Life Partners (NASDAQ:LPHI)

Life Partners Holdings Inc., (LPHI) headquartered in Waco, TX, is the oldest and only publicly traded life settlement company with the following characteristics:

(i) recurring revenues derived from fee based business model (ii) favorable growth dynamics resulting from increased awareness and acceptance of the industry among older Americans (iii) excellent operating margins and prodigious cash generation (iv) compelling valuation trading at 8.5x FY 2010E earnings and offering dividend yield of 5.7 % (based on $1.14 per share paid in calendar 2009).
I view investment in LPHI as a way to capitalize on the growth of the underlying uncorrelated asset class via a publicly traded vehicle and, at the same time, own a highly profitable and cash generative business.

Background

Life settlement transaction involves sale of an existing life insurance policy to a third party whereby the policyholder receives an immediate cash payment and the purchaser takes an ownership interest in the policy at a discount to its face value, assumes an obligation to continue premium payments and receives a death benefit upon insured’s death. There is a crucial distinction between life settlements and viatical contracts – the latter are for terminally ill individuals with very short life expectancy (2 years or less) whereas the former usually involve older (over 70 year old) but healthy and often affluent seniors who do not wish to continue marking premium payments.

Life settlement industry generated negative publicity in the past due to several unscrupulous players and ensuing media coverage with labels such as “merchants of death” being tossed around. Few people know that the option to transfer life insurance policy to a third party in exchange for the monetary consideration has existed in the US for nearly a century, affirmed by the 1911 Supreme Court case of Grigsby v. Russell which established the policy owner’s right to treat a policy as property. Since its inception in 1991, LPHI has facilitated transactions with policies with aggregate face value of over $2.1 billion for over 25,000 accredited individual and institutional investors. Yet, for the last couple of decades, the Company operated largely under the investor radar screen, with market cap under $400 m and virtually no research coverage.

A study by Conning & Co. conducted in 2003 found that senior citizens in the US owned approximately $500 billion worth of life insurance, of which $100 billion was owned by seniors eligible for life settlements. In October 2009 Conning & Co. estimated the size of the market at approximately $11.7 billion in terms of Face Value of Polices Transacted (“FVPT”). Taking into account this estimate and based on $694 m of face value of policies transacted for the FYE Feb 2009, Life Partners’ market share is approximately 6%. The market is still fragmented, though: two largest companies in the industry control about 35% of the market (roughly evenly split between the two) with the next five controlling between 5% and 10% each. According to Conning, the market is projected to grow at 15% CAGR through 2012.

LPHI’s business model is predominantly fee-based, with revenues derived from facilitating life settlement transactions. Essentially, it acts as an agent for buyers/investors for whom it identifies and qualifies policies which meet their specifications through a network of insurance brokers and financial planners / advisors. LPHI performs due diligence, such as verifying insurance and medical information of the insured, and prices settlements based on the policy face amount, anticipated life expectancy of the insured and policy maintenance costs. Post closing (which is done through an independent escrow agent), Life Partners holds title to the policy as a nominee of the purchaser, monitors premium payments and insured’s health condition and notifies escrow agent upon insured’s death.

Investment Thesis

The value proposition of life settlement transaction from the insured’s point of view is simple: it allows someone to monetize their policy and realize higher value than cash surrender value offered by the insurance company. Typical insured can get 20% to 25% of the final death benefit of their policy, which is three to four times more than the insurance company would pay as a surrender value. According to the industry data, a settlement payment for a typical universal life policy for a male aged 79, face value $3.5 million, cash surrender value of $185,000 would be $970,000.

Statistically, approximately 90% of life insurance policies never pay the death benefit because they are allowed to lapse. When they lapse, the insured loses all the money they've invested into premiums and their beneficiaries receive nothing. In the absence of life settlement, the only alternative for the insured is to take a very small cash surrender value amounting to pennies on the dollar of their original investment. This coupled with increased acceptance of the industry among older population has led to an increased supply of high value policies on the market. The average value of the policy transacted by Life Partners has increased to $3.53 m in FYE Feb 2009 (up from $2.07 m in FY 2008 and ~$700K in FY 2007).

From buyer’s perspective, purchasing a life settlement policy is like buying a zero coupon bond with certain payout but an uncertain maturity date. Since there are no cases of someone living forever that I am aware of, the risk of an investment in a policy can be thought of in terms of collecting the death benefit, i.e. the credit risk of an insurance company backing the policy. Insurance is a heavily regulated industry and historically there have been virtually no cases of insurance companies failing to pay death benefits to policyholders. Nevertheless, to mitigate this risk, unless specifically waived by the purchaser, the Company transacts only with carriers rated B+ or higher by A.M. Best and in policies beyond their contestable period (generally older then 2 years).

LPHI is poised to benefit from confluence of favorable secular trends on both supply and demand side. On the supply side, first baby boomers (those born in 1946) became eligible for retirement in 2008 (at age 62). According to the US Census Bureau, the number of boomers is projected to double to 72 million by 2030. I believe that for at least the next several years real estate values will remain stagnant across most of the US and availability of consumer credit will continue to decline for the significant proportion of the population. As a result, more and more boomers will turn to life settlements as a way to monetize one of their more valuable assets, insuring continuing growth of the “supply” side of the market.

On the demand side, financial crisis has heightened investor appetite for absolute, uncorrelated returns. Returns in life settlements depend purely on the life expectancy of the insured and, as such, are not correlated to the equity, debt, currency or commodity markets and do not depend on liquidity flows and investor sentiment. This means that they are structurally uncorrelated, as opposed to synthetically uncorrelated (with claimed lack of correlation achieved through a hedging strategy) -- an important distinction in the aftermath of 2008. From an accounting standpoint, a rule mandating that policies be carried at their cash surrender value (which is lower than purchase price, thus resulting in immediate write downs) has been relaxed and, since 2006, policies can be carried at initial investment value + direct costs. This more favorable accounting treatment has spurred additional institutional interest in the market. During August 2009 shareholder meeting, CEO Brian Pardo stated that in response to increasing institutional demand, the Company plans to launch a series of life settlement funds which can be marketed by broker dealers in all 50 states.

According to Conning Research, aggregate face value of policies transacted in 2008 stood at $11.7 billion, a 4% decline from 2007 level of $12.2 billion. However, as financial crisis intensified and supply of credit dried up, a number of leveraged players were forced to exit the market. Management estimates that during 2008-09 the number of companies operating in the life settlement market (either as principal investors or agents) has shrunk from 35 to under 10. LPHI did not face the credit issue since its model does not rely on leverage -- instead it has permanent capital through public listing. In fact, calendar 2008 (or Fiscal 2009 with Feb year end) was LPHI’s best ever: FVPT grew from $415.3 m in 2008 to $693.7 m in 2009, a growth rate of 67%. The Company believes FVPT could hit $1.0 billion in FY 2010.

In addition to capturing greater share of the growing market, LPHI will benefit from reinvestment by current clients as they collect payouts from existing policies and seek to reinvest high percentage of those payouts in new life settlement transactions as a way to diversify their overall investment portfolios. Management anticipates that over $1 billion could become available for reinvestment over the next 5 years.

Financial Performance and Valuation
For the last 2 years from 2007 to 2009 LPHI’s net revenue (net of brokerage commissions) has grown from $12.2 m to $54.4 m (CAGR of 111%) and its earnings have grown from $3.4m to $27.2 million (CAGR of 184%). For the next 3 years I assume both revenue and earnings CAGR at around 20%.
At $19.50 / share (closing price as of Jan 5, 2010, which includes roughly $1.50 cash on balance sheet) LPHI trades at approx. 8.5x my estimate of FY 2010 earnings and 7.2x FY 2011 earnings.
I estimate that by 2012 FVPT grows to ~$1.2 billion. This appears very conservative since management believes that FVPT could hit$1.0 billion in FY 2010. To put this figure in perspective, let’s assume that LPHI gains 2% market share to 8%. This implies the total FVPT market of $15 billion, a very reasonable figure that in 2003 the value of life insurance owned by seniors eligible for life settlements was pegged at $100 billion.
As of August 31, 2009 LPHI had invested in 964 policies with carrying value of $16.2 million and face value of $26.1 million with over 90% of those having expected maturities of less than 3 years. This implies that the Company could realize in excess of $9 million of pre-tax cash flow over the next 3 years if its assumptions re: life expectancy prove accurate.
I estimate that LPHI will earn a bit over $3.20 / share in 2012 (up from $2.30/share in FY 2010) and will have about $5.00 of cash on its balance sheet. I assume continued investment in policies (at 10% of net revenues) and about $8.5 m in policy payouts over the next 3 years, as discussed above. I also assume dividend payout ratio of 35%. My exit price is ~$37 /share, over 80% upside from the current levels. Also, 5.7% dividend yield is quite attractive in the current interest rate environment.

Risks
Insurance Company Credit Risk
It is conceivable that insurance company may not be in the financial position to honor its obligations to policyholders, although such instances have been extremely rare to date. As stated above, the Company deals only with reputable and highly rated insurance carriers. There have been certain instances in which insurance companies denied payment based on certain legal technicalities, mostly on policies settled prior to 1998. In those cases LPHI took it upon itself to pay the purchasers. For FYE Feb 2009, such payments totaled $905K and accrued settlement expense was under $350K as of August 2009.

Purchaser Credit Risk
Clearly, purchasers of polices (institutions and high net worth investors) are incentivized to make premium payments on the policy in order to realize ultimate return. However, some purchasers could fail to make timely payments due to financial difficulty. While the Company has no legal obligation to do so, it has elected to make advances to the purchasers in cases where there is risk of a policy lapse. Such advances are typically reimbursed upon final settlement. In FY 2009, such advances totaled $1.9 m and reimbursements -- $472K.

Heavy Reliance on Brokers
The Company relies almost exclusively on independent brokers / financial planners to generate policy inventory. Broker concentration is pretty high—top two brokers accounted for 29.2% of the total face value of completed transactions and top five brokers –over 60%. Those brokers do not have exclusive relationship with LPHI and are free to direct their business to the highest bidder.

Regulatory Risk
In the US, 41 states have regulations regarding the sale of life insurance policies to third parties. The Company is currently licensed to operate in 13 states where it is licensed and regulated under the laws governing life settlement companies. The Company complies with those regulations as well as with state insurance and consumer protection laws. Currently, to my knowledge, only state of Colorado has taken the position that the Company’s transaction structure is a security under Colorado Law but LPHI modified its structure in Colorado to comply. It is possible that additional states elect to treat life settlements as a security, but even in this instance, the Company should be able to rely upon exemptions under securities laws afforded to entities dealing with qualified accredited investors, such as hedge funds and private equity funds.

The Company has no major analyst coverage and is overlooked by the investment community due to its mall market cap and the lingering negative perception of the industry. I view the Company as a highly cash generative enterprise which is poised to capture an increasing share in a growing market.