In part 1 of this series I gave some background on the life settlement industry, and I tried to show where Life Partners (LPHI) fits into it. After a decade of continuous rapid growth, it's not surprising that there wasn't much bad news to report. Analysts are notorious for extrapolating recent trends far off into the future. So in this segment, I'm going to discuss some of the risks to Life Partners shareholders, and some of the challenges the company faces. The market makes mistakes, but it's not totally stupid, and if LPHI is trading at only 10x earnings after such a long period of strong growth, there's probably reason(s) why.
One of the reasons why this stock is probably so cheap is that management predicted in the 2009 annual report that the face value of policies transacted in 2010 would be over $1 billion, a 44% increase over 2009! Not surprisingly, with three quarters already on the books, LPHI is nowhere near transacting $1 billion of face value this year. Actually the face value of policies written this year has decreased! This being said, revenue is up 19.2% and EBIT is up 24.7% in the LTM compared to the twelve months before that. So the execution continues to be strong despite the fact that management fell short of expectations. But that doesn’t change the fact that management made the mistake of extrapolating recent growth trends into the future and publicizing those expectations in an annual report. It’s appropriate to prepare for continued growth, especially in a capital un-intensive industry. It’s also appropriate to tell your investors that you’re prepared for it. But to set 44% growth as a target in an annual report is not appropriate, and investors are upset.
With growth slower than management guidance for the year, investors might be wondering what growth is left in the industry. The actual size of the industry is largely dependent on what subset of the insured population has a significantly reduced life expectancy and how well underwriters can predict those life expectancies. Recent adjustments to mortality tables suggest that life expectancies were too low with some underwriters consistently missing the mark by as much as 25%. If life expectancies are higher than expected, life settlement yields will be lower than expected, and the market for life settlements will be smaller than expected. However, VBT 08 (the new table) only suggests a 5% increase in life expectancy over VBT 01 (the old table), which fails to explain the major revisions made this year by two of three major life settlement underwriters. Fasano, the market leader in life settlement underwriting in terms of matching life expectancy to actual mortality, is pushing for standardized performance reporting. Anecdotal evidence suggest that LPHI in-house underwriters might have estimated lower life expectancies than their counterparts at Fasano, but LPHI contends that they sell policies to end investors with a “cushion” to insure actual investment yields remain high.
Fortunately for all brokers in the life settlement industry, the potential inventory of policies is still growing and the percentage of policies traded in secondary markets is still just a drop in the bucket. Estimating the potential market size starts with existing life insurance in-force and winnows that pool down based on a number of factors. The insured has to exceed a certain age and have impaired health, the policy should have a face-value of at least $100k and it will most likely be universal life or at least whole life insurance. Then, of course, the policy holder must have a need or desire to sell the policy, and know that life settlements are an option. Estimates of this total market size will vary widely based on assumptions, but the best analysis I’ve seen estimates the market at over $100 billion in 2010, and expects it to continue growing in the low teens through 2015. This compares to $9-10 billion of total market transactions in 2008. I think it’s safe to assume that the market will continue to grow as long as life settlements continue to perform well.
The issue of margin sustainability is another pressure point. In 2009, LPHI transacted $694 million in policy face value off which it generated $104 million of revenue, half of which was paid out as brokerage and referral fees. This means that the total transaction cost for the policy purchaser is an upfront fee of around 15%. Obviously this is factored into investor return expectations, but intuitively it still seems high. The crazy thing is that it had been even higher in past years.
Part of the justification for the higher revenue/face value earlier in the decade is a higher reliance on viaticals (policies on people with terminal illness expected to live less than two years). The transition to life settlements means LPHI transacts greater face values at lower "margins". Interestingly, in the last twelve months, the trend has reversed, indicating that LPHI might be returning to its viatical roots in search of better profitability. Assuming our underwriting was absolutely perfect, if the life expectancy of the insured was actually a year (or less) than investors should be willing to pay 90% of face value for an 11% yield, whereas the insurance company will still only offer maybe 10%. Somewhere in between is a fair compromise for the insured, the investor, and brokers. As life expectancies increase, the spread between value to the insured and investor closes, narrowing potential margins. Obviously competition narrows the margins too, but comparing life settlement brokers to brokers of far more liquid investments where there’s no structural difference in fair value to different buyers might not make for a meaningful comparison.
Without any comparable publicly traded companies, it’s difficult to say whether or not the commissions are fair (or sustainable). A member of seekingalpha.com posted an analysis questioning LPHI’s margin sustainability, and referenced an earnings press release from Peachtree Financial, a company that is no longer publicly traded. The analyst states:
Peachtree, a direct competitor to LPHI, was a publicly traded company on London’s AIM market prior to their acquisition by DLJ Merchant Banking. Peachtree’s last earnings release is somewhat dated (6/30/06), but does provide some color on their fees. “In the first half of 2006, Peachtree purchased policies with a face value of US$400 million generating gross revenue of US$24 million.” Peachtree’s “gross revenue” of 6.0% was less than half of LPHI’s gross revenue to face (14.4%). Surely, this cannot go unnoticed forever.
The analyst includes a link to the press release which has since been taken down, but I’ve reproduced it here. For anyone who opens that pdf, the first thing you will notice is that Peachtree has multiple lines of business and that their financial statements are far more complicated than Life Partner’s. Most importantly, however, is that Peachtree’s “gross revenue” of 6.0% seems to have already deducted the brokerage fees which are included in LPHI revenue. Looking down the financial statements of both Peachtree and LPHI, we see that the “brokerage fee expense” for Peachtree is $240k over $24 million life settlement revenue (1%) compared to “brokerage fees” of $49.194 million over $103.614 million of revenue (47%) for LPHI in 2009. There is no line item in Peachtree’s financial statements that makes up for this discrepancy. This accounting makes sense as Peachtree describes itself as an “originator” rather than a “broker”. From their 2005 annual report:
Through Life Settlement Corporation, the Company provides liquidity to persons or entities that own life insurance policies by facilitating the sale of their policies to trusts in which the Company owns the Unified Trust Interest. In turn, the trusts transfer Special Undivided Beneficial Interests (of which the Company has no interest) in the policies to unrelated parties to raise funds for the purchase of the policies. The Company also performs servicing functions related to mortality tracking and monthly reporting. The Company earns origination and servicing fees related to the life settlement transactions. Fees are based on a percentage of the net death benefit of the underlying life insurance policies.
LPHI’s auditor, Eide Bailly, resigned in January. Eide Bailly had only been the auditor for one year after acquiring the previous auditor, Murrell, Hall, McIntosh & Co. In 2009, Eide Bailly did uncover a material weakness as outlined in the 2009 financial statements. However, the auditor resignation press release stated “the decision to change auditors was not the result of any disagreements between the Company and Eide Bailly on any matter of accounting principles or practices, financial statement disclosures, or auditing scope or procedure.” Eide Bailly signed a letter to the SEC confirming this statement. If I had to guess, I would say the disagreement was probably a matter of compensation. In 2008, LPHI paid an audit fee of only $85,881, which jumped up to $146,421 in 2009. Either LPHI is upset about the increased fees and wants to shop around, or Eide Bailly is upset that the fees are still very low for a business with over $100 million in revenue, complex financial transactions, and thousands of customers.
Until LPHI has audited financial statements for 2010, Eide Bailly’s resignation is a red flag, but I’m not exactly sure how to work this information into my valuation. The New York State Society of CPAs took an “Inside Look at Auditor Changes” in November 2005. The report has some good statistics and information on why companies change/loose their auditors, and what it might mean for the company going forward. The good news is that Eide Bailly is required to inform the SEC of any accounting disagreements it has with LPHI, even if the disagreements are resolved, so the signed letter to the SEC is actually a valuable piece of evidence. This could actually be a catalyst for stock price appreciation if LPHI appoints a big four accounting firm, putting to rest some of the concerns investors have had over the past few years.
Insurance Company Competition
One final reason why investors might be discounting LPHI is the threat of competition from life insurers. As the reasoning goes, if the life settlement market grows large enough, the insurance companies could respond and offer greater cash surrender values. This is the only challenge/risk to LPHI that I will refute. In a paper titled “The Benefits of a Secondary Market for Life Insurance Policies”, Neil Doherty and Hal Singer from the Wharton Financial Institutions Center explain how the emergence of a life settlement and viatical market benefit policyholders. They also explain why insurance companies are unlikely to respond to competition:
If competition in the primary market constrains an insurance carrier’s monopsony power over the surrender of a normal policy, then why does competition not have the same effect on the surrender of an impaired policy? The answer lies in the regulatory constraints faced by life insurance carriers. If an insurance carrier wished to increase its market share in the primary market for life insurance by offering more competitive surrender values for impaired policies, it would have to offer consumers a set of health-dependent surrender values. Such an offering of explicit health-dependent surrender values by a life insurance carrier, however, would be fraught with regulatory, actuarial, and administrative difficulties. Life insurance carriers to not offer health-adjusted surrender values, which suggests that these difficulties outweigh the benefits that carriers would obtain by offering health-dependent surrender values to consumers.
These are only the issues I think are most important. Management's aggressive forecasting is a problem that will fade with memory. The growth and margin sustainability issues are questions investors will continue to have as long as LPHI maintains its profitability, which will hopefully be for a long time. And the accounting/auditor issues will hopefully be resolved in the next few months. A thorough audit might reveal some new issues, but it can also reduce uncertainty.
There are other issues as well, some of which I might discuss next week in Part 3 when I present my model. But I’d also like to take a minute to discuss some interesting positive aspects of LPHI.
Advances on Policy Premiums
If you get your morning coffee at the same shop every day, and every day they give you the wrong change, you might assume that the guy at the register is trying to steal your money. But that’s only true if the error is always in the coffee shop’s favor. LPHI might have some accounting issues, but the peculiarities aren’t always the result of aggressive accounting. In particular, “advances in policy premiums” is somewhat hidden in the G&A expense, but it represents premium payments that were made by LPHI to keep underperforming viaticals in force despite the fact it has no obligation to do so. At 17% of 2009 G&A expenses this is a material expense. While these advances are 100% expensed, management keeps track of them and takes its cut from the benefit payout when the insured dies. This repayment is net against additional pre-payments each year costing around $2MM annually. According to LPHI investor relations, no interest rate is charged on these advances, but the outstanding balance represents a sort of hidden asset on LPHI’s balance sheet worth $6.5MM (or $0.44/share) in the most recent quarter.
Focus on non-Institutional Investors
Many of Life Partner’s competitors have focused on institutional investors. On the surface, this is the sexy end of the market to be in. With only a few large financial backers, it’s possible to compile a huge pool of life settlements in a short amount of time, and using third party underwriters, you don’t even need any expertise to scale your business instantaneously. However, Life Partner’s unique focus on high net worth investors has provided some structural advantages and a competitive moat. Unlike institutional investors, HNW clients don’t leverage their portfolios. Believe it or not, some people are satisfied with a 13% yield. A tremendous network of HNW clients and/or their financial advisors takes a long time to build, but it also allows LPHI to continue transacting business when the big financial institutions are taking a hit.
Providers naturally seek the underwriter that will supply the lowest life expectancy because that makes the policy they’re trying to sell appear more valuable. Smart institutional investors, however, will demand life expectancies from only the most accurate (and conservative) underwriters. This dynamic helps explain why there is such variability between underwriters.
LPHI relies on its own in-house underwriters to price policies. In the short-term it would benefit LPHI to underestimate life expectancies and sell life settlements for more money. But finding the best settlements and passing them on to investors at attractive prices allows LPHI to build a brand name and reputation with every transaction. This is particularly important when dealing with non-institutional clients lacking the bargaining power (or resources or sophistication) to demand the best underwriting.
The risks mentioned above have all been mentioned elsewhere before. For the most part, I think concerns have been overdone. But regardless of what the risk or underlying fundamentals are, without understanding the valuation, analysis is meaningless. Until I present my model next week, I hope some of my more dedicated readers take the week to do their own research and let me know what they think so far!
Disclosure: Long LPHI in my kaching portfolio