We are reiterating our Underperform recommendation on the shares of Tower Group Inc. (TWGP) following second quarter results which reported earnings of 63 cents missing the Zacks Consensus Estimate by a penny.
Lower-than-expected results came on the back of huge catastrophe charges, partly mitigated by higher revenues and a lower share count due to share buybacks. After-tax losses from these events amounted to $4.6 million or 11 cents per share. Notably, the company did not incur any catastrophe loss (cat loss) in the year-ago period.
Tower generates a substantial portion of its revenues form Northeast United States, an area which is significantly vulnerable to catastrophes. Though Tower has reduced the number of polices in Massachusetts and Rhode Island, we believe the company runs a high catastrophe exposure in those regions.
Moreover, due to severe catastrophic events in the first half of the year, reinsurance rates might experience upward pressure, and thus the company’s operating margin could get suppressed in the upcoming months.
Like other insurers, Tower has also been affected by the global recession. Management believes that reduced capitalization, decreased new business ventures, increased business declines as well as negligible new home ownership will reduce the demand for small commercial and personal lines policies. Moreover, soft property and casualty markets would restrict premium growth.
As the current economic climate offers limited scope for organic growth, Tower is considering inorganic growth via acquisitions. It has made a number of acquisitions in the past one and a half years.
Gross premiums written and managed leaped 41% in the second quarter to $468 million from $332 million in the comparable period last year. This growth was driven primarily by the acquisition of the OneBeacon Personal Lines division and the organic growth from new business units, customized solutions and assumed reinsurance and risk sharing
Tower had also developed a new organic growth strategy in the second half of 2010 to improve its existing business units and create new ones to generate profitable organic growth. This is being done by improving efficiency through product improvement, automation and cost reduction. Management believes that these business units will gradually increase their profitability. These initiatives are implemented throughout this year and next year.
Meanwhile, to offset the lack of growth in its existing business units, management has decided to allocate capital and resources to create new business units, as well as focus on markets with strong growth potential and higher profit margin. During the quarter, the company benefited from this strategy, as reflected in its strong top-line growth, generated by its customized solutions and assumed reinsurance business units.
Tower has also been aggressively seeking acquisitions for the past two years to expand its Commercial, Personal and Specialty lines of business. It continues to see a robust pipeline of acquisition opportunities as many companies faced with difficult market conditions are now seeking to exit from the marketplace through a sales process.
Though Tower’s organic and inorganic business strategy looks solid, we expect near- term results to be weighed down by heavy cat losses. Management also expects 2011 earnings per share to trail at the lower end of its earnings guidance of $2.70 to $2.90 per share.
New York-based Tower competes with American International Group, Inc. (AIG), and Aviva plc (AV).
The stock carries a Zacks #4 Rank, which translates into a Sell rating over the short-term (1-3 months). Also over the longer time horizon (6+ months), we rate the shares Underperform.
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