HCI Revisited: It Still Looks Risky

HCI Revisited: It Still Looks Risky

Almost six months ago, I pointed out four red flags for HCI Group , a Florida-based homeowner's insurance company. At the time, the stock was trading for $32 per share. Since then, it's up more than 50% to $48 per share. The company was named to Fortune's List of the 100 Fastest Growing Companies. The CEO, Paresh Patel, has started referencing Warren Buffett in interviews, even going so far as to claim HCI is following the path laid out by Berkshire Hathaway.

So what has happened with HCI over the past six months? Here are four key developments.

1. This was the most benign Atlantic hurricane season in decades
HCI primarily insures homes in Florida, and bad weather (i.e., hurricanes) is bad for business. Fortunately for the company, the 2013 Atlantic hurricane season ended on Nov. 30 without a single major hurricane formation. We saw the fewest named hurricanes since 1982. In other words, HCI's incredible streak continues. The company, which was founded in 2006, has never experienced a major hurricane in its history.

Thanks to good weather, the company's third quarter was smooth sailing. The company reported an outstanding combined ratio of 62. Of course, that's to be expected without a hurricane. My concern about this company is what happens when a big hurricane hits. Does it have enough reinsurance coverage and reserves to remain solvent?

2. HCI "takes out" more policies from Citizens Property Insurance
In November, the company assumed 34,000 homeowner's policies from Florida's state-operated insurance company, Citizens Property Insurance. In other words, the state simply transferred the policies and the associated premiums to HCI, futher fueling HCI's growth. That deal increased annualized gross premiums to $400 million. Of course, HCI is also on the hook for losses, but until a hurricane hits, the company is raking in profits. In a show of confidence, management recently increased the dividend 22%.

3. HCI announces low-cost flood insurance
Thanks to the Biggert-Waters Flood Insurance Reform Act of 2012, many Florida residents will see fewer subsidies and higher premiums for flood insurance. Obviously, this sparked outrage, but HCI has boldly announced a plan to offer flood insurance to its policyholders. HCI will charge the same prices that homeowners paid before the Biggert-Waters act.

This move could certainly engender customer loyalty, and it provides a new growth area. Yet I'm still a bit skeptical. Biggert-Waters was enacted because the low rates charged by the National Flood Insurance Program weren't sustainable without subsidies. It's hard to understand how HCI expects to profit without raising prices. Further, as this is a totally new line of business, it's not clear that HCI has the underwriting expertise or experience necessary, despite claims by management.

4. HCI is issuing $100 million of convertible senior notes
HCI plans to close the sale of $100 million convertible senior notes on Dec. 11. The notes will pay 3.9% in annual interest, mature in 2019, and convert to equity at $62 per share, which is a 30% premium to current prices. In tandem with this offering, the company is entering into a prepaid forward contract with Deutsche Bank for up $30 million of HCI stock to be settled in 2019. If the deals goes as outlined, HCI will end up with about $65 million in extra cash, or maybe $80 million if the deal gets upsized. Note, that's after pre-paying Deutsche Bank for the forward contract and doling out $3.5 million in fees to JMP Securities and the other underwriters. In short, it's an expensive, convoluted deal, and I don't understand the strategic rationale.

It's a bit puzzling to see the company raising debt. First, HCI already has a lot of cash on its balance sheet -- $274 million in cash, compared with only $91 million in investments. Second, given management's optimism about the company's future, I'd assume they would avoid selling long-dated options on the stock, which they're essentially doing with the convertible debt. Third, Patel hasn't disclosed any opportunities to invest at rates that justify borrowing. On the last conference call, Patel hinted that the company could potentially start investing in bonds yielding 4%. That hardly seems worth the cost of borrowing of borrowing at 3.9%, even before considering the implicit cost of the convertible option.

Meanwhile, management hasn't made any attempts to explain the deal to shareholders. According to the company press releases, "HCI intends to use the remaining net proceeds from the offering for general corporate purposes including, but not limited to, working capital." That's a pretty vague explanation.

Foolish takeaway
Although the stock has been a strong performer recently, I'm still skeptical of this business and its management. In the past six months, nothing has happened to assuage my earlier concerns. In fact, I've got a few more concerns. So, I'd advise Fools to tread with caution on this stock.

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The article HCI Revisited: It Still Looks Risky originally appeared on Fool.com.

Brendan Mathews is short shares of HCI Group. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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