Progressive Corp -- For those investors who are willing to be patient, we think Progressive Corp (PGR) is an interesting opportunity at current prices. Our thesis is not built upon a near-term financial model that looks different than consensus, but rather on our view that PGR may be at a turning point with respect to policy and premium growth that may cause Wall Street to think differently about the company. We also believe that this may be a multi-year opportunity to compound capital safely if our thesis remains intact.
We won't spend much time describing PGR's core business, because everybody knows Flo. They sell auto insurance (and boats, and RVs, and motorcycles along with some commercial vehicles) in the United States. At year-end 2011, they had written 8.5M policies (55% through the Agency channel, and 45% Direct). There are dozens of lousy competitors in the Agency business, and really only one legitimate competitor in Direct (Geico). Rather than spending more time here, we're happy to address the nuances of the channels in the comments if anyone is interested.
The Competitive Advantage
Simply put, there are two ways to build a competitive advantage in insurance. You must either be a good underwriter, or you must have skill to invest the float (or ideally, you have both). We believe that among auto insurers, PGR has a very strong underwriting competitive advantage that is incredibly difficult to replicate for a variety of reasons. We also believe that they are increasing their underwriting advantage, along with Geico to some degree, and thus have an enormous opportunity to gain market share for many years. Essentially, our investment thesis hinges on the idea that growth is at a turning point and that PGR will continue to widen their underwriting advantage relative to the competition.
With that said, PGR has NO advantage investing their float and have chosen to spend their energy almost completely on building a sustainable underwriting advantage. In fact, of the $16.0 billion investment portfolio equities make up just north of 16%. The remainder is invested in a short duration (1.9 years at 12/31) bond portfolio with relatively low credit risk. As you might imagine, the interest rate policies of the Fed have taken a significant toll on PGR's near term earnings power. The good news is that we need not spend time wondering about their investment skills, and can focus on their underwriting advantage.
Many years ago, PGR began it's life as an insurer of "non-standard" drivers. These are individuals who, for whatever reason, are considered dangerous to insure. Perhaps they've received too many speeding tickets, they have a DUI, or they have extended periods without insurance. Suffice to say, if you build your business by insuring non-standard drivers, you better create a very robust underwriting advantage. PGR did just that and has spent their history building and investing in their underwriting capability. Today, of course, they insure both non-standard drivers and standard drivers.
We believe that when the 2011 results are final for the auto insurance industry, PGR will have written insurance with about a 5-6 point combined ratio (CR) advantage over the industry (and it may actually be higher, we think we're conservative here). Further, we believe that this CR advantage is relatively stable and relatively permanent over time. As an example, Allstate has released their 2011 figures and wrote auto at 98.3 CR (accident year) for the full year compared to 94.6 for PGR. What makes this number tough to compare is that Allstate had zero growth in policies (ALL's earned premiums declined 2% y/y excluding acquisitions compared to 4% growth at PGR). Renewals (old policies) are considerably more profitable than new policies. The biggest advantage is relative to State Farm (and they skew the industry figures). We won't know their results for quite some time, but they are the biggest contributor to the gap between PGR and the rest of the industry. They are terrible underwriters, so as the insurer with the largest market share, they influence industry figures quite dramatically.
As an aside, PGR has introduced a product called Snapshot which may radically reshape the industry, and PGR's underwriting advantage, in the future. This is a little device that plugs into your car and measures all sorts of data regarding how you drive. PGR is then able to price your policy much more accurately, and quite often at a significant discount to competitors. Our industry diligence suggests that this technology is extremely worrisome to PGR competitors, including Geico, given the incredible technical lead PGR has over the industry. At this stage, Snapshot is too small to make much difference, so we'll have to see if PGR is capable of marketing this opportunity effectively.
As mentioned previously, the key to our investment thesis here is the possibility of PGR entering a growth phase in terms of both policies written and revenue per policy. Our work here rests on very careful analysis, and scuttlebutt research, regarding several aspects of the underwriting process. We'd be happy to discuss this in further detail in the comments.
In the meantime, think about the insurance purchase decision. Most consumers are not constantly searching for lower auto insurance rates. There are typically two instances where a consumer considers switching. First, if they are involved in an accident and have a bad claims experience, they'll shop around. Second, if they get the renewal notice and they see a noticeable price increase, they'll shop around. Otherwise, inertia is a powerful force (and the industry loves this because renewals are so much more profitable). Over the past few years, insurance pricing has been quite soft, so the primary reason for shopping has not been relevant. Insurers weren't raising rates, so consumer stayed with their existing insurer rather than going through the hassle of a switch.
In the case of PGR, this was compounded by an interesting issue. A couple of years ago, they began noticing some troubling trends in personal injury claims that made premiums inadequate in several high premium states (think Florida, New Jersey, etc). We believe very strongly that PGR was the first underwriter to notice these trends. As a result, they began to raise rates in these high premium states to keep their CR at acceptable levels (and remember, they don't plan to make up bad underwriting with their investing accumen). This had the perverse, but necessary, effect of putting a significant damper on PGR's growth as competitors weren't raising prices. A review of net premiums earned over the past few years demonstrates this phenomenon.
We believe that throughout 2011, the industry has realized that they have under-priced policies in several large premium states. We also believe that to remedy that situation, they are/will aggressively raise prices now to get in front of this issue. This will provide a very interesting dynamic for PGR, and one that we believe may lead to some interesting policy and premium growth. The trouble is that our thesis will take time to prove out due to the nature of insurance policies. Typically, insurance policies are written in six month increments. Thus, some consumers are still waiting to see the higher premiums that are coming their way, and thus aren't likely shoppers until they get their next renewal.
Equally important, there is a lag between when insurers discover they have mis-priced policies and when they get approval from the state insurance commissioners to remedy their underwriting problem with a price increase. Add the commission approvals to the six-month lag due to the nature of the renewal schedules, and this growth opportunity will play out somewhat slowly, but will last quite awhile if we're correct.
However, there is evidence in PGR's monthly results. For quite some time, net premiums earned and net premiums written have grown at roughly the same rate (premiums earned are recognized over the life of the policy, compared to the real time snapshot in premiums written). Lately, there has been a divergence with premiums written growing faster than premiums earned. This would suggest that PGR is finally getting traction in the high-premium states, just as our research would suggest. It's very early, so our thesis may not play out as we're currently thinking. However, we think the safety of the investment makes this a risk worth taking.
We won't spend too much time on valuation, only because the variables impacting such a discussion make the range quite wide. Also, any discussion of earnings per share in the near term depends on short-term interest rates given the low-duration $13.3B bond portfolio on which they are currently earning very little.
However, we would point out that PGR ran into a similar growth spurt in the early part of last decade. Premiums earned per share went from $6.49 in 1999 to $15 by 2004. Earnings grew materially during that period, and the share price went from mid-single digits to around $20/share (depending on exact dates). We think that PGR may be poised to enter another growth phase that may prove equally interesting. Importantly, the competition is so poor at underwriting over the long term that it is safe to assume that the runway for growth is real, and lasting. The question is, when does it start?