Tuesday, February 10, 2015

Mercury General (MCY) Has More Room to Fall

Mercury General Corporation (MCY) is an auto insurer that traditionally focused on California. It took a beating the past couple days after the latest earning release, dropping from $60 to $53 per share. I think it has more room to fall.

Anyone who followed this company even peripherally can te­ll it was (and still is) way overvalued. The only thing propping up the stock price is the high dividend payout, and that is hardly sustainable. The last 2 days of price action shows that dividend investors may finally be coming to their senses. If MCY finally get valued on earnings like its peers, we could see a ~40% drop.

Mercury General is obviously a less attractive business compared to peers Progressive (PGR) and Allstate (ALL). I will provide a list of reasons here.

  • Unattractive business model. Mercury General relies on independent agents, which I consider less attractive compared to the direct channel or using captive agents. Independent agents can sell other brands, which means MCY will pretty much have compete on price, provide much better service or advertise to build brand equity. This puts MCY in a tough spot versus the big boys. Clearly, it's no easy task for them to compete on an ultra-low cost structure against GEICO and Progressive. On the other hand, if they go for better service and brand name, that will exert pressure on margins due to higher expenses. This brings me to the next point. Judging by MCY’s combined ratios, this is simply not working.
  • Above average combined ratio of high 90 to 100% (PGR and ALL both in the low 90%’s). Mercury General is the high cost producer in the group, with expense ratio approaching 28% of premium earned, compared to Progressive at ~20%. Lower expenses allow insurers to give a better price to consumers as well as bear higher losses. On the loss side, MCY has a history of adverse reserve developments - obviously there are worse insurers out there but this is no PGR.
  • Geographic concentration in California. The company is trying to expand to other states but that does not seem to be working too well, particularly in NY/New Jersey. In the near term they plan to ramp up advertising, which gets us to the next point..
  • Lack of advertising fire power to compete effectively against the insurance giants. This is important as auto insurers are pretty much in a constant advertising war. How is Mercury General going to compete with the Geico gecko and Flo?? 
  • Investment portfolio has high exposure to energy sector which is clearly not well in this environment.
  • Insiders have been selling more than buying 
  • Founder/Chairman George Joseph is highly respected in the industry but he is 92.
  • Stock trades at 19x forward P/E and 1.6x P/B. 
  • Dividend is not sustainable. They have about $135mm of annual dividend obligation, I calculated 2014 normalized net income (adjusted for non-recurring items) of $125mm 

So yeah, I have been eyeing this one as a short for a while. The only reason I did not short this sooner was the high dividend yield, and the lack of a catalyst to shut off that dividend (debt to capital is only 12% so they can keep borrowing to fund dividends, even in the absence of any cash flows from opco). The catalyst to start a short position would have to come from signs of business deterioration. Only then the dividend investors might wake up and see this is a bad deal.

The latest earning provided that. 4Q14 combined ratio was over 100%, even adjusting for prior year developments, catastrophes, and non-recurring expenses. In the conference call, management basically acknowledged that dividend payout is unsustainable if current performance continues. Analysts questioned how Mercury can compete on the advertising front. With some of the weaknesses I listed above being exposed, the stock price dropped 5%. I started a short position then. Today it dropped another 6% and I added more to my short. Hopefully, this is the start of a change in how the market values MCY.

MCY still trades at 19x P/E even after the latest drop. Progressive and AllState trade at 14.5x and 12.2x 2015 earnings, respectively. MCY deserves a discount, not a premium to these better run, better positioned competitors. Taking consensus 2015E earning of $2.7/share at 12x multiple would value MCY at $32.5 a share, a 39% drop from its current level of $53.

The other way to play this is to a pair trade: short MCY and long PGR or ALL (or both). I am also long PGR - although not intended as a pair trade.

** Updated 2/12/2015

KBW find it hard to justify MCY's stock price. So, people whose job is arguably to justify high valuations are struggling to justify those valuations. If you still own MCY you need to take a serious look.

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