Inside Ownership Of 51%, 6.2% Dividend: Is The Present Dividend Sustainable?

| About: Mercury General (MCY)

While scouting around to find some good dividend stocks, I noticed that Mercury General, an issue I sold several months ago was down below the price at which I originally bought it. Since the dividend returns over 6 per cent, I decided to research MCY to see if the present dividend is sustainable. MCY's price chart with its dividend history for the year is below: (taken from Interactive brokers)

The dividend represents 93% of the company's earnings (Yahoo). This payout looks dangerously high unless the company is on the verge of increasing earnings over the next several years. Year over year revenue growth does not bode well because it decreased by 8.3%. But then I noticed that 51% of the company's stock is held by insiders and it urged me to dig deeper.

The semi-annual operational review as of 8/12 showed that premiums earned were down 1% year over year. Losses and loss adjustments were approximately $50 million higher. The only area showing improvement was a $5 million reduction in policy acquisition costs. These differences resulted in a 45% decrease in income for the first 2 quarters. These figures explain the August fall in the stock price. S&P placed the book value of the company at $32.13 per share. Therefore the stock is selling at about 1.2 times book. On the other hand S&P placed the fair value for the stock at $38.20 per share.

Most of the company's business comes from selling auto insurance in California. The company was originally started in California and should know its market well. A major reason for expenses moving higher is the higher bodily injury losses being sustained in California. It has begun to expand geographically to other states, but a lion's share of its business is in California. The company requested a 6% rate increase for its auto policies in California. Management said that it hoped to receive rate relief shortly and if the judge concurs, the company should begin charging increased rates for auto renewals starting in December. Management also stated that the company is facing another income headwind with rate compression on its investments. As old loans are paid off, new assets that it purchases are carrying lower interest rates. Hence the company must confront making less money on its investments.

The historical data for MCY over the past 10 years presents an anomaly. The book value of the company has grown from $20.21 per share in 2002 to $32.13 now but the price of the stock is lower than it was in 2002. Its earnings have been all over the map. See the chart constructed from S&P data below:

Another interesting anomaly is displayed on the chart above. In 2008 MCY lost $4.42 per share, but paid a $2.90 dividend, the highest in its history. Management's continuance of the dividend even while losing money suggests it may keep paying its current dividend despite the fact it is paying out most of its earnings. The decision makers at MCY are the same ones that started the company and made all the previous dividend decisions displayed above.

Based upon the history of the company and its practices, it is reasonable to assume that the company will attempt to keep its dividend intact. It is a growing company that's hit a speed bump in a cyclical business. With reasonable assurance of a rate increase and the company's forging ahead with expansion across the U.S., this issue represents a good dividend growth opportunity. However if the company cannot get rate relief from California on its car insurance within the next 2 quarters, there is a good likelihood of a dividend reduction.

Lack of a decision on the California rate increase and the loss of momentum in its insurance business has made investors wary of this issue. An interesting suggestion might be to sell $35.00 puts dated 12/21/12 at a price of $.65 each or more. A $35.00 per share buying price for this issue represents good value. If the price is at or below the strike price in December, one owns the stock at a reasonable price. If it remains above $35.00, one reaps the option premium.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am likely to exercise the suggestion on placing an order for the December option.