Buffett's Newest 'Purchase'

In this article, we're digging into a new section of Morningstar Opportunistic Investor's repertoire: initial public offerings (IPOs). While investors often get overly excited about these things, IPOs can sometimes be a fertile hunting ground because of the limited operational data available, minimal analyst coverage, and perceived exogenous risks. A legendary example in this vein was  MasterCard (MA), which went public at $40 a share because investors didn't understand the company and were afraid of potential anti-trust lawsuits. We don't claim to have found another MasterCard, but this upcoming offering is definitely intriguing.

Let's get started. On Oct. 6, insurance data provider Verisk Analytics is expected to come to market in one of the largest IPOs of the year, and there are some interesting technical aspects of the deal that have us excited. Verisk is primarily owned by property and casualty (P&C) insurance firms such as  AIG (AIG),  Berkshire Hathaway (BRK.B),  Hartford Financial (HIG), Swiss Re, and so on. These firms were hit hard by the financial crisis as their investment portfolios took a beating. Also, underwriting losses were large in 2008 due to the damage caused by hurricanes Ike and Gustav.

Verisk will not be raising any "new" capital in its IPO. Rather, a 30-plus lot of its insurance-company owners and some employees will be cashing out. In some respects, these insurers are "forced sellers"--the IPO proceeds will help repair their balance sheets. If these sellers are willing to take a lower price to get some much-needed capital, we are happy to accommodate them. Interestingly enough, Berkshire is the only stakeholder not selling shares. While Buffett's lack of action is not the same as if he were participating in the IPO, we're still intrigued because it represents a vote of confidence for the business. It could also be an indication of the firm's economic moat, which we think to be at least narrow, if not wide, though this is still being debated internally.

What Does It Do?
Verisk started off as a nonprofit association of insurers in 1971 to help P&C insurers meet state regulatory reporting requirements. The company's core customer remains the P&C industry, which makes up the majority of the firm's revenues. About 10 years ago, Verisk dropped its nonprofit status, and started expanding its product offerings. Besides helping insurance firms meet regulatory reporting requirements, Verisk's products, simply put, allow them to better understand and manage their risks.

The company has two divisions, Risk Assessment and Decision Analytics. Risk Assessment represents about 60% of sales and EBITDA. While revenue growth is in the low-single digits, it's very stable and recurring in nature. Moreover, because it's a subscription-based model, customers pay up front, creating negative working capital and boosting returns on capital. With little reinvestment needs outside of server maintenance and data storage, Verisk is a cash machine.

Within Risk Assessment, Verisk has two main product lines--Industry Standard Insurance Programs and Property Specific Rating and Underwriting. Within the former, Verisk helps insurers write policies that are competitive and meet myriad legal and regulatory requirements. Rules and regulations change every year, and keeping up with these changes for 50 state-regulatory bodies is very onerous. For each insurer to maintain a massive legal staff doesn't make much sense--it's expensive and there's no edge to be gained over the competition. Having Verisk do the legwork is much more efficient, and because there are scale advantages, Verisk makes a lot of money doing it.

The Property Specific Rating and Underwriting line is essentially a database of property information, which helps insurers price and manage their risks better. Verisk collects data in a number of different ways: from clients, public records, and the firm's proprietary legwork. One example of its proprietary work is its evaluations of community firefighting capabilities, which helps insurers estimate potential losses in the event of a fire. Given the robustness of Verisk's database, we suspect it is difficult to replicate. This reminds me of Moody's and S&P debt databases, which allowed them to expertly rate debt (cough, cough). All jokes aside, this is a good thing and a competitive advantage.

However, Verisk's future is the Decision Analytics segment, which has been growing over 20% per year due to acquisitions and increased adoption of its products. While not quite as profitable as the Risk Assessment business, its 39% EBITDA margins are nothing to blush at. Decision Analytics' main products are its Fraud Identification and Detection tools, but it also offers tools to help insurers quantify and predict risk.

The P&C industry is also responsible for a large proportion of revenues in this segment, but Decision Analytics also offers solutions to the mortgage and health-care industries. Branching out of its core market brings growth potential but likely more competition. Growth rates and margins in this segment will be important to monitor going forward.

Valuation and Closing
Based on the initial valuation work that we have done, we believe Verisk is worth around $25-$30 per share. Management currently expects top-line growth of 10%-12%, which doesn't sound unreasonable. But growth largely depends on the firm's ability to expand its Decision Analytics segment into insurance segments outside of P&C, given its P&C market penetration.

Verisk is a pretty high-margin business--EBITDA margins have been steady around 42% for the past few years. Although we think that margins can improve somewhat as Verisk grows due to the scalability of the business model, other factors will largely offset these gains. For example, costs will go up as Verisk adapts to being a public company, and growth will primarily come from the lower-margin Decision Analytics business. Therefore, we assume margins will remain roughly flat.

To round off our analysis, we looked at a number other companies that share similar business traits to determine an appropriate multiple. Based on trading comps from  Fair Isaac (FICO),  RiskMetrics (RMG), and  IHS  among others, the average EV/EBITDA multiple is around 10 to 12. Given its growth expectations, great margins, sticky core customer base, and almost zero reinvestment needs, we think this is a reasonable range for Verisk's shares.

Given the limited information currently available, we still have some lingering questions that can't be resolved until speaking with the company. That said, we believe Verisk has an attractive business model and should it price at the low-end of the range, it could warrant a purchase for Morningstar Opportunistic Investor's Mosaic Portfolio. We view this as a lower-risk, medium-return type of investment.

Note: This article was corrected since original publication. Please click here for details.

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