Verisk Analytics: Big Data At A Fair Price

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This article originally appeared on Seeking Alpha on October 27, 2016.

  • Verisk Analytics provides insurers and businesses with sophisticated risk analysis services and software.
  • Aggregating and interpreting massive amounts of data is on the leading edge of technological innovation.
  • A foray into the energy industry and challenges in the property & casualty markets present headwinds.

Economies of scale and an entrenched user base ultimately present long-term rewards for investors.

I struggle to justify current market valuations, and my articles have been mostly bearish. It’s unusual for me to recommend an investment, but I believe Verisk Analytics (NASDAQ:VRSK) has a business model which is too good to be ignored.

In spite of vast improvements in mobility, connectivity and automation, economists have been puzzled by the lack of productivity growth over the past 10 years. The naysayers point to social media as nothing more than a distraction. The optimists believe the innovations of the recent past will soon appear in productivity statistics as the benefits proliferate. One of the key sources of projected growth is the ability of technology to analyze streams of vast amounts of information in order to detect patterns or hidden anomalies that may lead to better decisions and efficiency. From human genetic material to battlefield simulations, big data is becoming big business.

An investment in Verisk could be one way to participate in the profit opportunities buried in the sophisticated analysis of mountains of data. Verisk Analytics, based in Jersey City, operates in markets throughout the world. At the recent price of $82 per share, Verisk has a market capitalization of $2.27 billion on $2.0 billion in revenue. The company was formed in 1971 to provide as a resource for insurance companies and regulatory bodies to provide and share information on property and casualty insurance claims. Insurance companies were the initial stakeholders in VRSK, and a 2009 IPO allowed them to liquidate their holdings. Interestingly, Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) is one of the few insurers that have retained their position.

Verisk is a key provider of risk analysis solutions. Property and casualty insurers confidentially share their data and Verisk aggregates the information. In turn, VRSK provides complex models on weather patterns, building losses, catastrophic scenarios and other hazards. Verisk also provides risk analysis solutions and software to the financial services, defense, entertainment, retail and food industries. Importantly, the company entered the energy industry in a big way during 2015 when it acquired Wood Mackenzie, a UK-based provider of analysis tools for the hydrocarbon industry.

The positive story

Verisk has grown revenues and EBITDA by double digits on a compounded basis over the past five years. With over 7,000 employees, it has a global reach. Most importantly, it has a treasure trove of data that is continually updated and expanded. The economies of scale are immense. Risk analysis is becoming more essential as volatile political, macroeconomic, and geological challenges become increasingly complex. For example, the host of cataclysmic meteorological impacts upon lives and property will continue to increase as global warming persists. Does your company need to know the possible effects of a pandemic or terrorist attack? Verisk will tell you. VRSK lists 29 of the largest 30 insurers as clients.

Verisk recently expanded into the energy data business with its Wood Mackenzie acquisition. It purchased the business during the lowest points of the oil market collapse in 2015, leaving the company poised to benefit from a rebound in crude exploration. Not only is the science of oil discovery evaluated, but also its expertise extends to geopolitical risk assessment. The company also divested its healthcare analytics business in order to profit from its primary expertise in the physical environment.

Leadership has recently been solidified: Mark Anquillare was named as COO and Eva Huston was promoted to CFO in May of 2016. Management is proud to mention the strong profitability at VRSK, with EBITDA margins over 49%. Free cash flow has consistently risen and will allow VRSK to pay down debt and continue to expand through future acquisitions.

The risk factors

VRSK has some hurdles. Property & casualty insurance markets are under pressure. Loss ratios have been rising and investment income has dwindled. Verisk earns about 75% of its revenues under long-term contracts, so it does not face a sudden loss of business. However, insurers will likely seek to reduce costs in the years ahead and service vendor contracts will certainly be vetted. On the other hand, a challenging underwriting environment may only reinforce Verisk’s position by providing insurers with a competitive advantage. Any tool to help mitigate losses should be welcomed by the casualty insurance sector.

VRSK is now highly exposed to the UK pound sterling through its Wood Mackenzie energy subsidiary. The 15% decline in the pound since the referendum vote will be a drag on revenues. Energy clients may ebb and flow more quickly than others as the price of crude fluctuates. Verisk’s steady stream of growth may be more volatile in the future. Slightly less than 20% of revenues come from Wood Mackenzie.

VRSK does have a debt level in excess of 2.2 times EBITDA. At the end of June, VRSK had $2.27 billion on the books, an increase of $1.2 billion from 2014 following the Wood Mackenzie acquisition. Debt levels would have been higher but for the sale of the healthcare analytics business during the second quarter which allowed VRSK to pay down its revolver line by about $600 million. Management is determined to hold the line on debt at a steady state level of 2.5 times EBITDA. VRSK will continue its acquisitive ways and liquidity is essential for growth.

After growing 18% in 2015, revenues will likely decline in 2016 by about 3%. This excludes the six months of revenue from the healthcare segment that will post “below the line” as income from discontinued operations. With the British pound flattened, it will be 2017 before meaningful top-line growth is restored. Analysts are projecting a 6% increase to $2.1 billion next year. Still, the company should generate over $500 million in free cash flow next year.

Verisk has a high price because it is a great business

The valuation looks a little high right now. VRSK trades at 27 times earnings and 9.5 times book value. The pretax operating earnings yield from continuing operations is a paltry 4%. However, returns on capital are in the mid-teens and operating margins are above 35%. I ran a discounted cash flow analysis and arrived at a value of $75. It’s more than I’d like to pay, but not out of the realm of reason if considered as a long-term holding.

Would I rather over-pay for a great business or try to wait for a lower price? I will admit to a “fear of missing out” mentality, but I tend to lean towards the side of investing in spite of some downside risk. I believe the long-term value will emerge as cash flow improves and future acquisitions appear. I am going to wait until after the November 1 earnings announcement. I do believe there may be some disappointing numbers as a result of dollar/pound strength that may chase away some bulls. Ultimately, though, Verisk is an investment that will prove to be profitable.

I have attached my discounted cash flow analysis for your consideration. I use a weighted average cost of capital of 5.46% and a revenue growth rate projection between 6% and 8% over the next several years. Operating margins of 35% are employed – consistent with recent performance.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in VRSK over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: As always, the author has presented his own opinions and analysis. You should conduct your own due diligence before investing. I welcome feedback and discussion and I am happy to correct any errors or add any pertinent information to the article.

Munger on the Proper Discount Rate

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Questioner: When you try to arrive at the valuation number using the discount rate…

Munger: Your opportunity cost is so great. Considering everything else, you should forget about it. Most people don’t pay enough attention to opportunity cost. Bridge players know about opportunity cost. Poker players know about opportunity cost. American faculty members and other important people, they hardly know their ass from a plate of hot squash.

We don’t use numeric formulas that way. We take into account a whole lot of factors. It’s a multifactor thing. There are tradeoffs between factors. It’s just like a bridge hand. You have to think of a lot of different things at once.

charlie-mungerThere’s never going to be a formula that will make you rich just by going through some little process. If that were true, every mathematical nerd that gets A’s in algebra would be rich.

Charlie Munger

Thanks to Farnam Street
(C) 2016 FARNAM STREET MEDIA INC.

What the world’s richest man can tell us about Omaha – and, no, I’m not talking about Warren Buffett

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Aside from the occasional plague and peasant uprising, Europe during the early 1500’s was an exciting and prosperous place to be. New worlds were being discovered, art and technology flourished in the Renaissance, nations emerged from fiefdoms, and religion was undergoing a massive reformation.

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In spite of growing wealth in the 1500’s, peasants could still prove to be an unruly bunch.

The strongest financier during this period was a German by the name of Jacob Fugger (rhymes with cougar) who hailed from Augsburg, in present day Austria. He transformed his family’s textile business into a massive empire of banking, mining, and trade. Fugger was wealthier than the famous Medici clan who received much more historical attention. As a percentage of GDP, his wealth would dwarf Rockefeller, Gates and Buffett.

Fugger financed the Habsburg dynasty and the expansion of the Holy Roman Empire – an empire that ruled the core of Europe for four hundred years until World War I swept aside Austria-Hungary. He was a shrewd operative who financed the Vatican (indulgences aren’t free, you know), and obtained the ownership of entire villages when debtors defaulted on their loans.

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Fugger did not mince words with the Habsburgs. In one undocumented incident, he threw his gold cap at Maximilain and told him to “Fugg off”.

Greg Steinmetz’s book “The Richest Man Who Ever Lived” is the latest book to revive the legend of Jacob Fugger.     The book is a business biography, but it is also a geographical instruction manual.

The story of Jacob Fugger illuminates the importance of cities in the development of commerce. Augsburg, Rome, Venice, Antwerp, and Mombasa are the supporting cast of characters in the book. The evolution of these cities provides insights into our own urban areas. For me, the book provides a lens through which to look at he challenges faced by Omaha as it tries to surge past 1 million people and reach the second tier of US cities.

Fugger maintained his home in Augsburg, but he located important business centers in Venice and, later, Antwerp. He chose to locate in Venice early in his career because the Venetians were the leaders in big business at the turn of the century. Their fleets traded goods from all over the world and their management skills were second to none. Most importantly, the Venetians mastered the system of accounting. Double-entry book-keeping was a new science, and Fugger used his mastery of accounts to centralize his far-flung empire. Later, Antwerp became popular as shipments from the New World increased. It’s massive port and access to the European heartland drew Fugger.

Charles_V

Charles V borrowed heavily from Fugger and took it on the chin.

This process of city and regional emergence is on display today as ConAgra considers moving its executives to Chicago. Omaha has a strong infrastructure in place to serve the agricultural industry, but Chicago has what it takes to reach consumers: It has a core group of companies like McDonalds, Kraft, Mondelez, ADM, and Ingredion all sharing resources. Chicago has thousands of well-educated people, young folks who can identify with a growing millenial target market, and dozens of advertising and marketing firms. Chicago, with its high cost of living and pension problems, trumps Omaha when it comes to innovation and sales. Like Silicon Valley, the costs of living are far outweighed by the opportunity to rapidly gain from networks of people. Omaha lacks the talent needed to reach rapidly-evolving consumer tastes.

Omaha also suffers from its peripheral location on the Great Plains.

One of the most fascinating stories in the Fugger biography is the rise of Portugal. Once a European backwater, the Portuguese decided to punch above their weight. They spotted their opportunity in pepper.

Portuguese_galleon

The Portuguese galleon. A badass to be reckoned with. Shut up and dance with me.

Pepper was essential for the bland European diet. Spoiled meat was a frequent entree and it needed a little, ahem, flavor. At the time, the Venetians controlled the pepper trade from India. They had a direct route but it required an overland trans-shipment at Suez. The Portuguese made the bold move of sending ships around the Horn of Africa to the Indian Ocean. While the route was dangerous, it was much faster than the Venetians could manage.

augsburg

Augsburg. It’s no Frankfurt, but Pope Leo X said it was “pretty darn good.”

One of the most exciting chapters in the book is the siege of Mombasa in present day Kenya. Only a few cannon blasts allowed the Portuguese to take over the trade hub. From there, it was a direct route to India. The galleons returned to Portugal loaded with pepper. They reaped a fortune from the trade. Fugger, as their investor, took his handsome share as well. Steinmetz argues that the loss of the pepper trade is what directly led to the demise of the Venetians.

The story illuminates the role of trading hubs and transportation centers to the growth of an economy. It seems fairly obvious, but it is remarkable that a city or region can grow exponentially without having a local industry. Singapore and Hong Kong are certainly modern examples of this phenomenon. Closer to home, Louisville and Memphis show how modern transport hubs have emerged in the jet travel era as the hosts of UPS and FedEx respectively.

“I’ve already bought my Cubs season tickets. Last one to leave Omaha, turn out the lights.”
– ConAgra Executive O. Redenbacher

Omaha may have lost it’s stockyards, but it remains an important commodities trader with firms like Scoular and Gavilon. Trucking is big here. But at the periphery, Omaha will probably never emerge as a transportation and market hub. Alas, it does not have a fleet of galleons to lay siege to The Loop.

Remaining a lower tier City is not all bad. Cost of living does matter when it comes to location selections. Nice people and good education systems do add value. By all accounts, Augsburg remains a pretty nice place to live even though the banking capital of Germany moved to Frankfurt centuries ago.

The Discipline to Say NO

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You want to follow the herd. It’s natural. Do you remember the 1999 internet bubble? I got so frustrated hearing about my neighbors investing in Level 3 Communications, I thought I was the dumbest person on the block. I bought some Level 3. I made a little money, but I was too chicken to ride it out. I’m glad I didn’t.

Yes, some people escaped that bubble with fortunes intact, but most were swept away. The same can be said of house flippers and land developers in Las Vegas during the middle of the 2000’s. I remember feeling so envious of all these people making quick bucks left and right. What did I do? I went to Baltimore. I flipped a house and lost my ass. Thankfully I got out before the meltdown and I didn’t lose my entire net worth.

So, now, I look at my industry: apartments. Everybody loves apartments as an investment right now. The yield, the safety, the myth that people can’t afford houses anymore. I remember fretting about Omaha surpassing $1.00 per square foot rents in the late 2000’s. We’ve blown through that number.

Downtown is hot. Midtown is hot. But someone is going to be the last one in and they’re going to be late to the party. They will overpay for land, underestimate costs, and underestimate the depth of the market at an affluent level of rent.

It’s frustrating. You know people are making a lot of money right now. But you also have a sick feeling in your gut that everything is being propped up with artificially low interest rates. I went to a conference and heard they are paying 4.82% cap rates in Dallas.

Are we there? Is this Japan with a perpetual zero interest rate policy?

Everybody repeats the same cliche that real estate is about location, location, location. Here’s what they don’t say: real estate is also about price. You can have the best corner in the world, but if you pay too much for it you will dig yourself a hole that will take a generation to extricate yourself from.

We have to take risks as developers. You can’t make money without taking a risk. But you can’t follow the herd. Sheep get slaughtered as the saying goes. Lemmings head blindly over the cliff.

Farnam Street blog has an outstanding transcript of a television interview in India featuring Warren Buffett and Ajit Jain. Everyone needs to read it and watch the interview. It is pure gold.

Ajit: The discipline to say no, if you have that and you’re not willing to let people steamroll you into saying yes. If you have that discipline, that’s more than 50 percent of the battle.

Warren: Don’t do anything in life where, if somebody asks you the reason why you are doing it, the answer is “Everybody else is doing it.” I mean, if you cancel that as a rationale for doing an activity in life, you’ll live a better life whether it’s in the stock market or any place else.

I’ve seen more dumb things, and sometimes even illegal things, justified (rationalized) on the basis of “Everybody else is doing it.” You don’t need to do what everybody else is doing. It’s maddening, during the Internet craze when the bubble was going on.

You have to forget about all those things. You have to do what works, what you understand, and if you don’t understand it and somebody else is doing it, don’t get envious or anything of the sort. Just go on and wait until you find something you understand.”

Krafty Buffett Manufactures a 20% Return. How?

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Warren Buffett has teamed up with his Brazilian friends again. 3G and Berkshire Hathaway have announced a merger deal with Kraft and Heinz, a company which they took private in 2013.

I am not a financial analyst, although I have run a fair number of spreadsheets for real estate deals. Alas, I am woefully unprepared to analyze the complexities of a $42 billion merger. I will just give it my best shot – my ballpark/back of the envelope. I would love to hear from serious securities analysts about how they believe the deal is valued.

What I really want to know is what does Mr. Buffett get for his investment and is it worth it? In my estimate, he gets a cash yield of 20% by the third year if 3G delivers the promised expense reductions. If Kraft’s sales can grow (they have been stuck around $18 billion for a while now), then its gravy – or melted Velveeta, as the case may be.

The first thing to know about the transaction is that it really began two years ago. Berkshire bought $8 billion of preferred stock in Kraft yielding 9%. The New York Times reported that Berkshire has received about $1.1 billion in dividends since that investment was made. The preferred stock can be redeemed in 2016.

The deal announced Tuesday has Kraft shareholders receiving 49% of a new combined entity with Heinz. This is a private company, so anyone who bid the Kraft stock up by 35% after the deal was announced was taking a real flyer on the idea that owning half of a private company is somehow significantly more valuable – even though the true price is not known. But the Heinz value is a different conversation. We’re just talking about how Mr. Buffett benefits directly from Kraft.

In addition to the merged stock, Kraft shareholders will receive a special dividend of $10 billion. Assuming Berkshire is putting up half of this cash (which is what the news agencies seem to be reporting), then the total is now $13 billion that Berkshire has invested: $8 billion in preferred stock plus $5 billion representing half of a special dividend to Kraft shareholders.

3G and Berkshire bought Heinz for $28 billion. The market cap of Kraft on Tuesday before the deal was announced was $36 billion. The new entity will be 51% Heinz and 49% Kraft, but lets use 50/50 for easy math. Now, assuming Berkshire was/is half of the Heinz acquisition, they will ultimately own 25% of the new entity.

So, where do the costs stand now? Heinz is giving up 50% of its ownership for $14 billion (based on the $28 billion 2013 price) to receive 50% of Kraft for $18 billion. So the net “cost” to Heinz’s $4 billion. If Berkshire is half of this number, then Buffett’s “cost” is $2 billion. But since, it’s stock that’s being swapped, there is no true cash outlay and the fact that Kraft shares by 35% Wednesday matters not a whit to Heinz.

So Buffett has still invested a total of $13 billion of Berkshire’s cash in the deal of which he will own slightly more than 25%.

He will receive $720 million per year in dividends through 2016. Kraft generated $2 billion in cash flow last year. If Berkshire takes 25% of this number, they will pick up $500 million. If 3G generates the kind of cost cutting they promise ($1.5 billion), Berkshire will pick up a further $350 million. So for an investment of $15 billion, Berkshire will receive $1.5 billion in cash flow. That’s a 10% return. Except that $2 billion is in stock, so real cash is $13 billion – an 11.5% return.

Now, lets say that 2017 rolls around and Heinz-Kraft can either return to the public markets in a new IPO, or Berkshire can use its AAA credit rating to go to Europe and sell some sub 1% Euro-denominated bonds. They raise $8 billion and Berkshire’s preferred stock is redeemed.

Now what happens? Berkshire has $5 billion of hard cash still invested after the redemption of preferred stock. Cash flow increases in the range of $700 million as the 9% interest cost disappears. Berkshire is now getting $500 million in cash flow, plus $350 million is new cash flow from cost cuts, and another 25% of $700 million in interest savings – $175 million. Let’s call it $1 billion of cash per year on $5 billion. 20%.

That’s assuming Kraft sales stay essentially flat. Any growth will push Berkshires internal rate of return even higher.

Today’s Charles Munger Wisdom

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“People chronically misappraise the limits of their own knowledge; that’s one of the most basic parts of human nature. Knowing the edge of your circle of competence is one of the most difficult things for a human being to do. Knowing what you don’t know is much more useful in life and business than being brilliant”

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“It’s waiting that helps you as an investor, and a lot of people just can’t stand to wait. If you didn’t get the deferred-gratification gene, you’ve got to work very hard to overcome that.”
He says he sees nothing worth investing in right now and hasn’t bought an investment in his personal accounts in at least two years. He is waiting for an irresistible bargain.
From Saturday’s Wall Street Journal (9/13/14)