Upgrading Tower to Neutral – Analyst Blog

We are upgrading our recommendation on Tower Group Inc. (TWGP) to Neutral as we believe the company’s earnings will improve during the second half of 2010, following the completion of the acquisition of OneBeacon Insurance Group’s Personal Lines division.

Though the current economic climate offers limited scope for organic growth, Tower is considering growing inorganically via acquisitions. To this effect, it completed five acquisitions over the past eighteen months: Hermitage, CastlePoint, Specialty Underwriters’ Alliance, the renewal rights of workers’ compensation business of AequiCap Program Administrators and the Personal Insurance business of OneBeacon Insurance Group. 

The CastlePoint and Specialty acquisitions expand Tower’s offering into specialty classes of business written by program underwriting agents throughout the country that it has not written earlier. The Hermitage acquisition would enable Tower to expand its wholesale distribution system throughout the country as well as establish its retail distribution system in the Southeast. The AequiCap acquisition positions it to further expand its presence in the Southeast region.

 

The most recent acquisition − OneBeacon’s personal lines business − will also broaden Tower’s existing personal lines division by increasing its portfolio and penetration in the Northeast. Thus, the challenging economic environment with its ripe-for-acquisition scenario has poised Tower to benefit from the turn of the market cycle.

 

However like other insurers, Tower has not remained immune to the global recession. Management believes that reduced capitalization, increased business declines as well as negligible new home ownership will reduce demand for small Commercial and Personal lines policies. Moreover, soft property and casualty markets will restrict premium growth.

 

As a property and casualty insurer, natural calamities also act as a headwind for Tower. The company generates a substantial portion of its revenues form Northeast regions of the country, an area that is significantly prone to catastrophes. After a benign 2009, it is being warned that 2010 could be high on natural disasters, which would make earnings volatile.

 

However, Tower also stands solid from the balance sheet perspective, with a moderate debt-to-capital ratio of 21.4% as of June 30, 2010 and $348.5 million in cash and cash equivalents. It also remains in compliance with minimum risk-based capital ratio. Its effective use of capital is reflected by its return on equity, which has averaged 19.2% for the past five years.

 

A solid balance sheet also enabled it to raise quarterly dividend by 79% during August 2010 to 12.5 cents from 7 cents. Its book value has also grown at a 5-year CAGR (2005−2009) of 28.9%.

 

During the second quarter, Tower reported 57 cents of earnings per share, beating the Zacks Consensus Estimate by a penny, helped by higher premiums earned.