Tower is a New Zealand general insurance company paying out excess capital to its shareholders. Once it pays out this capital, it will be a well-capitalised insurer that (absent a share price increase) will be trading at a dividend yield of approximately 13%. If it decides to payout all the capital that it has identified as surplus to its current needs, adjusting its current price for those capital payouts and its stated dividend policy would lead to a dividend yield of 18%.

Tower used to be a diversified insurer with health, life, and investment businesses as well as general insurance. Due to pressure from its 33% owner GPG (a company that is liquidating its non-core assets, including Tower), it has sold three of its business arms (Health, Investments, and Life), and is now a focused general insurer.

The market seems to be implicitly discounting the value of this remaining business – a surprise given how clear Tower has been about what it intends to do with the proceeds from the sales: pay it out to shareholders. I find it hard to believe that the market will maintain its discount once Tower starts its regular dividend.

It has already paid out $120m through a cancellation of shares. It intends to pay out another $114.5m to shareholders, and repay $81.8m of bonds. It is also paying out a $10m (5c per share) dividend, and intends to pay out 90-100% of net profit after tax in the future.

It sets out exactly what it means to do in this presentation.

To believe the market’s current valuation, you’d have to believe that the presentation is delusional.

Shares are currently priced at $1.96. Here’s what Tower says it’s going to do:

Pay 5c dividend on 1 July

Pay 55c capital return later this year

Consider paying further 32c capital return due to excess capital (while still retaining 175% of its minimum regulated solvency capital)

Adopt a 90-100% payout policy “which would produce dividends per share of approximately $0.18-$0.20 per annum based on proforma FY12 profitability and an estimate of the reduced number of shares on issue” (slide 22 of presentation)

See if it can sell its remaining life assets (which have an expected value of 13c per share)

So let’s assume the following:

You buy the shares tomorrow for $1.96

You get the 5c dividend on 1 July 2013

You get the 55c capital return on 1 November 2013

In August 2014 (I’m just making these dates up) Tower decides to return excess capital above their target of 175% of the minimum regulated amount). That’s a 32c capital return

Tower have a rough couple of years, and it takes until the year ended December 2015 to earn 18c (as compared with current normalised earnings estimation of 18c-20c)

In December 2015, with its new 90% payout ratio, Tower trades at a dividend yield of 10%

Tower don’t manage to sell the life assets (worth 13c a share) and it turns out they’re worth nothing

If you get paid the above dividends, capital returns, and Tower trades at a 10% dividend yield while paying out 90% of its 18c a year earnings in December 2015, the internal rate of return is 24% until December 2015.

I don’t think the above assumptions are particularly optimistic, but one thing to test is whether Tower would really carry out the 32c second capital return. Perhaps the company will decide to simply keep that money to try to finance growth. If that’s the case, it’s likely that the stock would receive a significantly better dividend yield or P/E valuation given its added security.

If you assume a growth rate of 5%, a required return of 15%, and a 90% payout ratio, you get a justified P/E of 9. Lowering the required rate of return to 10% gets you a justified P/E of 18. Applying that to Tower in 2015 would pretty easily get you to $2 a share. Given that it is at $2 a share today and intends to pay out 60c very shortly, you’d be doing pretty well.

This is an insurance company, and you can see past combined ratios in their annual reports, and pro forma ratios in their presentation linked above. Past combined ratios are difficult given that they’ve changed their business so much, and pro forma combined ratios are open to manipulation.

I’ve bought the stock, but not because I think Tower is a particularly effective underwriter. To me, the margin of safety seems very high, and there seems to be a real opportunity for above normal returns in the next few years, if the market starts to remove its discount once the company pays out excess capital and gives better line of sight to its underlying earnings.

Risks

I guess the primary risk is the risk of another big earthquake in New Zealand. Given I live here I’m probably a bit overexposed to this risk already. Tower has reinsurance contracts in place (obviously not for all of the risk) and given their capital buffer (a minimum of 175% of the regulator’s prescribed amount) this wouldn’t ruin the company.

Other risks are that Tower holds on to the excess capital and can’t achieve any real growth. They are a small player, and there’s no particular reason to suspect that they are going to be able to aggressively gobble up market share. I think it’s likely that if this happens, they eventually release the excess capital.

Check out this article for a similar view to mine.

In my view these risks do not justify the discount, so I’m long the stock, and it’s 17.5% of my New Zealand portfolio. It’s larger if you count my position in GPG – a position that I’ve recently initiated after a steep price decline.

Alternate ways to access this

Tower is listed on the New Zealand stock market. If you don’t have access to that market, it might be worth taking a look at GPG (listed on the New Zealand, Australian, and London stock exchanges). As I noted above, GPG owns 33% of Tower, and is in liquidation mode.

Oddballstocks wrote up GPG this time last year. I think Nate sold after it quickly ran up in price, as did I. It has fallen back significantly then and could well be worth a look. Just beware of the pensions, and be sure to check out their pension presentation. I may write up GPG in the future, but it’s pretty complicated.

Disclosure: Long Tower and GPG