here. We know from the 10-Q that this case "concerned the chronology, events and announcements relating to Ernst & Young LLP (“E&Y”), our former independent registered public accounting firm, withdrawing its audit reports for the years 2001 through 2003 for the Company." Finding out how costly this can be will be important in judging its ultimate impact. Overall, while the business showed improvement this quarter and valuations became more compelling, a new risk has also popped up with regards to this SEC matter.

2nd Quarter Earnings Update

Earnings season has come and mostly gone for the companies in my portfolio. Here's a brief overview.

The Bad
Bancinsurance
The company reported 1 million in net earnings, or $.20 diluted EPS.
Shareholder's equity increased to 37.41 million, or $7.406 per share.
The big negative for this quarter was the .5 million increase in reserves for the discontinued bond program, as well as the addition of this statement:

"Highlands has provided claim information to the Company with respect to alleged losses during 2001 and 2002 for bail bonds issued in the State of New Jersey and for federal immigration bonds. Highlands has indicated in filings that it has additional exposure for bail bonds issued in states other than New Jersey. Highlands has not provided sufficient information for the Company to quantify certain of these additional losses or allocate such losses among the 2001 and 2002 years in which the Company participated and the 2000 year in which the Company did not participate. As of June 30, 2007, the Company is reserving to its best estimate of future Highlands losses based on the most recent loss information received from Highlands with respect to immigration bonds and New Jersey bail bonds only."

Also, commission expense continues to go up as business shifts to other products.
The one positive is that the company started providing more information about their premiums, including how much is ceded to the reinsurance companies. For the six months ended june 30, written premiums ceded were 14.29 million, compared to 4.16 million last year.

SFK Pulp Fund
SFK earned distributable cash of only 7.6 million for the quarter, although several factors were affecting the figure.

On the NBSK side- besides it being a maintenance shutdown quarter, the company also lost some business from some customers and was unable to replace it in time. Sales volume in the quarter was only 75,514 tonnes, while production per quarter for the mill averages approximately 93,000. Since NBSK pulp is a commodity product currently at record low inventory levels (24 days according to Canfor), I am not worried about the quarterly drop in volume.

The other main factor was the continued strengthening of the Canadian dollar. Quarter over Quarter prices actually fell from $821 CAN to $800CAN, even though prices have been rising in US terms. Also, the company took an additional 3.8 million charge from writing down U.S. accounts recievables.

The main thesis behind SFK still remains intact. Although the Canadian dollar has continued to increase since the 2nd quarter, this affects all other Canadian pulp mill operators equally, and Econ 101 tells us producers will continue to curtail production. (The most recent announcement being from Pope and Talbot for 68,000 tonnes NBSK pulp) Also, we are seeing the fiber price imbalance between Western and Eastern Canada also starting to reverse, which will put additional upward pressure on pulp prices. There will be a profitable spot for a low cost producer like SFK in such an environment when all is said and done.

The Good
Fairfax Financial
FFH has come along way and things are really starting to shine.
Underwriting income for the quarter increased to 87.2 million, net earnings per share of $8.92.
Book value increased to $165.50 per share, debt continues to be paid off or extended.
I've long stated my agreement with Prem's prediction of a one in fifty year event coming along in the markets. The positioning of his portfolio looks brilliant right now.
-Majority in cash and long term US government bonds, and no exposure to mortgage securities.
-Equity portfolio is 80% hedged with shorts against the market or specific stocks.
-a large CDS portfolio against financial services companies. At the end of the quarter this had a market value of 198 million. By the end of July, given recent market events, the market value of this has increased to 537 million, and so far since August the move has been significant as well.
Also, so far the hurricane season has been benign, and if things continue this way we can look for a positive reserve adjustment by year end.

Exchange Bank of Santa Rosa
YTD net income of $6.59 per share, Book value of $78.16 per share.
Continued excellent loan performance and conservative accounting:
-Nonperforming loans as % of total loans at .41%
-Total Delinquent loans as % of total loans at .66%
-Allowance for loan losses of 1.81%

As I am writing this, I'm realizing that I have never done a complete and thorough write-up on Exchange Bank. Many of you are probably wondering why I would invest in a bank given my negative thoughts on the financial industry, so look forward for some clarification soon.

Updated Write-up on Bancinsurance

I wanted to do an updated write-up on Bancinsurance now that I have a greater understanding of the company and hence the investing situation. You can find a link to the original write-up at the bottom.

The Company
Bancinsurance is a small insurance company(market cap of 30 million) that focuses mostly on two small niche lines of business. 53% of their premiums are from Ultimate Loss Insurance(ULI). ULI covers physical damage to collateral in cases where it has been repossessed and is not insured, up to the lesser of fair market value or the remaining loan balance. The 2nd biggest line is GAP insurance, which makes up 23% of premiums. When a car is damaged beyond repair or stolen, GAP insurance pays the difference between the amount left owed on the lease and the insurance on the car. (Generally, the fair market value falls much faster than the amortization of the loan or lease.)

The Situation
In 2001, Bancinsurance expanded into a new line of insurance in a bid to grow their business. This ended up being a huge disaster- In 2004, huge losses came up, the auditors left, an investigation began, and the company took the company who managed the new line of business to court for missrepresentation.

Bancinsurance Today
The investigation concluded with no wrongdoing, the company hired a new auditor and became up to date with their filings, and most the claims have been handled and the rest have been reserved for on a practically worst-case basis. The last court arbitration should finish by this year and with it, take away a huge legal expense which cost Bancinsurance approximately 4 million in '06.

Valuation - Safety
Bancinsurance's losses in their lines of business are fairly predictable and stable. GAP relies on a car being either stolen or damaged beyond repair, while ULI covers physical damage on car's that are being repossessed. A recession would lead to more repossessions, but the combination of recession and physical damage is needed for bancinsurance to pay anything. Hence, I think book value is the safety net, especially considering that the company is still making healthy profits. The book value as of last quarter was $7.54, compared to a current price of $6.05. (24.6% return)

Upside Potential
Bancinsurance is in small niche lines of insurance and has been able to earn nice returns on capital throughout its history. And although growth has stagnated recently, over a longer time horizon they have done an excellent job running the business.
The following numbers are the results from 2006 to 2000. (numbers in millions)

Premiums: 49.1, 51.7, 50, 50, 42.6, 33, 25
Net Inc: 5.5, 6.3, -8.5, 3.9, .9, 3 , 3.9
One time
expenses: -1.8, -.4, -20.2, 0, -1.5, 0 , 0
(included in
net inc)
From 2004 to 2006, these one-time expenses consisted of reserves for the discontinued bond program, while in 2002 it was from the affect of an accounting change. Also, keep in mind that expenses were inflated in 2005 and 2006 due to approximately 4 million in yearly legal expenses. Put it all together and there is considerable upside potential for the company.

Moat
The company operates in niche lines of insurance, keeping many competitors away due to the small size. Also, the company sells its products mostly to lending institutions and car dealers, and there is some efficiency gained by having Bancinsurance operate a centralized claims management.

Risks
The main risks revolve around the discontinued bond program and the SEC investigation, but I believe these are accounted for because they are reserved for it and the SEC investigation has been open for a long time without any prosecution. (Usually, it takes a long time for the SEC to formally close an investigation, but if nothing happens within the first two years it diminishes the risk of the situation greatly) There is also a risk that premiums and business will continue to decline.
Given the price, I believe these risks are more than accounted for.

Original Write-Up on Bancinsurance on 9/19/06

Disclosure: I own shares in BCIS. This is neither a recommendation to buy or sell any of these securities. All information provided believed to be reliable and presented for information purposes only.

The Marginal Investing Framework Self-Test:

I wanted to do a quick overview to show how my portfolio holds up to my marginal company framework.

Fairfax Financial (FFH)
The Industry: Insurance. Barriers to Entry: Capital.
The Price: when I purchased Fairfax, the company was trading at approximately 70% of book value.
Qualitative Aspects: Fairfax has one of the most astute value investing teams around, with an amazing track record to match. In an industry where most participants break even at underwriting, the investment side of the business can be critical to success.

Bancinsurance (BCIS)
The Industry: Insurance. Barriers to Entry: Capital.
The Price: Bancinsurance is currently trading at 85% of book value.
Qualitative Aspects: Bancinsurance is a microcap company that serves a small niche market, and it has a history of generating very profitable underwriting income.

SFK Pulp Fund (SFK-UN.TO)
The Industry: Pulp. Barriers to Entry: Capital.
The Price: At an enterprise value of 600 million, SFK is trading below the replacement cost of their businesses, which i calculate to be 750 to 850 million.
Qualitative Aspects: A globally growing industry protected by the limited nature of softwood fibers. The company has one of the lowest manufacturing costs in the business and can benefit greatly from a rationalization of fibre prices in the Quebec region. Finally, the company has a very great management team and does not have to pay taxes until 2011.

Delta Financial (DFC)
The Industry: Subprime Mortgage Origination. Barriers to Entry: Capital.
The Price: The price paid for Delta was in excess of the 150 million in equity of the company. However, this understates the income the company expects to generate from its 7 billion securitized mortgage portfolio. When you look at the fair value of this portfolio, which should approximate the economic reality behind the present value of this portfolio, the "true" equity is approximately 350 million.
Qualitative Aspects: One of the only subprime originators that maintained its strict quality standards and avoided the loan volume frenzy of its peers.


I left out Brick because I have treated it as a quality company and hence I am valuing it based on earnings power instead of replacement cost. It is interesting to note however, that many of my most successful past holdings, such as Posco, Sino-Forest, and KHDH, were trading at "marginal investing" prices while still having some respectable qualitative aspects to them. Conversely, Most of my losing investments have occured when I overestimated the quality of a company and paid an exuberant price. So, I should probably look over my investment in Brick one more time to see if I am not making this mistake again. I think the message is that it is much more difficult to understand quality than value, and that the growth of a value investor involves a sharpened ability to assess the qualitative merits of a company. Until that ultimate stage is reached, it is best to look for companies trading at a "marginal investing" prices and to treat most qualitative aspects as just potential bonuses.

Some Updates:

Delta Financial
The company released their 2006 Shareholder letter, which can be downloaded at the link below. It is a great read for anyone trying to understand more about in the subprime industry.

2006 Shareholder Letter

Bancinsurance
The company reported first quarter earnings today. Net income was $.21 per share, and Book value increased to $7.54. Legal fees began to decrease, but the expense ratio is still abnormally high at 42%, compared to their historic average of 27%. They also repurchased 75,000 shares of their 500,000 share buyback within the first 24 days of its announcement. With the share price currently at $6.50, this seems like an excellent use of capital.

Other
Jeremy Grantham released his 1st Quarter 2007 Shareholder Letter, which discusses his thoughts about "the first truly global bubble."

Quotes
"The amount borrowers owe on their home-equity lines of credit has slipped in the past six months, to $561 billion at the end of March, the first such decline since 1999, according to new data from Equifax Inc. and Moody's Economy.com Inc. Although that decline was partly offset by a pickup in fixed-rate home-equity loans, total home-equity borrowing rose just 9% in the 12 months through March, well below the 21% average annual growth rate of the past five years."(my emphasis added)

"This month is terrible," Ford chief sales analyst George Pipas said in an interview. "We are not even close to where we expected to be in April." Pipas said industry volume appeared to be down 10 percent to date before seasonal adjustment,…

Some Recent Portfolio Earning's Reports:

Several portfolio companies have reported earnings in the past week. Below are some notes taken for each. I'm still waiting for SFK's earnings release.

Fairfax Financial (Current Price: $200.04)
Market Cap: 3.55 Billion

-Book value is up to 2.7 Billion, or $150.16 per share.
-2.6% benefit of float
-Runoff seems to be very well contained and costs should be down next year due to office closures.
-ICICI Lombard (equity accounted) is the largest private insurer in India with a 12.5% market share, and grew premiums over 80% this year to $700 million
-Expecting a soft market ahead for insurance, Fairfax's goal is to write costless float.
-8.1% return on portfolio for 2006, long term average of 9.3%. This is amazing and what makes Fairfax stand out from its competitors.
-continued to be hedged for 1 in 50 year market meltdown with S&P puts and CDS.
-Subsequent to year end, Hub Group was bought out for consolidated pre-tax gains of 220 million, and the CDS portfolio has regained much lost ground after the recent market scare. Note that the CDS portfolio is against several US mortgage companies, which is where we are seeing a lot of devastation. It is also mark-to-marketed each quarter, affecting Fairfax's income statement.

I recommend that everyone reads their shareholder letter to get a clearer understanding of the company and to understand the rationale for their market hedge.
Prem Watsa 2007 Shareholder Letter


Bancinsurance (Current Price: $6.05)
Market cap: 30 million

-Shareholder's equity up to $36.4 million, or $7.30 per share
-Net income of $5.5 million ($1.08/share) for 2006, affected by:
1. 1.8 million loss in discontinued bond program
2. 2.5 million realized gain on sale of publishing subsidiary
-Only the highland arbitration remains, and:
During the third quarter of 2006, the Company received information indicating that Highlands and the U.S. Department of Homeland Security (“DHS”) reached a global settlement concerning Highlands’ immigration bond obligations, which settlement is subject to the approval of the court in which the receivership is pending. Based on this information, the Company recorded reserve redundancies of approximately $0.1 million during 2006.
-So, I expect to see little to no more losses from the bond program.
-15.5 million in debt
-91 million investment portfolio
-Loss ratio of 53%, Expense ratio of 45%, premiums of 50 million.
-For 2007, company has already been informed of 4 million in premiums that has been moved or transferred.
- For 2007, the company expects a significant reduction in arbitration legal costs.

I believe legal costs have been costing the company about 4 million/year, so look for huge improvements in the combined ratio and earnings now that the legal disputes have been largely resolved.

Delta Financial (Current Price: 9.72)
Market Cap: $227 million

Highlights:
-Shareholder's equity of $150 million, or $6.23 per share.
-Net income for 2006 of 29 million, or $1.28 per share.
-92% Fixed Rate Origination, 8% ARM
-52% Retail , 48% Wholesale
-Cost to Originate down to 1.6% for 4Q, expect about 1.8% for 1Q due to seasonality. Still, very great progress on the expense side.

With all the bad press surrounding the subprime industry, many of you are probably wondering why DFC is any difference. Well, besides their disciplined underwriting and focus on fixed rate loans, DFC also uses very conservative accounting, that chooses to realize residual interests as they occur rather than try to estimate the gain and record it on the sale. Also, DFC has a much safer balance sheet than its competitors.

DFC
Loans held by co: 340 million
Loans securitized: 6 billion
equity: 150 million

NEW
Loans held by co: 9 Billion
Loans securitized: 13.8 Billion
equity: 2 Billion
Residual Certificates: 223 million

NFI
Loans/Securities held by co: 2.35 Billion
Loans securitized: 2.05 Billion
equity: 500 million

As you can see, Delta holds a far lower proportion of loans in their own name, lowering their own risk. That said, the 90+ day delinquency for the quarter was about 5% for DFC. Going back to '94 for the company, this percentage has always been closer to the 1-2% range. The sudden rise does bring some cause for concern, and this is why Delta still remains a small percentage of our portfolio. But, i still believe Delta will survive any disaster and will become a bigger player in the future of the industry as more competitors go under.

Bancinsurance Corp (BCIS): undervalued and off the radar

Bancinsurance is a microcap insurance company whose main business involves providing insurance against collateral for lending institutions. Basically, if someone defaults on a loan, bancinsurance makes sure that the collateral is still worth as much as it was originally. Bancinsurance provides its services to approximately 400 lending institutions, and it operates in a small and highly profitable niche. So why the great opportunity?

5 years ago, Bancinsurance entered into a new line on reinsurance covering for immigration and bail bonds. The results were disastrous; the company was forced to take a big hit to reserves, their auditors left, and they were delisted from the Nasdaq. Bancinsurances responsed quickly, hiring a new auditor, discontinuing the business, and hiring a legal firm to dispute the charges.

This was 2 years ago. Bancinsurance has now returned to filing, its legal disputes are coming to a close, and its core business is still highly profitable. Adverse loss reserves from the discontinud bond program are pretty much not a problem as the company has already assumed close to worst case scenarios for its legal disputes and the policies were also short-tail. We are left with a company that is severely cheap and with a catalyst to improving earnings.

How Cheap?

BCIS currently has a market cap of 30 million, and total debt of 15 million, minus 4.2 million recieved from the sale of its publishing division, giving an Enterprise value of 40 million. It has a 95 million investment portfolio; assuming a 4% yield, this gives you approximately 4 million in earnings. If discounted at 10%, this gives you 40 million. With simply the investment portfolio, the current price is already justified.

Underwriting

05 04 03 02 01 00 99 98 97 96
Loss Ratio 45.8 95.1 66.1 69.3 56.6 60.7 57.8 63.9 54.4 53.3
Expense Ratio 47.8 34.6 26.0 21.0 35.4 27.4 26.6 16.5 22.1 30.5
Combined Ratio 93.6 129.7 92.1 90.3 92.0 88.1 84.4 80.4 76.5 83.8

BCIS currently writes over 50 million in premiums annually. Historically, the company has averaged combined ratios in the mid 80's. What has changed recently? A comparision of the loss and expense ratios makes this clear. BCIS's expense ratio has increased significantly in the past few years as a result of increased legal and audit fees. The company has been able to increase pricing to compensate for this, resulting in the lowest loss ratio in the company's history. This shows to me the pricing power the company possesses in this niche. Regardless, management has stated by the end of the year they should be mostly finished with their legal fees and the expense ratio should fall to a more normal level.

Assuming the 93% CR the company achieved in 2005, this would be an additional 3.5 million in pre-tax income, or 2.25 million after tax. If the company improves the expense ratio to 37%, that changes it to 5.5 million after tax. If it improves the expense ratio back to the historic average of 25%, it will earn 9.25 million after tax. Combine any of these figures with the 4 million earned from the investment portfolio and you get a net income range of 6.25 million to 13.25 million.

As for manamgent, the Sokol family owns 62% of the stock, does not take excessive pay, and has done a good job steering the company. At an EV of 40 million, BCIS has a significant margin of safety and a huge potential for upside.

Disclosure: I own shares in BCIS.