Fat Prophets take profits

Several factors underpinned our initial recommendation of Wellington Underwriting (WUN) last July (FAT93). Besides a robust rate environment and reductions in industry capacity, we anticipated consolidation in the Lloyds insurance market. As such, this week's announcement that fellow insurer Catlin is in discussions with Wellington regarding a takeover was a welcome development.

Not surprisingly, talk of an acquisition has dominated price action in Wellington this week. From a close of 97.25p on Monday, the stock rallied more than 19 percent during the day on Tuesday to reach 116p. This is the highest level achieved by Wellington in more than five years.

Although this week's gains have seen the stock post a bullish break above the consolidation band that has been forming for the past three and a half years, we remain cautious. Sharp breaks fuelled by takeover activity are notorious for clouding the technical picture.

From a fundamental perspective, a combination looks like a solid proposition. A general indication of this is the increase in both companies' share prices. While Wellington's rise was expected, Catlin's increase reflects a wider consensus that the combination will create shareholder value. The opposite is very often the case when acquirers overpay for assets at the expense of shareholders.

Scale is important in the insurance industry as it confers more power to set prices and terms. A large insurance book also allows for higher levels of diversification of risk and a larger capital base to support the business.

In this context, Wellington and Catlin would create an insurance company with a combined market cap of over £1.3 billion. Already two of Lloyds' larger syndicates, the enlarged group would become the largest in terms of underwriting capacity.

A major justification of the takeover for Catlin is the acquisition of Wellington's healthy US business. Through the first six months of this year, Wellington increased gross written premiums in America 26 percent to US$111.5 million. Expectations for the full year are close to US$230 million.

Also included in the deal is the fast growing Wellington Specialty group, which now operates in 43 states. This division's first half premiums stood at US$20.1 million; compared to US$3.5 million 12 months ago, whilst a growing distribution network should see total premiums climb to US$50 million this year.

Catlin was the first Lloyds insurer to change its domicile from Britain to Bermuda in order to take advantage of the less onerous tax and regulatory environment. This situation enables Catlin to offer lower quotes on international reinsurance. By adding Wellington to the mix, a larger portion of business can operate through Bermuda to take advantage of these benefits.

Whether the acquisition occurs or not, we believe Wellington may pursue a Bermuda listing in the future. The announcement last month that Hiscox was moving their domicile to Bermuda may have marked the start of the trend.

In our last review of Wellington in FAT150, we were upbeat following a strong underlying underwriting performance in the first six months of the year. The group's net combined ratio (claims as a percentage of premiums) of 87.3 percent and 23 percent increase in premiums to £358 million were both respectable.

Offsetting the gains were translation losses from an under performing US dollar. However we still believe that growth opportunities in America along with higher premium rates will longer-term underpin sterling profitability.

As such, we are optimistic regarding Wellington's standalone prospects as a well run (as demonstrated by the low core operating ratio), growing insurance provider. This is particularly true in light of this year's low level of hurricane activity in the Gulf of Mexico. In addition we regard Wellington's valuation as undemanding with a 2006 price earnings ratio of less than 11 times and a healthy 4.5 percent dividend yield.

However, corporate activity has presented the opportunity to crystallise profits today. Therefore, we believe it is prudent to take some profits now in the event the takeover talks go no further.

While the longer-term outlook for Wellington remains positive, we believe the risk of near term volatility is high. Accordingly, we recommend Members sell half of their holdings in Wellington at around 113p, to take advantage of this week's gains.