Mercury General - 6% Dividend Deal or Total Wreck?

If you could somehow buy the stock of automobile insurance company Mercury General (MCY) at a used car lot, the greeting from the man in the crazy plaid jacket might go something like this:

“Psst! Want a great deal on a slightly used Dividend Achiever? This baby yields over 6% and just started boosting its dividend again.

Of course, it was totally wrecked last year, but that’s why this shiny little sweetheart is priced to move!”

Yes, indeed. But don’t run away screaming quite yet.

Since it began paying dividends in the first quarter of 1986, midcap MCY increased its dividend at least once a year. These increases averaged nearly 20% annually when compounded over more than 20 years, though about half that for the most recent increases.

Then, in 2008, MCY ran off the road, piling up a net loss of well over $4 a share due to its sinking investment portfolio, as well as declining revenues from premiums. So MCY froze its dividend at the Q1 2008 level for seven quarters.

Meanwhile, a tanking stock price ballooned the yield to over 7.5% amid speculation that MCY would be the next wreck to chop-shop its dividend and put its decades-long Dividend Achiever status in the rear-view mirror.

Stomp the brakes on all that.

As part of its most recent, strong quarterly earnings report the company lifted its dividend for Q4 2009, marking 23 straight years of increases and signaling confidence that its business has cruised out of the danger zone and is headed in the right direction again. The dividend increase was piddling, just 1.7%, but the turn signal wasn’t.

I attended the Morningstar Stocks Forum in Chicago a couple of weeks ago, which was shortly after MCY’s announcement, and spoke with several of their stock analysts, including their top analyst for the insurance industry.

While MCY was hardly his top pick, he stated quite firmly his opinion that MCY is a strong dividend play, and he sees no danger of a cut. The risk to MCY, as he sees it, is that the company is highly dependent on the still-gridlocked California economy, and so may show slow growth in premiums, and therefore revenues, as strapped consumers cut back on coverage and even on cars. He also pointed out that MCY has typically underperformed in its much smaller markets outside California, so a rough road in California means a rough road overall.

OK, time for a quick look under the hood.

First, that recent earnings release: in Q3 2009 MCY earned $2.85 per share, compared with a loss of $2.57 in Q3 2008. For the first nine months, the figures are earnings of $6.70 vs. a loss of $1.35.

This is against a new quarterly dividend of $.59. Reuters puts the trailing 12-month payout ratio at 63%, with 3-year and 5-year dividend growth both about 11%.

Deeper under the hood: when capital markets came back from the crash, MCY’s investment portfolio recovered, but not everything’s running at full speed. Premium revenues are still down versus a year ago, and those revenues need to get into gear. But an important insurance industry metric, known as the “combined ratio,” did improve, which helps profits in the meantime.

Combined ratio shows the percent of premium dollars that are paid out in claims, so a ratio under 100% indicates an insurance company is profiting on its underwriting, not simply on the “float” of its investment portfolio. MCY’s combined ratio was slightly over 96% for both Q3 and the first nine months of 2009, compared with 102% and 98% for those periods in 2008.

MCY has typically been among the industry’s most profitable underwriters, and Morningstar calls the company’s Q3 underwriting results “a positive sign.”

As you might expect from the potholes it hit, MCY valuations are a sweet ride right now. Morningstar puts the trailing 12-month P/E just above 10, which is just above a 10-year low. The Price to Sales ratio is at a 10-year low.

Although Price to Cash Flow isn’t at bargain-of-the-decade lows, both Cash Flow from Operations and Total Cash Flow have been positive in each quarter of 2009. ROE is 12% and debt to equity just 20%.

MCY stock has not been a high-performance story recently. Over the trailing 1-year period it lagged the S&P 500, the S&P Financial Sector ETF (XLF) and the S&P MidCap ETF (MDY). MCY did outrun the XLF over the trailing 2-year and 5-year periods, but straggled behind the other benchmarks.

There are plenty of investors that won’t want to jump behind the wheel and take MCY for a spin. Those looking for turbo-charged growth certainly won’t, nor will those looking for the kind of smooth, predictable ride some utilities or other high-yielders might provide.

But income investors who can tolerate some uncertainty might see an entry point here for a relatively high current yield on a recovering business; some capital appreciation potential down the road; and the likelihood of improved future dividend growth to keep goosing the yield-on-cost. Those investors might want to at least kick the tires and research MCY for themselves.

Finally, if you’ve had enough car-talk, maybe you’d like to check out a sweet-smelling 3.5% yielder with a big fleet of garbage trucks. If so, see my Seeking Alpha article “Waste Management's Rising Dividends” (WM).

References and Links

Press Release, “Mercury General Corporation Announces Third Quarter Results and Increases Quarterly Dividend,” November 2, 2009.

Morningstar Stock Analyst Notes, “Investment Gains Help Mercury's 3Q,” November 2, 2009.

Morningstar, “Mercury General 10-Year Valuation,” 2009.

Yahoo Finance, “Mercury General Quarterly Cash Flow,” December 2008 through September 2009.

Disclosure: Long MCY, WM.

Comments

[fortypercent]

great work, thank you.

2009 Nov 18 11:25 AM

[mbkelly75]

Nice catch. A couple of things to be careful of but overall it looks good and is trending up (just barely - but still up). Insiders own 34.45% and it has a nice P/S of 0.69 (<1 is good) and P/B of 1.15 (<1.5 is good). Well done and clearly written - please keep up the good work.

2009 Nov 18 06:28 PM

[Low Sweat Investing]

Thank you for your comments and for the additional data points.

MCY was interesting to me because though it has some risks, they seem reasonable based on the stock’s current yield and the future potential for both a high yield-on-cost and capital appreciation.

2009 Nov 19 09:10 PM

[ozymandias888]

I personally don't know much about the insurance industry. Maybe it's not uncommon for insurance companies to have detractors who are angry enough to compile and publish lists of negative points.

Questions of ethics apart, I would give due consideration to the potential ramifications of potentially bad business practices.

www.consumerwatchdog.o.../

2009 Nov 19 10:11 PM

[FB5000]

Yes. Thanks. Very good article. How does MCY compare vs. PGR on combined ratio?

2009 Nov 22 11:48 AM

[Lightway]

Looks like a great buy on paper from an investment standpoint, though word on the street here in Southern California is that Mercury has some pretty shady treatment of their customers. They have also been fined in Florida due to denying payments, delaying them, and terminating contracts after hurricane damage.

There are better dividend investments, though appreciate your diligence in trying to locate a good stock with a good entry point.

2009 Nov 27 04:01 PM

[Low Sweat Investing]

Thank your for your comments and info.

MCY does indeed have an ongoing ruckus with some California watchdog groups, some of whom also have a history of tilting with other insurance companies.

There are no doubt some legitimate complaints.

Last year, California fined MCY $300,000 for violations. In 2006 Florida ordered two MCY subsidiaries to return $2M to policy holders.

MCY’s CEO was quite angry at the Florida managers involved. Separately, the Morningstar analyst I spoke with said regional management outside California had traditionally been a problem for MCY, and he believed some managers had been fired for manner in which they ran their business.

Not pretty, and I was not aware of all of it when I wrote the article, though it is interesting that Google, Yahoo and Bing searches also show negative results for State Farm, Allstate and others.

Still, it is another uncertainty and risk with MCY, and likely another reason for the current valuations and yield.

It does not change my personal view of MCY’s risk-reward potential, though I understand that it might affect others’ views.

As far as PGR, I don’t follow that stock. A quick look shows they have a better ‘combined ratio’ than MCY, but an unusual ‘variable dividend’ that resulted in no dividend paid at all this year.

2009 Nov 27 05:50 PM