Description

INVESTMENT SUMMARY

Progressive is a slowly turning battleship with a number of extremely desirable investment characteristics.  The analytical community is down on the company due to its lack of premium growth and simultaneous margin compression since the end of 2005.  Additionally, PGR looks expensive on a price:book basis, which most property/casualty analysts employ but is not particularly relevant given the nature of its business. At 10-11X earnings with growth set to resume in 2010 (operating earnings should be very slightly up in 2009 and, more importantly, I believe that 2010 earnings growth should become clearly visible during 2009), this is a very attractive entry point for VIC members looking for a long-term compounding machine with a very wide moat comprised of a leading brand name, extremely sophisticated underwriting abilities demonstrated over decades, superior claims service and a low-cost position (9 points superior combined ratio versus the industry over the past decade and 5 points in 2007).

Tdylan wrote a highly detailed case on VIC for Progressive in May, 2007, which I encourage anyone who has read this far and is interested to review.  The auto insurance market is huge ($160 billion), fragmented and nondiscretionary.  Geico and Progressive, who have been and will continue to be market share gainers, have a combined share of 15%.  While Geico is a pure play on the direct market, PGR combines both agency business and direct business.  In its agency segment, which is roughly 50% bigger, policies in force (PIF—the company’s focus in measuring growth) peaked in early 2006 and have been declining slightly since.  In the direct segment, fueled by Internet shopping, PIF has continued to grow in the 7-8% range.  Over time, of course, this will raise the overall growth rate as the segment becomes larger.

PGR has focused more in the last couple of years on customer retention and there are signs that this is taking hold in both segments. 

The industry and Progressive are emerging from a soft market where pricing declined meaningfully and margins retreated toward historic norms.  For decades, PGR has targeted a 96% combined ratio—but there is a strong aversion to exceeding that level.   A hard market and lower frequency pushed the combined ratio down to a low point of 85% in 2004.  Management anticipated that accident frequency would rise to historic norms and, in retrospect, was slow in lowering rates and hence left business on the table.  That changed with a vengeance and PGR’s combined ratio has risen to 94%. Now, rates have stopped falling and seem poised to rise.  Net premiums written, a lead indicator, went positive (+2%) in Q3 and, as PGR reports monthly results, has remained positive thus far in Q4.  Hence, with further upward pressure on the combined ratio unlikely and a change in pricing dynamic, earnings growth is set to resume over the next few quarters.  Continued migration to the direct channel, and especially the Internet, should accelerate unit growth over time.  One wild card that could potentially lead to much faster growth is usage based pricing, where a device in the car would transmit data to PGR (miles driven, speeds, time of day) and potentially reduce rates for millions of consumers. 

Over a long period of time Progressive has both enjoyed high returns on equity (average over 20% for the last decade) and focused on capital management:  shares outstanding have declined almost 25% over the last ten years and there was also a $2/share special dividend in mid-2007.  PGR should continue to generate ample excess cash going forward.  Management targets a 30% debt/capital ratio.  Capital losses in both common and preferred stock have eroded the equity base in 2008 and have pushed the debt/cap ratio to 35%.  Hence, while additional buybacks are unlikely through mid-late2009, PGR generates capital from operations rapidly and, by the end of 2009 should be at its target ratios and in a position again to return cash to shareholders.

Catalyst