We are downgrading our recommendation on the Tower Group Inc. (TWGP) to Underperform from Neutral. We believe that a lower interest rate environment and higher expense ratio will suppress earnings in the near term.
A weaker investment yield continues to be a concern for Tower. In response to this environment, management implemented a strategy to purchase dividend-paying common stocks during the fourth quarter of 2010 to enhance investment income. The company is also evaluating alternative investment classes to further boost the investment income. Though management is trying ways to offset pressure from low interest rates, we are not sure how far the company will be successful in this respect.
Management expects a higher expense ratio in 2011 due to OneBeacon’s Personal Lines system integration as well as other systems-related initiatives. Net expense ratio in the fourth quarter of 2010 improved to 38.3% compared with 41.8% in the prior-year quarter.
There also remains a catastrophic risk as Tower generates a substantial portion of its revenues from the Northeast United States, which is significantly prone to catastrophes. Although Tower has reduced the number of polices in Massachusetts and Rhode Island, we think the company runs a high catastrophe exposure in the region.
However, we are impressed with Tower’s strategy to expand inorganically in an environment that offers little scope for organic growth. It has made numerous acquisitions over the past two and a half years to grow its book of business.
Moreover, with approximately $30–35 million of cash at holding company along with $125 million of available credit capacity, we believe Tower is favorably poised to pursue further acquisitions, which would significantly broaden its business. Management also reiterated during the conference call that it continued to see opportunities to make acquisitions at reasonable valuation levels.
However, given the current near-term pressure from low interest yields and high expense ratio, we would recommend staying away from the stock.
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