AMSF AMERISAFE Inc

We reiterated our Underperform recommendation on Amerisafe Inc. (AMSF) based on its persistent weak performance that questions its current sustainability factor. The company’s second-quarter operating earnings per share of 23 cents substantially lagged the Zacks Consensus Estimate of 38 cents and 53 cents reported in the prior-year quarter. Operating income substantially plummeted 56.4% year over year to $4.4 million.

Results worsened primarily due to higher underwriting losses, reduced investment income and higher-than-expected expenses, which further deteriorated the combined ratio and weakened the return on average equity (ROE).

These factors also negated the higher premiums earned that shored up the top-line growth. However, a modest cash and capital position coupled with lower share count supported the book value per share growth.

While Amerisafe is at an inflection point, the company witnessed drastic decline in earnings growth in the first half of 2011, given the inadequate growth in investment income owing to low investment yield, which was followed by increased loss and loss adjusted expenses. Moreover, higher underwriting expenses also withheld the company’s underwriting profitability. Consequently, net income and operating income have been witnessing sharp declines.

Going ahead, increasing imbalance in underwriting profitability and sluggish investment yield inflates ample financial and operating risk, thereby entailing vigilance over the company’s growth model in the upcoming quarters.

Additionally, higher-than-expected losses from weather-related events, underwriting and loss adjusted expenses are further nibbling into the bottom-line growth. As a result, combined ratio, a significant operating risk measurement ratio in the insurance industry, has been continuously declining over the past several years.

These issues have even marred the ROE. Amerisafe’s financial objective is to produce an ROE of at least 15% over the long term while maintaining optimal operating leverage in its insurance subsidiaries. However, the sluggish economic recovery and dampened macro factors have produced an operating ROE of 9.9% for 2010 against 15.4% in 2009, and 6.6% in the first half of 2011 against 12.3% in the year-ago period. Being a significant growth measure, deteriorating ROE further showcases declining earnings growth.

Moreover, the workers compensation industry is cyclical in nature and influenced by many factors including price competition, natural and man-made disasters, changes in interest rates and general economic conditions. Currently, the workers compensation insurance industry is in the midst of a soft market cycle, characterized by increased competition that results in lower premium rates, expanded policy coverage terms and higher commissions paid to agencies. Going ahead, any change in the workers compensation laws could also affect the revenue.

On the flip side, though Amerisafe’s top-line growth has been improving through its strong market presence in its niche workers’ compensation market for high hazard risks, a proactive and disciplined approach in underwriting and prudent capital management. These aspects also contributed to a favorable growth of book value per share.

Moreover, the company and its subsidiaries enjoy superior credit and financial strength ratings, which further reflect Amerisafe’s potential to overcome its operational risks and regain growth in the long run, once the macro dynamics rebounds to their historical highs.

Overall, though the pricing environment has witnessed some improvement, the company is expected to face uncertainty for the next few quarters as the market weakness continues to hurt payrolls. Amerisafe competes with SeaBright Insurance Holdings (SBX) and Employers Holdings Inc. (EIG).

On account of all these issues, Amerisafe’s third quarter earnings are expected to be 30 cents, about 15% higher than the year-ago quarter. However, for 2011, earnings are projected to plunge to $1.23 per share, down 24% over 2010.

Additionally, the quantitative Zacks Rank for Amerisafe is currently #5, indicating strong downward pressure on the shares over the near term.

 
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