Description

For those of us that don't spend much time in the unprofitable (or at least very little cash flow) tech space, Progressive may be the most fascinating situation among major US companies right now. Lys615 posted PGR in Feb 2012 at $21/share. We agreed with that writeup and have owned the stock since then. The idea got a performance rating of 5. Since then, including dividends, PGR has compounded 21.1% annually. The S&P is up 12.9% annually. Btw, I know I'm going to get the "should have told us yesterday" tag. It's deserved.

Let me start by saying I wouldn't blame you for skipping this writeup after looking at the earnings multiples in the table above for an insurance company. There is no doubt that it appears expensive on 2023 earnings (btw, numbers in table are Street estimates). However, for those that have a few minutes to spend on an insurance business, I'd suggest PGR is in a unique position to rapidly grow earnings for many years. 

Rapidly escalating loss costs have hammered the auto insurance industry in the past year. The industry went from making huge profits when nobody drove their cars during COVID to an absolutely brutal environment where costs have escalated very quickly and premiums were not anywhere near keeping pace. Keep in mind, most auto insurance policies are either 6-month policies or 1-year policies. That gives you one or two chances per year to change price. Even trickier, insurance is regulated by all 50 states separately. In order to raise price, you must ask each state insurance commissioner for permission and prove that it is necessary. In some places, like California, the insurance commissioner is elected which means they have an incentive to slow down the price increase process.

It gets more complicated. First, an insurance company needs to understand that they have mispriced policies and need to ask for price increases. If you discover that you are underpricing and ask for a rate increase before your competitors, many of your customers will shop around when they get the renewal notice that shows a large price increase. If your competitors haven't figured it out yet, they may be offering your customer an uneconomic price. Your customer switches. It is tricky to be an early mover, but it is absolutely imperative that you do not write too many policies at the wrong price. PGR appears to have been at the leading edge of figuring out the industry had a problem.

The industry figured it out in late 2021, and everyone began to raise prices (at the mercy of insurance commissioner timing across the country). They didn't raise them quickly enough or high enough. During 2022, perhaps the worst year ever for auto insurance companies, the industry wrote at a 111.8 combined ratio (CR). That was 10.4 points higher than 2021. Losing $11.80 for every $100 in premiums is not a sustainable business. 2023 may not be much better. As a result, every auto insurance company is scrambling to raise prices even higher.

Then, there is Geico. During 2022, Geico got creamed, reporting a $1.9 BILLION underwriting loss. They realized their problem and began raising prices aggressively (keep in mind that Geico is over-indexed to places like NY, NJ, CA -- places where regulators are notoriously slow at approving rate increases). Also keep in mind that Todd Combs runs Geico (no, they still have not found a permanent replacement CEO to run the biz -- perhaps a sign that nobody wants the job). In response to these terrible financial results, Combs/Buffett slammed on the brakes. Policies-in-force (PIFs) declined 8.9% in 2022 (premium per policy increased 11.3%). Geico killed their advertising budget and cut expenses to the bone.

Fast forward to the first half of 2023 -- PIFs declined another 14.4% during the first half, while premium per policy rose 16.3%. It is hard to imagine a business like this in retreat mode like Geico is right now. Obviously, they are very concerned that despite massive price increases, they may not have their underwriting model correct. I get it. Buffett preaches that they won't write insurance if the price isn't right. I think that's a harder model to follow in a consumer product like auto insurance, but whatever. The point is, Geico is not the competitor it once was (and we can talk about this more in the comments if interested).

In 2012, I suspect Lys615 would have named Geico as the most dangerous competitor. That might still be true, but they are clearly wounded. The rest of the industry is even worse. State Farm loses considerable money every year (even when the environment is favorable). Allstate is a perpetual clown show, and they may be among the best of the rest. Suffice to say, it has become abundantly clear that PGR is WAY ahead of their peers and the advantage is growing. This is important because at this moment in time, there is an opportunity for PGR to take share from competitors who are either essentially leaving the market (Geico) or are so screwed up that their customers are very likely to shop around (Allstate, State Farm, Farmer's, etc).

Does that thesis show up in the numbers? Absolutely. In the past year, PGR has grown PIFs by 14% in auto. Overall, they've grown policy count by 11% (they also write commercial vehicle insurance and homeowner's insurance, but those aren't as important as auto). Premium growth has been 18% (I'm taking out the calendar shift benefit in July 2023 figures). As you can see, PGR is not having to raise prices as much as their peers (they were early, so they've already lapped some price increases). Effectively, PGR is taking huge share and their competitors customers are slowly seeing the renewal pricing and coming to PGR.

As of June 30, the TTM net premiums earned (NPE) were $53.3 billion. Underwriting profit during that period was $954M for a CR of ~98.2. We believe that PGR has at least an 8-point CR advantage over time, and there are a variety of reasons why they've built such a huge advantage. The simple reason is because they believed underwriting should be the source of edge rather than investing, which forced them to invest heavily in their underwriting capabilities. By now, it is very difficult to catch them. Geico would have the resources to make similar investments, but Buffett doesn't do that (he likes to milk things, not invest in them). None of the remaining public competitors have an appetite to make the necessary investments, and State Farm doesn't have the management team to succeed even if they chose to go that route.

What does this mean for PGR investors? There is considerable room to take market share given they have ~14% of the market currently. I expect both State Farm and Geico to give up share (they are the only two in the same ballpark of share with PGR), and every other auto insurance company is significantly disadvantaged relative to PGR... so will likely give up share over time. It is not a stretch to say that PGR can grow PIFs in the mid-high single digits for years to come. 

There is another important element to the PGR story. The balance sheet has a few lines of Investments that total to about the level of NPEs. However, at PGR they have a very conservative investment strategy. 95% of their investments are in short-term fixed income with a 2.9 year duration and AA credit quality. They are benefitting enormously from rising interest rates, though in the GAAP financials they have had to take mark-to-market writedowns. These investments are not impaired, and will be reinvested at significantly higher rates at maturity. Contrast that with their competitors who have significantly higher risk in their business due to a much higher equity allocation. 

Given current interest rates and expected equity returns of around 5-6% (probably too high, but who knows), we think the industry must raise prices until their CR gets down to at least 102, and ideally closer to 100 in order to make a reasonable return on their shareholder's capital. That would suggest that PGR can write at a 94 CR over time and be price competitive with peers. In the current environment, we think PGR can grow NPEs by at least 8% annually for the foreseeable future. Looking out a few years, it is not hard to pencil out NPEs in the $75B neighborhood with a 94 CR which yields a $4.5 billion pretax underwriting profit. 

With $75B of NPE, the investment portfolio is probably about $82 billion. Using 3-year Treasurys plus a little for some credit risk, we think pretax investment income at that time comes in around $4 billion. Of course, this figure is very dependent on the Fed's decisions on rates over time.

Effectively, just north of 50% of pretax income comes from underwriting in our base-case scenario ($4.5B of the total $8.5B). We think the underwriting profit deserves a very high multiple given the competitive advantages. This is by far the dominant player selling a product that must be purchased for every car in the US, and they are operating against competitors who seem lost. I would say that's a rare combination.

In contrast, we'd place a fairly low multiple on the investment income given it is entirely outside the control of the company and brings zero competitive advantage. For years, PGR allocated about 10% of their portfolio to equities, but that piece is now down to ~5%. They seem perfectly content to earn current 3-year Treasury rates on their investment portfolio.

Adding the two pieces together, we think a mid-teens total return is still available to PGR buyers even at today's price. We think it is very possible that PGR will print $12-$13 of EPS in a few years, and that is probably conservative. You'll get a few special dividends along the way, some share buybacks, and the possibility that they grow considerably faster given competitor woes.

Risks:

1. The single biggest risk is that PGR actually does not have their arms around a rapidly changing underwriting environment and are growing PIFs at the wrong prices. This is a large risk, and hard to handicap. The good news is that most of their policies are 6-month renewals, so they can correct quickly. The bad news is that they are making estimates on policy life expectancy that could be way off if they are forced to take radical price increases (and their customers leave). Based on their history, we think it's very likely that they have this under control, but it is certainly not guaranteed. PGR shareholders will lose money from current prices if this risk even looks like it may bite us.

2. Yields -- if you believe interest rates must fall from here, that reduces the value of this business over time. Each 1% drop in rates (based on my NPE/investment assumptions above) hits the pretax income by ~$800M annually. I use a 12x after-tax multiple on investment income, so it's not quite as bad to have rates fall, but it still reduces the intrinsic value of the overall biz. 

3. AVs -- lots of talk about autonomous vehicles and what they might do to auto insurers. I don't have any insight into this, but of course, any sudden change to the outlook would have a huge impact on valuation.

Catalyst

No specific catalysts other than PGR taking market share over the next few years.