Hilltop Holdings (HTH) is an attractively priced special situation that offers investors the opportunity to capitalize on the worst financial implosion in generations. At the current price of $11.90, investors have the opportunity to invest alongside Gerald Ford, an experienced, opportunistic investor with a long paper trail of success at significant discount to HTH’s asset value and long term earnings power.
The bottom line here is that HTH’s first class management team is armed with 770M in dry powder and finds itself in the cat-bird seat, perfectly positioned to take advantage of ongoing market turbulence (and the depressed prices that come with it) for the benefit of long-term shareholder’s. Better yet, the current price ensures that investors in HTH won’t have to pay up for it.
Hilltop Holdings was formerly known as Affordable Residential Communities (ARC), and until recently operated mobile home communities as well as a small P&C insurance company based in Waco called NLASCO. In 2007 it sold its manufactured home business to Farallon for 1.8 Billion and changed its name shortly thereafter. HTH in its current form is comprised primarily of a large pile of cash earmarked for opportunistic acquisitions and NLASCO – the small insurance company mentioned above.
In essence, HTH offer investors the opportunity to generate attractive returns over the next few years as well as a relatively safe way to participate in and profit from the immense dislocation within the distressed lending/banking industry (by safe I mean in a manner that is extremely unlikely to result in permanent capital loss). A rather attractive combination in my opinion. The situation/opportunity is as follows…
HTH as essentially a SPAC (or at least that is how I view it) – i.e., a big pile of cash and an opportunistic management team on the prowl for attractive acquisition candidates. Yet, HTH is not your typical SPAC. Reasons why include…
(1) The Unique Quality Management – Hilltop’s management team is specifically well equipped to take advantage of the current distress within the banking industry. Gerald Ford, its chairman has a 30 year history of buying and selling thrift banks (usually in distress) and flipping them for enormous profits. Ford’s track record is impressive enough that “smart money” has recently been willing to invest hundreds of millions of dollars in Ford’s new private equity firm in hopes he can do it again. The fact that sophisticated investors are willing to pay 2 & 20 to do so is telling (although someone should have told them about HTH, as they could have participated in Ford’s deal flow for free)
(2) FDIC Charter – HTH’s investment funds (along with funds from Ford’s private equity fund) will be invested in Ford Group Holdings, Ford’s recently created bank…which in late 08 was granted the FIRST national shelf charter allowing it to buy failed banking assets directly from the FDIC. This Allows Mr. Ford and co. to acquire distressed banks from the government at what I believe will be give away prices (considering the magnitude of the current crisis and the resultant leverage they have over the government due to the lack of capable private capital needed to help the government deal with the problem).
(3) The Bargain Price – Investors who purchase HTH at or around today’s price can do so at a discount to HTH’s asset value (made up primarily of cash and other liquid investments). Notably, there is currently no premium built in to the current price for either the quality of the management team or the significant upside optionality that I believe is likely to come from the opportunistic deployment of HTH’s capital.
Why is it Mispriced?
Hilltop in my opinion small, misunderstood, and underfollowed. I also believe that when market participants have very little visibility into a company’s future, the uncertainty involved often can create huge discrepancies between price and value. With Hilltop I believe that the uncertainty regarding how it will allocate its war chest has prevented the market from taking notice (and in turn from properly discounting it into the current price).
Catalyst(s) – When can we expect a partial/full realization of value?
I expect that when this uncertainty is resolved (i.e. that after they have found a suitable acquisition) the market will quickly revalue HTH providing it with a much more appropriate valuation.
Excellent – HTH’s huge cash balance, as well as its relatively low debt (debt to equity is less than 20%); make concerns regarding HTH’s financial health a non-issue in my opinion. Notably, management has also stated that they are unlikely to do any deals where they would have to take on balance sheet risk, so worries about the company’s future financial health (post-acquisition) should be minimal (although this is certainly something to keep an eye on).
At a discount to its cash and investments (in combination with its outstanding management), there is not much more explanation needed. Some people like price targets, but due to the unique characteristics of this investment I feel it would be ridiculous for me to try and give one (I have no idea what they will buy as well as what price they will pay – though if I had to guess I would say, something good and not very much). I do know that the current share price is very well supported by the balance sheet and that future market turbulence will not erode that value…i.e. that the odds of permanent capital loss are low. As a rule of thumb I like to look for opportunities where I can build conviction that, looking out 3 years or more, there is an 85% probability that the price of the investment in question will be higher than it is today. This is one of those investments.
The odds of management going out and purchasing some toxic financial asset, which would then in turn destroy the existing value of HTH’s balance sheet, are in my opinion tiny to nonexistent (say 5%). A look at their words and deeds over time should provide comfort to those who are skeptical of this belief. The odds of management finding nothing to buy are higher, but are still unlikely in my opinion (10%)…and assuming it were to happen, investors who where to purchase at or around today’s price would still likely get their money back.
The most likely outcome (85%) is that management does what is has a long history of doing, i.e., purchasing banks/financial institutions at attractive prices and then working hard to maintain and build that value for the benefit of its owners over time. If such an outcome were to materialize, I predict that a combination of earnings growth and multiple expansion will drive HTH’s share price meaningfully higher from today’s level.
The Owners & Management:
As discussed above, management has a long history of value creation, and in my opinion is HTH’s best asset. Gerald Ford brings to the business valuable knowledge of the banking industry and large financial holding company’s in general. An examination of Fords impressive track record reveals a savvy dealmaker with patience and discipline. Consider that unlike many sophisticated financial services investors who decided to deploy their capital too early in this crisis, Ford and co. have for the most part stayed on the sidelines in anticipation of a more attractive opportunity set (Karman would be proud).
An instructive example of this can be found by examining his relatively recent negotiations with Fremont General, which reveal an investor focused first and foremost on the return Of his capital (as opposed to only on the return On his capital). Consider that with Fremont, he negotiated a deal that gave him a conversion price equal to 75% of whatever tangible book value turns out be worth AFTER Fremont takes its losses. And if that isn’t evidence enough that this is a guy you wouldn’t mind deploying your hard earned capital, Ford made sure that after all was said and done it turned out that Fremont’s common was worthless, his preferred stock would be issued by the bank’s subsidiary and was thus senior to the debt of the holding company that issued the stock. It’s worth noting that as part of the deal Ford made sure that should he decide that he didn’t not want to close for any reason, he would have the right to walk away free and clear…and he eventually did.
Other executives are similarly experienced and entrepreneurial. CEO Larry Willard is also financially sophisticated, having previously served as an executive at Wells Fargo. Additionally, the long-time CEO of NLASCO before its acquisition, C. Clifton Robinson, serves as a director.
Management owns roughly 28% of the outstanding common and has been aggressively acquiring shares in the open market around the current price.
Note – Management did take a few lumps over the last year in its investment portfolio from bad bets on corporate bonds, mortgage backed securities and equites – suffering a net loss for 2008 of 27%. Importantly management has said that going forward they don’t plan on making any more passive equity investments so this should not be a concern in the future. This pledge also gives me confidence that HTH’s balance sheet will stay fortress-like in case of any material pullback in the general markets from today’s level.
NLASCO provides fire and homeowner insurance for manufactured homes primarily in Texas (70% of sales) through two subsidiaries, National Lloyds Insurance and American Summit Insurance. It was purchased by ARC early in ’07 with a combination of cash and stock for roughly 120m. Investors in HTH who get in around today’s price are essentially are getting this small, consistently profitable, niche P&C insurer for free. Salient points regarding NLASCO include….
NLASCO’s financial condition is solid – it has a history of being conservative with its capital, has historically avoided large investment losses, and reinsures against catastrophic risk.
History of consistent cash generation – for example, from 2003 to 2006 it averaged roughly 16m in net income. In 2007 it made roughly 14m in net income. In 2008, due to 3 storms, it suffered roughly 14m in losses.
Quality underwriting – A historical examination reveals that the quality of NLASCO’s underwriting has been outstanding, considerably better than the industry as a whole on average.
NLASCO does have unique underwriting risks though – as its customers (mobile home owners) live in densely populated communities, and therefore there is always the possibility that an event in the area (like last year) could cause large loss claims to be filed simultaneously. NLASCO must always keep in mind the dangers that are part and parcel of having customers who not only live together but work together – which in combination make NLASCO’s earnings sensitive to fluctuation in local economic conditions.
Due to the small size of NLASCO in relation to the company’s assets as a whole HTH does not have a lot of business risk (at least at the moment). From an operational standpoint, HTH’s NLASCO faces the same risks that any regionally focused insurance operation faces, namely the risks outlined in the last paragraph of the operations overview segment. Also, if there was any reduction in the credit ratings of either of NLASCO’s subsidiaries, the firm could be required to repay 107.5% of principal for about 20 million in outstanding notes. Luckily, if this outcome were to materialize, HTH has the financial strength to deal with it (although I consider the odds of a downgrade to be minimal).
From a market risk standpoint HTH is well positioned – indeed, in my opinion ongoing market turbulence would actually be a huge advantage. HTH’s war chest insulates the firm from large hits to intrinsic value due to general market fluctuations. This is not a situation where one has to worry about how high & rising unemployment, weak consumer spending, constrained bank lending, and other factors will affect its business operations – Hilltop doesn’t really have any. In addition, falling stock prices would create more opportunities for acquisitions on favorable terms, and their roughly $770 million cash hoard gives it the solid backing and freedom it needs to opportunistically expand its operations in the current environment (as there is no need for HTH’s management to worry about external financing risks, etc.).
Financial risk is minimal as well due to the strength of the HTH’s balance sheet. Now it is obviously possible that management could go off and do something stupid with their cash (and end up purchasing a business that would jeopardize this), but CEO Larry Willard has explicitly stated that they are extremely unlikely to take on any balance sheet risk in any potential acquisition going forward. Considering who management is (based upon an in depth examination of their words and actions), I tend to take them at their word.
As I see it, the biggest risk for Hilltop and co. is that they are unable to find an attractive acquisition candidate to purchase over the coming months and years. This is a no moat company for the most part and its insurance operations have limited potential for internal growth. So, until HTH can add breadth and capacity to its business, meaningful growth in HTH’s intrinsic value from here on out will be nonexistent. In such an outcome downside protection will still be strong (due to the margin of safety provided by the balance sheet), but upside potential will not.
Future outlook – Tomorrow’s Opportunity Set is likely to be considerably more fertile than today’s:
It is important to keep in mind that a waterfall of bank failures is likely still to come – Although a common theme amongst recent general market and government commentary is that the worst is behind us, the FDIC’s recent second quarter report on the U.S. banking sector tells a different tale. The banking sector lost $3.7 Billion during the quarter as a result of large loan losses and significant losses on asset-backed commercial paper. At the end of the second quarter, the number of banks deemed to be troubled by the FDIC increased from 305 to 416 or roughly 5% of the 8,195 FDIC insured institutions. The data implies that a large and growing number of banks are likely to fail over the coming year and beyond…creating an increasing opportunity set for HTH to choose from.
*The author has a position in Hilltop Holdings (HTH). This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only