Case Studies

Follow a link to jump directly to a specific risk, valuation and forecast assessment performed by Predyct for a particular client OR scroll down to read all of the assessments. The following case histories are divided into the diagnostic categories Valuation and Growth, Captial Allocation & Adequacy, and Contingent Claims Impact to Shareholder Value. Companies are placed in each diagnostic category according to the discipline most responsible for diagnosing the root cause of corporate opportunity or distress. It should be noted that virtually all of the following analyses were performed using only publically available information.

Valuation & Growth:

Case History A.1: AIG, Lehman, Bear Stearns and Merrill Lynch

In July of 2001, we advised our client “The Economist Magazine” that AIG’s market value of $189 billion ($83.84 share) was overvalued by about 50%. Our (at that time Predyct Analytics was named Seabury Insurance Capital, abbreviated as SIC) valuation became the lead “Economist” cover story of February 28, 2002. The market's respone to SIC's valuation of AIG was one of incredulity and disbelief. So much so that one very well known securities firm, Sanford Bernstein & Co, published a report just days later on March 2, 2002 critical of SIC’s valuation citing that AIG was not over-valued, but significantly undervalued. But by February of 2003 AIG's share price had fallen to $49.24 and SIC began to receive many questions from the market about how we had forseen the rapid fall in price of AIG. We were asked to update our valuation of AIG again in the Fall of 2007, at which time we forecast that AIG was substantially bankrupt — this was at least 12 months before the market became aware of AIG’s extremis, while the company still had a AA rating and 16 months before it declared bankruptcy.

This prescient analysis indicating the depth of AIG’s problem was illuminated by our analysis of Lehman Brothers, Bear Stearns and Merrill Lynch, all of whom appeared to have similar asset compositions and risk profiles to that of AIG Financial Products. We used these companies as surrogates to perform a risk and valuation of AIG’s Financial Products unit. Our analysis of these three investment banks revealed that they had at least a 25% chance of insolvency at the one year horizon. This would constitute an “F” rating (they were all rated as investment grade) from any of the rating agencies had they been paying attention. We then imposed the same risk (proportionally) on AIG Financial Products as existed for the surrogates and observed that AIG did not have anywhere close to the level of capital that would be required to absorb the risk of this unit. This led to our prediction that AIG was substantially insolvent in the Fall of 2007. Click here to read about the details of the AIG case. along with links to the related analysis by Sanford Bernstein, The Economits article, and SIC.    Back to index.

Case History A.2: A large check printing firm

This firm approached us concerned about its falling share price. A quick assessment demonstrated that this firm’s largest revenues were from selling checks to depositary institutions—a dying business as financial commerce goes increasingly paperless. In a panic the firm had quickly acquired a number of companies most of whom were unrelated to its core business of serving financial and depositary institutions. Their strategy was to diversify away from the check printing business. But A.2's share price continued to plummet. Predyct identified that this firm also owned an EFT (Electronic Funds Transfer) business unit that was being largely ignored by company management. Electronic Funds Transfer (EFT) is a system of transferring money from one bank account directly to another without any paper money changing hands. Our benchmarking analysis revealed that the EFT business activity had a P/E ratio of 60 across the market whereas Company A.2’s P/E ratio was 10.

In short, A.2, was allocating significant resources and capital to its dying and low value business activities and almost completely ignoring its highest value proposition. We advised this company to sell off the unrelated companies it had recently acquired, conduct a slow strategic withdrawal from its cash cow (the check printing business) and reorganize the company around its EFT operations. We believed that ETF was the natural successor business to what the company had always been as a check printer since its founding 51 years earlier. The CEO informed Predyct that our plan was too radical. Six months later as the company’s stock price continued to sink the company’s board fired its CEO and executive team, hired a new CEO who announced Predyct’s plan as being its future direction. The company’s share price jumped almost 30% on the announcement. Back to index.

Case History A.3: A small Midwest life insurance company that had recently gone public

Company A.3’s stock price had initially taken off after a successful IPO conversion to a public company from that of a mutual company. But the company’s stock price had gone into a rapid decline owing to earning difficulties precipitated by its recent entrance into the health care field. Predyct performed analysis on this company in order to recommend a turn-around strategy to the company’s CEO. Our assessment diagnosed that A.3's health unit earning difficulties were not attributable to a lack of margin (as thought by the comopany and market analysts) but rather to a lack of scale. This was a highly significant observation since this meant that A.3’s value should be based on sales rather than net earnings. The CEO of Company A.3 was planning on retiring after the company’s successful launch as a Public company. But now the company’s stock price was crashing and he felt a strong responsibility to the IPO investors that he had been marketing to for the past two years to make sure the IPO was a success.

We advised that the best course was to either sell the health care unit or the entire company. The chairman and CEO did not believe the company could obtain a high enough sale price to satisfy the recent IPO investors without possible legal ramifications. Predyct advised the CEO that the company could fetch as much as $300 million in a sale, nearly twice its then market value. The CEO thought that Predyct was not being realistic — that is, until his company sold shortly after for $296 million. Predyct’s advice had prevented him from selling out at a far more modest price and perhaps incurring shareholder wrath and suits from the recent IPO investors. Back to index.

Capital Allocation & Adequacy

Case History B.1: A large global life insurance company

Between October 1998 and year 2000, Predyct Analytics was retained by one of the US’s largest audit firms to provide an opinion of its largest audit client’s risk (Company B.1) and value. We advised the audit firm as well as Company B.1’s CEO and CFO that it had over-leveraged itself in a major acquisition of an HMO. We advised that this increased leverage had increased its cost of capital to more than 20%, a rate that would most likely cause its stock price to collapse simultaneously triggering a loss of its AA rating absent an immediate restructuring. We provided an approach to averting such a calamity, long before rumblings from rating agencies, investors, or the company’s primary Wall Street financial advisor. Company B.1 disagreed with Predyct’s analysis, but eighteen months later after the company’s stock price collapsed in value by 50%, loss of its investment grade rating, and the discharge of its leadership, new management appointed by the company’s board implemented Predyct’s recommendations of splitting the company in two. The life insurance operations were divested. The surviving HMO quickly recovered and is now one of the most successful companies in the industry. Read More. After Thoughts: There were two factors that prevented this company from following Predyct’s advice early in the process: 1) B.1 had only acquired the HMO two years earlier that we recommended it divest , and 2) B.2 believed that its risk and cost of capital would follow its rating when, in fact, the opposite is true: cost of capital and ratings follow financial performance. In fact, the CEO informed us that his company had just had its rating reaffirmed with a stable to positive outlook. None of the rating agencies had raised Predyct’s issue of over leverage.

But rating agency ratings are highly lagging indicators of potential firm problems. Politically, Predyct’s advice would have been a very difficult thing for management to put before its board after having recommended the acquisition of the HMO only two years earlier. The momentum of Company B.1 to sustain its strategy remained strong even though the company’s newly installed EVP & CFO believed Predyct’s analysis could be correct. Incomprehensibly, Company B.1 engaged in an aggressive stock repurchase plan believing this would show the market how much confidence that B.1’s management had in its future. AIG had done the same thing in 2005 and 2006 in an attempt to boost its share price. The markets are usually able to detect management’s attempts to artificially boost performance when it is not being produced authentically. B.1’s financial staff believed that its evolving earning problems were exclusively due to “blocking and tackling” issues associated with the integration of the new acquisition, not structural, financial leverage or cost of capital issues as indicated by Predyct.. Ultimately, B.1’s stock price kept falling accompanied by several rating downgrades as Predyct had forecast until the board took control of the company (under pressure by stock holders) and ultimately implemented Predyct’s recommendation of divesting the the HMO from the life insurance company. Back to index.

Case History B.2: A large global property and casualty company

Our analysis revealed that this company’s homeowner’s line of business represented only 1% of its income but contributed a whopping 40% of its insurance risk. As a result, the homeowners’ line should have been allocated 40% of B.2’s total capital resulting in a pretax return on capital of only 1%. This ROE is far lower than what the company estimates its Homeowners ROE to be given the way it allocates capital using ad hoc metrics not related to risk. Predyct has advised this company that earning a 1% ROE on 40% of its capital is not sustainable. The company’s ongoing strategy has been to acquire additional insurance companies (at very high market premiums) ) that also specialized in homeowners insurance. B.2 is a mutual that had formed a mutual holding company in anticipation of converting to a public company. However, the mounting difficulties in its earnings and subsequent downgrading by the rating agencies caused by its ever increasing homeowner’s book forced the company to withdraw its bid to become a public company. Yet, Company B.2 continues to pursue its current strategy amidst embattled earnings and continuous rating pressure oblivious (just as was company B.1) to its real underlying problem. The real irony is that Company B.2’s problem is easily resolved once it finally recognizes the fundamental issue. Company B.2 is also identified as Company A in the Benchmarking discussion that compares B.2 (A) to two other companies.   Back to index.

Case History B.3: One of the US’s largest auto insurance companies

In January 2006, Predyct recommended to this company’s senior management that the company should repurchase up to $4 billion (between one-third and one-half of its book value) of equity to preserve shareholder value and ward-off unwanted acquisition activity. This company was more than 50% owned by five private equity firms making them vulnerable to an aggressive buyer, particularly if the private equity firms were persuaded that Company B.3's equity was underperforming due to excessive capitalization. We made this recommendation as our analysis (using Predyct ERM) informed us that the company had at least twice as much capital as it needed to sustain its “A” rating and associated business and financial risk. In January of 2006, this company’s internal risk management team indicated that it did not agree with Predyct’s analysis, but on June 14th of 2007, Company B.3 announced its intent to return up to $4 billion to shareholders through an extraordinary dividend and stock repurchase plan, about half of its capital and the largest stock repurchase in its history and in the insurance industry that year. Coincidence? Read More.    Back to index.

Case History B.4: One of the largest global diversified financial service corporations

Predyct was retained by one of the foremost global strategic management consulting firms (Call it StratCo) to obtain an understanding of B.4’s risk, capital adequacy and shareholder value. B.4’s board had retained a new chairman and CEO who had put out a request for proposal to leading consulting firms that it would like to receive proposals regarding B.4’s situation and insight for best strategy going forward. StratCo retained Predyct to lead this investigation. Predyct’s Analysis of this most venerable of old line US financial service companies revealed something very surprising: Predyct’s analysis revealed that this company had about half the capital it needed to justify its AA rating and that its return on capital (with the appropriate level of capital to justify this rating) would reduce its return on capital to 5%, about one-third the level of its competitors. The only thing that had saved B.4 to that date (Predyct asserted ) was its historical branding, inaccurate rating agency analysis (that allowed it to sustain its AA rating) and the fact that it was a mutually owned company (i.e., owned by its policy holders rather than by shareholders). Following Predyct’s advice, StratCo advised the newly installed CEO of the situation and he was most attentive while the rest of the company’s leadership was highly resistant to StratCo’s appraisal of their situation. Yet, subsequent events soon validated Predyct’s assessments –i.e., B.4 was put on Credit Watch three months later by the major rating agencies and B.4 also lost a significant number of large clients who were in credit sensitive lines of business with B.4. B.4’s CEO advised StratCo that StratCo had distinguished itself from the other competing consultancies and was awarded the largest part of B.4’s strategic advisory account. B.4 became one of StratCo’s largest accounts. Under the new CEO B.4 did begin an immediate set of divestitures allowing B.4 to recapitalize as Predyct had recommended. This action preserved the company’s rating ultimately allowing the company to make one of the most successful conversions to public ownership several years later.

After Thoughts: Company B.4 had followed many of its peers into becoming a financial supermarket and had spread out into securities, mortgages, merchant banking, consumer finance—almost everything away from its core competence in life insurance. Many financial service companies have done this without really understanding the capital requirements of each business they enter believing that their core capital and rating is sufficient to support all the add-on activities. In so doing, they generally capitalize the new business activities with what they are absolutely required to do from an operational, regulatory and rating perspective, but not what is actually required on an economic and risk basis (i.e. Economic Capital). As a result, all of their individual businesses end up earning very high rates of return on capital (owing to low capital attribution to each business activity) but very low return on capital for the entire enterprise. The end result is that the company has deceived itself into believing the fiction it has created until, one day, it learns that its rating is going to be lowered and/or it begins to lose customers. At this point they also realize they need additional capital to bolster market confidence but earnings are not adequate to raise capital at effective rates. Recognizing this usually requires the appointment of new leadership (such as this institution did) as the old guard does not want to acknowledge the failed capital strategy of the past.     Back to index.

Case History B.5: For the management of one of the largest global life insurance companies

Predyct was retained by this company’s leadership to perform a risk and profitability analysis of the firm’s principal lines of business. We identified that its largest line of business (fixed annuities) consumed 30% of the firm’s capital when capital was allocated according to risk contribution and produced only a 3% return on capital resulting in a huge drag on the firm’s value. Our first reflex in these situations is to identify what is wrong with a business and how it can be fixed. Our benchmarking of fixed annuity companies across the market revealed that the fixed annuity product had fallen out of favor with respect to variable annuity “type”products, commanded very thin profit margins and had very low growth. Most of these fixed annuity companies had very low price-to-book and price earing ratios. We advised this company to do a strategic withdrawal from fixed annuities. While the company complimented Predyct on our analysis they did not agree with our conclusion saying that they believed that total earnings is a more significant driver of shareholder value than return on capital. Several years later this company quietly divested its fixed annuities business unit.

After Thoughts: We learned that the real motivation for this firm not wanting to divest its fixed annuities business was that the CFO of the life business did not want to inform his holding company that the life company would be delivering less income due to the divestment of its largest line of business. This all has to do with the highly suboptimal manner in which most executives are compensated based on total growth of income rather than more productive factors such as risk adjusted return on capital plus growth. Also, the fixed annuities group employed a lot of people at Company B.5 and was important to the company’s independent insurance agents who, without a fixed annuities product, might be less loyal to Company B.5. These are all valid considerations but it would take a lot of validity to justify holding onto such a costly operation, and as we learned, Company B.5 divested its fixed annuity unit a few very costly years later. We find that once a company is made aware of a significant drag on its value it generally takes that company at least two years to act on it if they ever do. Back to index.

Contingent Claims

Case History C.1: One of the top US banks

Our client retained Predyct to assess the ongoing prospects for one of its largest counterparties (Company C.1 a large US commercial bank). Company C.1 had recently acquired another large commercial bank using proceeds it received from a convertible preferred stock offering it made in a private placement with a hedge fund. Predyct observed that while this bank led all of its peers in terms of most conventional financial and operating performance metrics it was last in terms of share price performance (i.e total return). What could account for this? Predyct observed that the convertible preferred stock offering by Company C.1 contained very unusual conversion features for the hedge fund investor. Predyct Analytics forecast that this private placement had the (high risk) potential to so dilute Company C.1’s value that its stock price may be badly compromised making it vulnerable to acquisition. This is because the conversion privileges of the convertible preferred shares contained a complex option (a complex option allows the holder to convert the shares into one of two different things owned by the issuer (C.1). Also called an exotic option) that asymmetrically aligned the value of these securities with the value of the issuing bank. This is precisely what happened. The value of the convertible preferred stock grew to equal 20% of Company C.1’s market value creating terrible dilution of its value. The hedge fund investor that purchased the convertible preferred shares earned a total return in excess of 400% on its investment in the preferred shares.

Bank industry analysts later acknowledged that it was this private placement that ultimately required C.1 to sell out to its competitor preventing it from becoming one of the nation’s top three banks. Read more. After Thoughts: This transaction occurred at a time when there was tremendous consolidation in the banking industry. Company C.1 had an opportunity to purchase a highly desirable bank and needed funds quickly, too quickly to make a public issue of its own stock to raise the capital, and besides, Company C.1 wanted to maintain secrecy and a public offering would require full disclosure. The banks senior management was also in a very big hurry to wrap up this acquisition as their desired acquisition was being pursued by several other potential acquirers. Predyct approached Company C.1 through the offices of its sponsor (the counterparty) to offer advice that Company C.1 should restructure the deal with the hedge fund as soon as possible to avoid what we thought could be a very costly result. Company C.1 did not receive this gesture kindly and threatened Predyct’s sponsor with a curtailment of a large volume business if it did not suspend all business activities with Predyct Analytics. Back to index.

Case History C.2: A life insurance company being converted from a mutual to a public company

We were retained by one of the top three rating agencies to advise it with respect to an “A” rating the agency had recently affirmed on a life insurance company that was converting from a mutual ownership structure to that of a public company. We advised the rating agency that this firm’s IPO structure had doomed it and its IPO investors from the day it went public by allowing its investment banker to create an IPO structure that diluted the company of in excess of $700 million in shareholder value—nearly half of its book value. We thought the company’s rating should at minimum be put on “Negative Outlook” and at best be substantially downgraded to less than investment grade. This scenario proved correct: Private equity IPO investors later (4 years later) brought suit against Company C.2’s management team for “operating” non performance, intent to sell the firm for 75% of book value (which it said was highly undervalued), and self enrichment for self directed bonuses that management would receive upon the company’s sale to the acquirer. Predyct’s analysis revealed (before and after the IPO) that this company’s poor performance was not due to management’s “operating” non-performance but due to its allowance of a highly dilutive IPO structure that depleted the company of so much value that it didn’t have the resources to effectively compete going forward.

Sales and profitability were greatly diminished by this dilution of value, stock price never rose above the IPO price and the company’s management sold out to a larger well financed company when it saw it had few other strategic options. Read more. How could this IPO structure have been approved? That was Predyct’s position. After all, before this transaction was approved it had been analyzed by Company C.2 and its financial advisor, by four rating agencies, the insurance commissioner’s office that would have retained a financial advisor to look out after the interests of the old policy holders. The answer to this question is that insurance analysts and actuaries are not commonly trained in options analysis. Two of the most dilutive features in this IPO structure were the options granted to the investment banker that took Company public and to the old policy holders. The third cost imposed on Company C.2 was that its new capitalization was not equal to that of its principal competitors thus making its cost of capital higher and its net earning margins (all other things being equal) smaller. As further evidence of these observations Company C.2 became a star performing unit when it was acquired by a much larger global insurance firm. Back to index.

Case History C.3: Hewlett Packard

This analysis was performed purely on speculation by Predyct and for the expressed purpose of illustrating the impact that contingent claims can have on corporate shareholder value. On August 8, 2010 HP announced that it had fired its CEO, Mark Hurd for cause. On that day HP lost $10 billion in market value. Upon hearing that that HP had not secured a non-compete agreement as part of Hurd’s employment contract, securities analysts and investors expressed grave concern that Hurd could now go to work for an HP competitor conveying all of HP’s most sensitive secrets and intellectual property (IP). Concurrently, there were rumors that Hurd was being offered the role of president at Oracle – one of HP’s most voracious competitors. While Predyct has not conducted a valuation of HP, we note that HP had matched the performance of its competitors prior to Hurd’s firing but fell precipitously behind immediately after. Predyct’s position is that Hurd’s employment contract (and most executive employment contracts) have all the analogue features of a standard option contract.

Thus, if we can value the features in a standard option contract than we can also value the cost of HP not obtaining a non-compete agreement from Hurd. This failure may have ultimately cost HP shareholders as much as $20 billion. HP shareholders have now commenced legal action against HP for not disclosing to shareholders that HP was performing an internal investigation of Hurd. While we believe this is a credible claim we believe that HP’s value was significantly more damaged by HP’s failure to obtain a non-compete clause and that the economic damages incurred as a result can be assessed using an options (contingent claims) framework.. While Hurd has agreed to surrender stock options worth $14 million he is still slated to receive $12.2 million in severance. Read more. Back to index.