Donegal Group trades at 80% of book value and 82% of TBV, which is hardly exciting, but represents an interesting situation due to its unusual capital structure. DGICA pays $0.64/sh in annual dividends for a 4.5% yield and continues to grow the business. Donegal is a $448 million market cap, regional property & casualty insurance company based in Pennsylvania. 37% of its business is personal lines, with personal auto representing 22% of its premium, and the remainder is in commercial lines.

DGICA has been written up once already on VIC in 2013, astutely I’d add, by David101.  When David101 mentions banks or insurance companies, I tend to pay attention.

If fact, the opening paragraph of this write up was copied directly from David’s original write up!  Not much has changed since 2013, unfortunately.  The stock is up a whopping .38 cents per share from his original write up!  The metrics have improved some, and I just updated the price to book, div yield, market cap and product mix in my opening paragraph.  The opening lines to 4^th grade book reports are often the most difficult, so I figured I would just use Dave’s format. Ha Ha!   At the time of David’s write up, he noted their plan to tilt toward commercial lines, and they appear to have done that successfully over the last decade.

Why hasn’t the stock gone up during this time?  Isn’t that what is supposed to happen if you hold cheap stocks for a long time?  Well, to be fair the company pays a not insubstantial dividend.  But insurance companies generally haven’t done well in the ultra-low interest rate environment.  There might be the usual value vs. growth headwind in there too.  Auto insurers, generally speaking, also failed to accurately price distracted cell phone drivers over the last decade.  Oh yeah.. and also…ahem… insiders and the board have been lining their pockets with stock options, stock grants, and other stock incentives.  The shareholders equity component on their balance sheet has increased steadily for the last ten years.  Unfortunately, the shares outstanding have increased at roughly the same rate, giving this a real “Lucy With the Football” buzzkill vibe.

My firm has owned a small position in DGICA over this time.  Obviously, it had been a drag on performance, but we didn’t bet the ranch on it and it has been ballast for the ship during volatile time periods.  We cringe from time to time when we look at it.  But we do believe David was right, just a little early.  And frankly we have done worse, sometimes our stocks go down in price!  We view it the same way David characterized it in his write up - as a convertible bond, with an option to be bought out.

David101 does an excellent job of describing the unusual ownership structure in his write up, and I suggest reading his write up to get acquainted with the situation.  Essentially Donegal Mutual Insurance Company, owns about 15 million shares out of the roughly 31.2m.  Some of which are the B shares, which have 10x the voting rights, giving them mathematical control of both Donegal Mutual Insurance Company and the public shares of Donegal Group.  In the event that Donegal was to merge with a mutual insurance company such as Nationwide or Liberty, they wouldn’t have to cash out the shares held by Donegal Mutual Insurance Company.  They would only have to cash out the public stockholders.  This may seem complicated.  It is.  But rest assured the folks at Donegal are apprised of the situation.   Nationwide and Liberty are well advised and also know a thing or two about these structures and mergers as well.

What I plan on doing in this write up is making a few observations and updates about the mutual insurance and auto insurance space from an M&A perspective.  I’ll give a few informational nuggets on key personnel and generally try to justify why we have recently added substantially to our position.

We were blessed with a large position in Gainsco, a sub-standard auto insurer that sold to Farmers Insurance at a wild premium at the end of 2020.  As a result, I have started to pay a little bit more attention to M&A in the auto insurance space.  It seems that there is a hardening rate environment in commercial and specialty insurance that should help with consolidation. 

The most notable transaction for the P&C industry in recent times was likely when Allstate acquired National General in 2021 for roughly 4 billion.

But if we focus down specifically for recent deals that would be an apples-to-apples comparison for Donegal, I think there are two that deserve special mention. 

The first one doesn’t fit my narrative, but I will mention it anyways.   EMC Insurance Group was acquired by Employers Mutual Casualty Company in 2019.  Instead of merging with another mutual, which is what we want to have happen at Donegal - they ended up selling to the parent mutual.  Although the deal was done at a nice premium to the market price, the pricing was a disappointment in my opinion.  I believe that the public shareholders would have been much better off in a merger with another mutual.  Of note Gregory Shepard, who agitated for a mutual merger with Donegal around the time of David’s original write up, was deeply involved in EMC Insurance as well.  He was unhappy with this transaction, rightfully in my opinion.  In his 13D filed 3/25/19 he suggests:

You Must Consider All Alternatives

As a Special Committee, you can only know the true value of the Company by doing independent work and evaluating all alternatives.

Other public downstream insurance companies that were controlled by mutual insurance companies have engaged in various forms of transactions to maximize value for the public shareholders, including a combination or affiliation among mutual insurance companies followed by a cash-out of the public shareholders, or an outright sale to the parent mutual insurance company.

Later in the 13D, Shepard Continues:

The Precedent Transactions Resulted in Values At or Above Two Times Book Value

There are several relevant precedent transactions for a mutual insurance company buying a publicly traded subsidiary, either in conjunction with a mutual-to-mutual combination or as a standalone transaction. There are five precedents in particular upon which the Special Committee should focus because of their similarity to the current circumstance. These transactions exhibit a clear valuation pattern: these transactions tend to occur at approximately two to four times book value.

The premiums and multiples achieved in these prior transactions reflect the unique circumstances of a downstream public insurance company being consolidated with its mutual insurance company parent either as a stand-alone transaction or as part of a consolidation among mutual insurance companies. The savings associated with public company cost and significant simplification of company operations – and, in the case of a mutual-to-mutual transaction, the mutual’s surplus that gets consolidated — justifies the substantial premiums observed in these deals.

Moreover, there is good reason to believe that the Company would be extremely attractive in an open and fair strategic alternatives review process and would garner book-value multiples closer to Allied Group’s 3.57 times than to the other public companies on this list. Among other things, the Company’s business is now entirely commercial (which is more attractive than personal lines of insurance), the premium base is large and in attractive geographies ($1.8 billion of premiums at EMCC and the Company), the employees and operations are in low cost areas and the opportunity to consolidate and reduce overhead are substantial given the market presence of several other large mutual insurance companies, and the surplus at EMCC is large, especially relative to the value of the shares owned by the public shareholders of the Company. Based upon my decades of experience investing in the insurance industry, I strongly believe that a large mutual insurance company would happily consolidate with EMCC — bringing better, more diverse and less expensive insurance products to EMCC’s clients — and pay a significantly higher price than the Proposal to Company shareholders in order to do so.

The underlined passage is my own emphasis here.  I would note that Donegal, since David’s write up, has shifted their product mix towards commercial underwriting.  Whereas at the time of the original 2013 write up, the majority of their product was personal lines.

The second example I would point to is Liberty Mutual acquiring State Auto Financial Corporation.  This is exactly the type of deal that I think would be in the best interests of the public shareholders of Donegal.

Below is the press release. 

https://investor.stateauto.com/news-and-events/press-releases/2021/07-12-2021-133152134

From a very high level, (using the GAAP share count and including the shares held by State Auto Financial Corporation) it appears that Liberty Mutual will be paying shareholders about two times book value.  In reality, they are only paying around book value, but all the cash is being allocated to the public shareholders.

Charlie Munger has said “Show me the incentive and I will show you the outcome.”  I think it makes sense to look at the incentives here at Donegal.  It is an odd juxtaposition because the incentives here are equally cringeworthy and appealing.

For starters, there is the standard but very generous max out of payments to key executives in the event of a change in control.  Since David’s write up the shares outstanding have gone up from about 26 million to 32 million, the result of generous stock options and restricted stock grants.  At the same time Donegal Mutual Insurance Company has been trying their best to acquire more stock in the open market, likely in an attempt to offset this obnoxious dilution.  In the last 12 months, DMIC has purchased a whopping 691,000 shares in the open market in six separate transactions. 

Thus far in 2022, Donegal has 21 form 4s filed so far, mostly for stock benefits.  In 2021, there were about 100 form 4s filed.  This strikes me as remarkable for a company this size.  I don’t have a very scientific way of looking at all these transactions, but the vast majority of these were all grants, or open market purchases.

I guess the main question becomes, when exactly will this happen?  If you hold this for another 10 years, and nothing happens, it will be like watching grey paint dry.  Obviously, I don’t know when exactly this will happen.  But ask yourself:  If you owned a ton of stock options, and restrictive stock awards, and had a nice change in control employment contract…what would you want to have happen?  Retire peacefully, and wait for the next generation of executives to accumulate shares for themselves and then sell it 30 years later?   Or cash in and sell it yourself now while you are still in control?

In merging Donegal with another mutual, you would have no choice but to be cashed out of the publicly held stock as stock deals are not available.  Of course, selling for cash and realizing massive long term gains is painful for those adverse to paying taxes, especially since Biden was unable to do away with the controversial “step up” in basis upon death.  If you place more utility on passing along as much inheritance to heirs as possible, rather than on immediate consumption, waiting for a step up in basis might also be a very good incentive.  For years people have pitched Mercury General using this thesis.  George Joseph, Chairman of Mercury, is a spry 99 years old and owns 35% of MCY.  I might be burying the headline here with this next sentence: With respect, I note that Donald H. Nikolaus passed recently at the age of 79.  Nikolaus was the longtime Donegal President & CEO and I believe the chief architect behind the current corporate structure.  It is my unfounded suspicion that he exerted heavy influence on the direction of Donegal, even after his recent retirement.  Despite being in poor health in recent years, he was a paid consultant.  Under the terms of the consulting agreement, Nikolaus was paid aggregate annual compensation of $600,000 according to the most recently filed proxy.  Nikolaus, according to the most recent proxy, owns 1,390,568 shares of class A and 186,603 shares of class B.  Nikolaus, a former lawyer prior to his involvement with Donegal, earned about 1.6 million in dividends and consulting fees last year.  If Donegal were to merge this year, his estate will likely will not pay any capital gains, or will at least pay significantly less capital gains. 

To summarize:  We own DGICA.   We originally purchased it at the time Gregory Shepard was agitating Donegal to merge with another mutual insurer around 2013.  We thought his plan made a lot of sense then, and that the same exact plan makes a lot of sense now.  It has been a disappointing return during that time.  But as we re-examine the thesis, we think that the premise is sound and holding the security has merit.  We would note that there has been substantial dilution to the direct benefit of key executives.  That has been frustrating, but also reinforces the original thesis.  We think the passing of Donald Nikolaus might also be a meaningful event.  Lastly, it seems like P&C insurance M&A has been active lately, especially with the two specific comps, EMC and State Auto, recently merging out. 

I had the pleasure of meeting David101 in person at an annual meeting in Philadelphia about a decade ago, and I hope he doesn’t mind me re-evaluating his original idea.  And since I copied David’s opening paragraph, I may as well go “all in” and also copy his original concluding catalyst which I believe is still accurate.  Pasted below in the catalyst section.