MRC Global: A Play on Oil & Gas Recovery

MRC Global is the largest distributor of pipes, valves, fittings, and related products and services to the energy industry.  The company was founded in 1921 as McJunkin Supply Company and grew organically and through acquisitions over the years.  In January 2007, Goldman Sachs Capital Partners acquired a controlling interest in McJunkin and in October 2007 merged the company with Red Man Pipe & Supply Company.  Over the next four years, several acquisitions were made in a strategy to “roll up” a number of smaller players in the distribution market.  In January 2012, the company’s name was changed to MRC Global and Goldman Sachs took the company public in April 2012 at $21 per share.  Shares of the company fell dramatically in late 2014 and 2015 due to weakness in oil and gas exploration.  Shares have recently been purchased by Fairholme Capital.

Oil Rig Counts

MRC Global’s business prospects are highly correlated with exploration and production activities which, in turn, are very sensitive to the level of commodity prices.  Starting in late 2014, the price of crude oil has been very weak and extremely volatile.  Crude oil prices below the marginal cost of production in many areas has resulted in rig counts collapsing over the past year.  Although MRC Global has international operations, 79 percent of revenue in 2015 was attributable to the United States with an additional 7 percent from Canada.  As a result, examining rig counts for the United States and Canada will shed the most light on industry conditions that most directly impact the company’s revenue.

Baker Hughes publishes extensive data on rig counts as a service to the petroleum industry.  The website is well worth perusing for anyone interested in the dynamics of the industry.  Data are presented in granular formats showing activity by region, well type, and resource plays.  For our purposes, it is sufficient to look at North American rig activity at a fairly high level.  The exhibit below shows the rig count in the United States over the past sixteen years:

US Rig Count Since 2000

As of April 22, 2016, there were 405 rigs operating on land and 26 rigs operating offshore.  This represents a 54 percent decline from the rig count one year ago and a 77 percent decline from two years ago.  The current rig count is at the lowest level in the history of the chart and far below the average level of slightly over 1400 rigs.  During the oil price collapse concurrent with the financial crisis, the oil rig count bottomed at 876 rigs in early June 2009, a level that is more than double of today’s rig count!  To say that the industry is in a severe depression could be an understatement.

The situation in Canada is also extremely depressed as we can see from the exhibit below.

Canada Rig Count Since 2003

The chart shows much more volatility due to seasonal factors in Canada that limit the level of drilling activity during the annual spring thaw.  However, it is obvious that the level of peak activity in 2015 was far below the peak level of any of the prior years in the chart.  Only 40 rigs were active in Canada on April 22, 2016, which is roughly half of the rig count one year ago.

Although the price of crude oil has recovered significantly since the lows of the first quarter, rig counts have not yet responded to higher prices perhaps because the current price of oil is still below the marginal cost of production for many E&P companies.  Additionally, many debt heavy E&P players are in severe financial distress and might not be in a position to quickly resume production unless prices rise significantly from current levels.

In contrast to the depressed state of the North American industry, the level of activity in international markets has not fallen as precipitously.  Baker Hughes publishes global rig count data.  Activity in certain locations with a low marginal cost of production, such as the Middle East, has shown no meaningful reduction.  However, with only 14 percent of MRC Global’s revenue coming from outside the United States and Canada, stability in international markets will not be a major factor in the company’s success in the near term.  MRC Global’s revenue will be highly sensitive to the future trends in the charts shown above.

Operating Performance

MRC Global had total revenue of $4.5 billion in 2015 which represents a 24 percent decline from 2014.  Revenue declined in all three of the company’s segments which are organized by region.  Canada was particularly hard hit with a revenue decline of 47 percent.  The exhibit below shows the company’s revenue broken down by geographic reporting segment:

MRC Global Revenue

The decline in revenue was also evident in all product lines sold by the company but particularly notable in the oil country tubular goods category.  This business is directly tied to drilling activity in the United States and is characterized by high volatility and extremely low margins.  MRC Global disposed of the tubular goods business in February 2016 and posted a loss associated with the disposal in 2015 financial results.  The exhibit below shows the breakdown of revenue by category in 2015.

MRC Revenue by Category

In general, the distribution industry is characterized by relatively low operating margins.  MRC Global has historically realized its best operating margins in the United States segment with more modest performance from Canadian and International operations.  During times of healthy drilling activity, such as 2012 through most of 2014, it appears that the company can generate operating margins in the 5 to 7 percent range.  In 2015, significant goodwill write-downs in the United States and International segments resulted in an operating loss.  Excluding goodwill impairments, the operating margin would have been 4 percent for 2015.  The exhibit below provides a summary of operating results since 2010:

MRC Global Operating Results

Gross margins have generally been in a range of 17 to 18 percent in recent years and management has indicated that gross margin in the high 17 to low 18 percent range is likely for 2016 as well.  The company’s income statements for the past seven years appear in the exhibit below.

MRC Global Income Statement

Free Cash Flow and Capital Allocation

One of the interesting characteristics of the distribution industry is that working capital requirements decline along with drilling activity which generates operating cash flow in years like 2015.  Both inventory and accounts receivable decline when business slows which makes cash available and provides some degree of operational flexibility.  The business has low capital requirements other than the maintenance of enough inventory to satisfy the demands of customers.  As a result, traditional capital expenditures are relatively minor.

As we can see from the income statements above, MRC Global posted a net loss of $345 million in 2015.  However, free cash flow was a positive $651 million.  The goodwill and intangible impairment of $462 million was a non-cash charge that turned what would have been an operating profit into an operating loss.  Additionally, both inventory and accounts receivable balances declined, partially offset by a decline in accounts payable.  Operating cash flow was $690 million and capital expenditures were $39 million.

Over the past five years, the company posted cumulative free cash flow of $919 million, well in excess of reported net income of $112 million.  A significant portion of free cash flow was used to fund acquisitions using $583 million over past five years.  It should be noted that the large goodwill impairments in 2009 and 2015 could be signs that management has overpaid for acquisitions in the past.  On the other hand, both impairments were taken in years when the price of oil declined to low levels and resulted in low rig counts.  Accounting rules require such write-downs even if long term prospects might be more favorable and goodwill that is written down can never be “written up” in future years.  Ultimately, management’s track record with respect to acquisitions will be measured based on free cash flow generation.

The exhibit below is taken from MRC Global’s investor presentation (pdf) at the BB&T Capital Markets 10th Annual Commercial & Industrial Conference on March 24, 2016 and illustrates the company’s use of cash flow over the past six years along with acquisitions since October 2008.

MRC Acquisitions

 

Capital Structure

MRC Global’s capital structure is currently less leveraged than it has been historically.  Management used the strong free cash flow in 2015 to pay down significant debt.  Additionally, convertible preferred stock was issued in June 2015.  Net debt was reduced by $974 million in 2015, a reduction of 68 percent.  Currently the only long term debt is a $524 million loan due in 2019.

Although balance sheet risk has been reduced over the past year, the terms of the preferred stock offering may not be favorable to owners of the common stock in the long run.  The 6.5% cumulative preferred is convertible into common stock at $17.88 per share.  While this is above today’s quote, it is likely that the preferred stock will eventually convert to common stock once rig counts increase and business prospects improve.  As a result, it is probably a good idea to simply assume dilution when analyzing the company.  The share count can be expected to increase by 20.3 million if the preferred stock is converted in full.  With shares outstanding of 102 million as of December 31, 2015, conversion would represent slightly under 20 percent dilution.

We would note that the working capital reductions that made strong operating cash flow possible in 2015 despite the industry downturn will certainly reverse once business conditions improve.  MRC Global will need to direct significant capital toward inventory and an increase in accounts receivable.  It appears that the company should have the financial flexibility to increase working capital once business conditions begin to improve although this might require adding leverage to the balance sheet.

Book value per share was $9.35 at the end of 2015 but tangible book value was close to zero so shareholders cannot rely on any tangible downside protection from a balance sheet perspective.  Shares recently traded at around $14 at a market capitalization of approximately $1.4 billion.

Conclusion

As the largest distributor of critical components and services to the oil and gas industry, MRC Global plays a very important role in the energy economy.  The business is highly correlated to drilling activity as represented by rig counts.  The collapse in energy prices caused rig counts to decline precipitously in 2015 (continuing into early 2016) and this had a major impact on MRC Global’s financial results.  However, management used strong free cash flow primarily generated through working capital reductions to deleverage the balance sheet.  A preferred stock offering, although potentially dilutive, further reduced the company’s risk profile.

MRC Global is not a wonderful business but it is an important business in a very important industry.  If rig counts remain depressed throughout 2016, MRC Global’s financial results will remain depressed as well and it is possible that further write-downs of intangible assets will be required.  Market sentiment would be negative under such conditions and the stock price is also likely to be correlated to the price of oil.  Eventually, supply and demand dynamics should result in a more normalized level of production in the United States and Canada.  The key question is when this “eventual” outcome will materialize.

As long as MRC Global does not face financial distress before a recovery commences, the share price should eventually recover along with industry activity.  The main risk appears to be a prolonged downturn with rig counts remaining at very low levels.  Investors who believe than energy prices will recover over the next couple of years might want to consider MRC Global, or other large distributors such as Now Inc., rather than investing in oil directly or through E&P companies.

Disclosure:  No position in MRC Global.

Company Profile: W. R. Berkley Corporation

WRB LogoW. R. Berkley Corporation is an insurance holding company operating in a variety of niche markets requiring specialized knowledge regarding a particular territory or product line.  The company was founded in 1967 by William R. Berkley who currently serves as Executive Chairman.  The founder’s son, W. Robert Berkley, Jr., has been with the company for eighteen years and became Chief Executive Officer in 2015.

W. R. Berkley has expanded mostly through organic growth over nearly a half century.  Of the company’s 51 operating units, 44 were organized and developed internally.  From 1974 to 2015, management compounded per-share book value (with dividends included) at an annualized rate of 17.3 percent compared to 10.8 percent for the S&P 500 over the same period.  With common stockholders’ equity of $4.6 billion at the end of 2015 and a current market capitalization of $7 billion, management continues to believe that the company’s business model can achieve long-term risk adjusted returns of 15 percent after tax.

Company Culture

There is usually a negative correlation between the length of a proxy statement and the utility of the document for investors.  Despite filing a lengthy proxy, the material presented by W. R. Berkley provides quite a bit of insight into the firm’s culture, much of which is based on how employees are compensated for long term performance.  Unlike many other businesses, the performance of an insurance company can only be evaluated over long periods of time.  This is because loss reserving can resemble more of an art than a science.  The estimates made for a given fiscal year are certain to be incorrect in the long run because actual losses will almost always vary from estimates.  High quality insurers put in place systems to reject inadequately priced business even if it means that premium volume will decline.  Additionally, conservative insurers will usually err on the side of overestimating reserves which can generate “favorable development” in subsequent years as reserve estimates are revised downward.

The exhibit below, which is taken from the company’s proxy, illustrates the insurance cycle and management’s approach to dealing with each phase of the cycle.

Classic Insurance Cycle

Every insurance company will claim to follow W. R. Berkley’s approach during soft markets which involves being willing to sacrifice volume for profitability.  However, this is much harder in practice than in theory since underwriters are often tempted to retain market share even if the business they are underwriting might prove unprofitable in the future.  If this unwarranted optimism filters into reserving judgments, unpleasant surprises are sure to follow in future years as “unfavorable development” results in charges for prior years when management was insufficiently conservative.

W. R. Berkley’s compensation philosophy appears to be aligned with management’s approach to the insurance cycle.  Annual cash bonus payments primarily emphasize the extent to which the company’s annual operating return on equity achieves the long term 15 percent target.  Long term incentive plan awards are tied to book value per share growth, are subject to claw-backs, and payouts below target levels have not been uncommon.  In order to encourage long term behavior, restricted stock awards remain deferred, even after fully vested, until the executive is no longer employed by the company.  Hedging is not permitted.

The summary compensation table from the proxy appears below:

WRBComp

Aggregate compensation is certainly generous but at least appears to be based on factors aligned with shareholder wealth creation.  Perhaps most notably, William R. Berkley continues to maintain a substantial interest in the company with 20.4 percent of shares outstanding. While it would be nice if Mr. Berkley adopted Warren Buffett’s “founder’s philosophy” of taking only symbolic pay, this is perhaps unrealistic for most companies so we prefer to focus on whether the incentives are properly aligned with smaller minority shareholders.

Strong Underwriting Record

W. R. Berkley targets a combined ratio in the low 90s and this goal has been met over the past decade with an average combined ratio of 93.6 percent.  A combined ratio under 100 percent indicates that the company operated with underwriting profits.  The combined ratio is the sum of the loss ratio and expense ratio.  The chart below shows W. R. Berkley’s net premiums earned along with the loss, expense, and combined ratios over the past decade:

WRB 2006-15It is interesting to note that management’s actual behavior has been consistent with the philosophy illustrated in the “classic insurance cycle” exhibit that appears above.  Premium volume was reduced early in the decade as pricing was inadequate to induce management to write policies, but has picked up in recent years as pricing firmed.

We should note one trend in the chart which is very important:  As premium volume decreased from 2006 to 2009, the expense ratio increased quite substantially.  This is because management did not attempt to reduce operating costs commensurate with the decline in premiums.  Should we regard this as good or bad?  Shouldn’t management aggressively seek to cut costs during times when business slows down?  While cutting wasteful spending is always a good idea, aggressively cutting headcount during soft markets creates perverse incentives for underwriters to look for business regardless of ultimate profitability.  We can see that the expense ratio has decreased somewhat in recent years although it is still elevated compared to 2006-2008 levels.  Presumably, the company is in a good position to work on expense ratio reductions now that premium volume is growing again.  We regard the track record over the past decade to be a good indicator that the company’s stated culture is, in fact, something that employees are regularly practicing rather than just serving as talking points from investor relations.

Business Segments

W. R. Berkley operates in three segments:  Insurance – Domestic, Insurance – International, and Reinsurance.  Domestic insurance is, by far, the company’s most important segment accounting for 77 percent of revenue and 83 percent of pre-tax income in 2015.  International insurance accounted for 13 percent of revenue and 11 percent of pre-tax income while Reinsurance provided 10 percent of revenue and 6 percent of pre-tax income.  The exhibit below provides a summary of business segment performance over the past four years. The company had a different segment organization prior to 2012.

Business Segment Data

Domestic insurance gross premiums in 2015 came from the following lines:  Other liability (31.8%), workers’ compensation (27.9%), short tail lines (21.2%), commercial auto (9.7%) and professional liability (9.4%).  The segment is highly decentralized with a large number of independently operating units none of which provides more than eight percent of gross premiums.  These businesses appear to participate in niche markets that focus on industries and products where in depth knowledge and expertise can add value.  This is evident based on the combined ratio of the group which is the lowest of all company business segments.

International insurance writes business in over sixty countries through a decentralized operating structure.  The segment is heavily focused on short tail lines, representing over fifty percent of gross premiums, and posted a combined ratio under 100 percent in three of the past four years.  The reinsurance group appears to run opportunistically with premium volume varying more than the other segments and showing declines over the past three years.   Primary markets include the United States, United Kingdom, Continental Europe, Australia, South Africa, and the Asia-Pacific region.  The reinsurance combined ratio has been under 100 percent in three of the past four years.

Overall, W. R. Berkley is primarily a domestic specialty/niche insurer with that segment driving overall company performance.  Given management’s willingness to reduce premium volume during soft markets and the demonstrated track record, particularly in the domestic specialty markets, it appears that the company has a good chance of achieving its targeted combined ratio in the low 90s over long periods of time.

Investments

Along with underwriting profits, insurance companies derive profits through the investment of shareholders’ equity and policyholder float.  Float represents funds that are available for investment during the time between receipt of premiums and the eventual payout of policyholder claims.  Although float is a balance sheet liability, it has a positive value to shareholders as long as the cost of float (underwriting losses divided by float) is below the rate of return achieved through investment of the funds.  As we have seen, W. R. Berkley has achieved combined ratios under 100 percent over the past decade which means that policyholder float has been available for investment at negative cost.

Most insurance companies invest primarily in fixed income securities and typically attempt to match the duration of the fixed income portfolio with the expected duration of its liabilities.  W. R. Berkley’s investment strategy has attempted to limit the duration of the fixed income portfolio (3.3 years as of December 31, 2015) and to supplement returns through investment in equity securities, merger arbitrage strategies, investment funds, private equity, loans, and real estate projects.

The exhibit below, taken from the company’s 2015 10-K, shows the composition of the investment portfolio at the end of 2015:

WRB Investments

Fixed maturity investments, at $12.4 billion, represents 77.3 percent of the investment portfolio and exceeds policyholder float, which we estimate to be approximately $9.9 billion.  Over time, the company has shifted away from equity securities which represents less than 1 percent of the portfolio.  Instead, management has put cash to work in a number of alternate asset categories including investment funds (7.3% of the portfolio), real estate (5.8%), merger arbitrate (2.3%) and a portfolio of loans (1.7%).

In addition to the investment portfolio, the company has wholly owned investees which are not included in the investment portfolio but provide revenue to the company reported in the income statement.  These businesses are managed through Berkley Capital LLC.  Berkley Capital’s investment criteria and portfolio companies are listed on their website.  Although granular disclosure of the results of these subsidiaries is not provided in W. R. Berkley’s annual report, the strategy is interesting to note because it seems to emulate Berkshire Hathaway’s strategy in some ways.

The annual report provides some limited insight into the strategy behind the company’s non-traditional investments:

“As interest rates declined in recent years, it became difficult to maintain a high-quality portfolio with a duration that reflects the average life of our liabilities, and still obtain adequate yields. The variables under our control are the quality, duration and liquidity of the fixed-income portfolio.  We were neither prepared to reduce the quality of our portfolio, nor were we willing to extend the duration since that could exacerbate our potential exposure to inflation. Thus we felt we had two alternatives. The first was to marginally reduce short-term liquidity by buying securities that might not provide immediate liquidity, but were of the highest quality. The second was to expand our investments in private equity, limited partnerships and real estate to improve returns. We have experience in all of these areas, and they have delivered excellent returns over many years.

Investments in these areas now represent an amount equal to approximately half of our shareholders’ equity. So far, this strategy has proven to be rewarding. Although the income is not reported in as consistent a manner as income from bonds, the internal rate of return is well above the 3-4% we would have received from fixed-income securities, and we have not sacrificed quality or increased risk. In addition, because accounting rules require us to carry many of these investments under the equity method, there is a significant amount of unrealized gains embedded in our portfolio that is not recognized on our balance sheet. The single most visible investment of this type is Health Equity (HQY), which we took public in 2014. If we were to sell our interest in any of these projects in any given year, our ROE would be positively impacted.”

Although the move toward non-traditional investments seems to be at least partially driven by the low interest rate environment, success in this area could result in W. R. Berkley finding additional opportunities for reinvestment.  Since the company has regularly returned cash to shareholders via dividends and repurchases over the years, additional opportunities for internal reinvestment could result in more attractive (and tax efficient) growth for continuing shareholders in the long run.

Conclusion

W. R. Berkley is a very high quality insurance company.  While the company has not posted underwriting results on par with RLI Corporation, which we recently profiled, the valuation assigned by the stock market is much more reasonable.  Book value per share was $37.31 as of December 31, 2015 and shares recently traded at about $56.50.  A price-to-book ratio in the 1.5x range doesn’t appear to be unreasonable for a company with W. R. Berkley’s track record and, by this measure, the shares trade at a level that compares favorably to Markel Corporation.  We have covered Markel on a number of occasions over the past year and have noted its emerging status as a “mini-Berkshire”.

Recently, Morningstar published an article calling into question Markel’s status as a “mini-Berkshire” and suggesting that W. R. Berkley offers a better value.  Although W. R. Berkley’s price-to-book ratio is indeed lower than Markel’s, it doesn’t appear that W. R. Berkley is as far along with its development of non-insurance subsidiaries compared to Markel.  The Morningstar analyst puts an emphasis on underwriting profitability as an indicator of whether an insurer has an enduring “moat” and doubts whether Berkshire’s approach of reinvesting in non-insurance subsidiaries can be successfully emulated. He claims that attempting to emulate Berkshire could take management’s focus away from underwriting performance.

We will probably not know the outcome of Markel’s attempts for many years but it is clear that the company is explicitly trying to emulate Berkshire.  The same does not appear to be the case for W. R. Berkley.  Based on management’s statements, it seems like the shift toward private equity and other non-traditional investments has a great deal to do with the current low interest rate environment.  It will be interesting to see how W. R. Berkley’s investment strategy evolves once the interest rate environment eventually normalizes.  The company is definitely worth tracking for anyone interested in exposure to a U.S. focused niche insurer with potential upside from wise investments.

Disclosure:  No position in W. R. Berkley.

 

RLI Corp: Profile of an Extraordinary Insurer

RLILogoRLI is a specialty insurer offering a variety of property and casualty insurance coverages and surety bonds in a number of niche markets.  The company was founded in 1965 by Gerald D. Stephens who observed a need for contact lens insurance and founded Replacement Lens, Inc.  Over the years, the company expanded into a number of commercial property and liability fields that were historically underserved and required specialized expertise.  From a standing start fifty years ago, RLI has grown into a company with revenues of $795 million and shareholders’ equity of $823 million at the end of 2015.  The company has posted twenty consecutive years of underwriting profitability.  This record of success has not been lost on market participants.  RLI’s market capitalization is currently $2.8 billion, or 3.4 times book value.

Strong Record of Underwriting Profitability

The insurance industry is generally highly competitive and has a mediocre record of aggregate underwriting profitability.  Many insurers struggle to achieve breakeven results on underwriting and rely primarily on fixed income investments to provide a return to shareholders.  The low interest rate environment in recent years makes underwriting profitability imperative for any insurer seeking to deliver a reasonable return on equity, but the commodity-like nature of insurance and increasing capital coming into the market makes underwriting at a profit difficult.  The niche markets that RLI focuses on in the specialty admitted and excess and surplus markets are generally less competitive and offer skilled underwriters more opportunities.

The exhibit below, which is taken from RLI’s 2015 annual report, compares RLI’s statutory combined ratio against the overall industry’s performance, as reported by A.M. Best:

RLI vs Industry Combined Ratio

On a statutory basis (which differs in certain ways from the GAAP figures referred to elsewhere in this article), the insurance industry has essentially operated at break-even levels on average over the past decade while RLI has posted an average combined ratio of 82.6.  A combined ratio of 100 represents underwriting break-even while figures below 100 represent underwriting profitability.  The combined ratio is the sum of underwriting losses and expenses divided by earned premiums.

The exhibit below shows a more detailed breakdown of RLI’s GAAP combined ratio over the past fifteen years broken down into the underwriting loss and expense ratios.  We can clearly see that RLI has an unusually strong record of profitability relative to the industry.

RLI Combined Ratio 2001-15

What accounts for consistent underwriting profitability in an environment where the industry as a whole struggles to break even?  The niche focus clearly plays a major role.  As an example, one of RLI’s specialty personal property products covers recreational vehicles.  Compared to the massive and highly competitive market for auto insurance, which is dominated by a few much larger players, RV insurance is a small niche where industry expertise and longstanding relationships are likely to play a significant role.  By employing underwriters with in depth understanding of the RV market, along with similar niche product segments, RLI can price insurance competitively but with enough margin of safety to make underwriting profits more likely.  RLI’s skilled underwriting team is clearly part of the company’s “moat” when it comes to beating the overall industry’s combined ratio over long periods of time.

Conservative Reserving Philosophy

Every publicly traded insurance company includes information on loss reserving in annual reports and other filings.  RLI’s disclosures are extremely detailed and serve as a good primer on insurance loss reserving for anyone interested in learning much more about how reserve estimates are made.  The nature of reserving involves numerous assumptions and estimates and depends on the judgment of management.  If there is one universal truth when it comes to insurance companies it is that the current year loss figures are certain to be wrong!  The only question is whether management tends to err on the side of caution or not.  Except for insurers specializing in short tail property coverages, the conservatism of management’s estimates can only be inferred over a period of many years.

Insurance companies include an exhibit in annual reports commonly referred to as a “loss triangle”.  This exhibit shows the net liability for unpaid losses at the end of each of the past ten years along with a re-estimate of this loss figure for every subsequent year.  For example, RLI initially estimated its net liability for unpaid losses at the end of 2007 to be $774.9 million.  This liability was re-estimated each subsequent year.  At the end of 2015, the figure was estimated to be $554.6 million.  This implies that the estimate eight years earlier was too high by over $220 million, which is referred to as a redundancy.  Over the years, RLI recorded these redundancies as favorable development.

RLI’s loss triangle, which appears in the company’s annual report, is shown below (click on the image for a larger view):

RLI Loss TriangleIt is clear that RLI has demonstrated a very conservative reserving philosophy over time.  One might ask whether being overly conservative with loss estimates could be as undesirable as being too aggressive since ideally one would like to be right on target so that each year’s underwriting loss accurately reflects actual losses during that year.  RLI management states that they would rather be conservative given that the niche market segments in which the company operates can produce results with higher than average variability.  This seems like a plausible rationale in favor of RLI’s historical approach.  While there can be no assurance that reserve estimates will continue to be conservative going forward, past results demonstrate an attitude that is unlikely to suddenly shift in favor of recklessly aggressive estimation practices.

Limited Premium Growth … Demonstrating Discipline

Over the past decade, RLI’s earned premium volume rose from $491 million in 2005 to $700 million in 2015, representing annualized growth of 3.6 percent.  Premium volume actually declined in two of the ten years.  While it would be wonderful to observe rapid premium volume growth, apparently RLI’s management was restrained in terms of what business to accept in order to maintain historically high underwriting profitability.  RLI could no doubt have grown premium volume much more rapidly by compromising on underwriting standards and pricing policies more competitively.  However, it is certain that doing so would have impacted underwriting profitability.

The exhibit below shows RLI’s earned premium volume and underwriting profitability over the past ten years (figures in thousands):

RLI Premium Volume & Profitability

A disciplined insurer must be willing to turn away business when pricing is inadequate.  Almost any insurer will say that this is the case but few have the discipline to act on it.  One section of Warren Buffett’s 2004 letter to Berkshire Hathaway shareholders profiles National Indemnity Company.  Mr. Buffett discusses how National Indemnity allowed premium volume to shrink dramatically for well over a decade until appropriate pricing returned.  This letter is highly recommended to anyone interested in the insurance industry.

Limited Float Growth … A Consequence of Discipline

One of the consequences of RLI’s underwriting discipline is that float growth has been limited over the past decade.  Float represents funds that are held by an insurance company that are expected to eventually be paid out to policyholders over time.  While float is held it can be invested for the benefit of shareholders.  RLI’s float grew from $909 million at the end of 2005 to $999 million at the end of 2015.  The annualized growth rate is less than one percent.  Due to RLI’s policy of returning all free cash flow to shareholders over time (which we will discuss shortly), shareholders’ equity and total investments have also remained rather static.

The exhibit below shows total investments, shareholders’ equity, and float over the past ten years.  RLI runs a conservative investment portfolio which was comprised of 79.3 percent fixed maturity investments, 19.3 percent equity securities, and 1.4 percent short term securities at the end of 2015.  Figures in the exhibit are in thousands.

RLI Float 2006-2015

It should be noted that other insurance companies, such as Berkshire Hathaway and Markel, have managed to grow float at more satisfactory rates over the past decade while producing underwriting profits.  RLI’s management has a long history of success and clearly believes that growth over the past decade could not be accomplished without compromising the company’s underwriting profitability.  One might consider whether RLI was excessively conservative but it is difficult to make any conclusive statements on this point.  In general, it is better for an insurer to err on the side of caution rather than aiming for potentially risky growth.

A Cash Flow Machine … But Limited Reinvestment Opportunities

As we have seen, RLI has not been a “growth company” over the past decade but the company has been a cash flow machine.  Return on equity has averaged nearly 16 percent, driven mostly by underwriting profitability and supplemented by investment returns.  Over the past ten years, RLI has produced nearly $1.2 billion of free cash flow and has returned almost all of this cash flow to shareholders in the form of repurchases and dividends.  The company pays a regular cash dividend and has paid supplementary special dividends as well in recent years.

The exhibit below shows RLI’s free cash flow, dividends, and net repurchases over the past ten years (figures in thousands).

Free Cash Flow

It is notable that RLI has a flexible policy when it comes to cash return.  From 2006 to 2010, the company repurchased shares.  From 2010 to 2015, special dividends were the primary means of returning cash.

The fact that the company has been returning cash to shareholders should be unsurprising given the limited growth in the size of the business over the years.  RLI could have retained earnings for investment purposes but apparently does not seek to build up a larger equity portfolio or acquire non-insurance businesses.  RLI does own a minority stake in Maui Jim, which sells premium sunglasses, but this ownership interest came about due to the company’s historical roots in contact lens insurance products and does not represent any strategy of pursuing non-insurance investments.

Investors Have Not Ignored RLI’s Success

Anyone reading this article probably has a good sense of the fact that RLI is a very good insurance company with a long track record of success.  This impression would be further reinforced by reading recent annual reports.  Where’s the catch?  It appears that market participants generally understand how attractive RLI’s business is and have acted accordingly.

The following exhibit shows RLI’s total return to shareholders compared to the S&P 500 and the S&P 500 P&C index:

RLI Stock Performance

A significant portion of the return has come from dividends, particularly the special dividends disbursed in recent years.  However, the market has also assigned a much higher price-to-book value to RLI as the following exhibit demonstrates:

RLI P/B Ratio

The company’s price-to-book ratio rose from 1.84 at the end of 2005 to 3.27 at the end of 2015 and stands at approximately 3.4 today.  We can see from the exhibit that the price-to-book ratio was as low as 1.3 at the end of 2001.  Clearly the market has massively increased the valuation assigned to RLI and this trend has been magnified in recent years.

Conclusion

RLI is among the best insurance companies in the industry with an enviable long term record of underwriting profitability.  However, the company has failed to grow rapidly in recent years as inadequate business was rejected in order to maintain underwriting profitability.  The company has continuously generated significant free cash flow that could not be reinvested in the business.  As a result, management pursued a repurchase program when the stock price was not as elevated relative to book value.  More recently, as the valuation increased, cash has been returned to shareholders primarily through special dividends.

Although there is much that is positive to say about RLI, it is difficult to justify the current valuation especially in light of the limited growth and lack of compelling reinvestment opportunities.  Although returning cash to shareholders is the right thing to do under the circumstances, the stock’s elevated level is likely to force management to pay special dividends, which are taxable to most shareholders, rather than to repurchase shares.

We have profiled Markel Corporation in the past and note that the company has been able to grow more rapidly, both organically and through acquisition, over the past ten years and to do so while maintaining underwriting profitability.  Although Markel’s average combined ratio is quite a bit higher than RLI’s combined ratio, Markel has retained all earnings and finds ways to redeploy funds internally.  Markel also has a growing non-insurance group offering shareholders more diversification and making it more likely that the company will avoid taxable distributions to shareholders.  At a price-to-book ratio that is less than half of RLI, Markel seems like the better value at current prices.  Interestingly, Markel has long held a significant investment in RLI.

The following video is worth watching to understand more about RLI’s history and leadership.  Gerald D. Stephens, the company’s founder, and Jonathan E. Michael, RLI’s current Chairman and CEO, discuss the company’s founding, history, and philosophy in some detail.  If we want to understand RLI’s moat, we need to understand the company’s culture and this is an excellent place to start.  (RSS Feed subscribers can click on this link for the video.)

Disclosure:  No position in RLI Corp.  Individuals associated with The Rational Walk LLC own shares of Markel Corporation and Berkshire Hathaway.