Allstate Can Weather The Storm And Bring Investors Lucrative Returns

Summary

• Allstate has fared poorly on the stock market for the last five years during a period where growth, rather than profitability, was favored.
• Despite pressure on profits in the last year, the firm has seen a boost in the market, as investors have recognised its competitive advantages.
• With an attractive valuation, the firm deserves to be considered as a long-term investment.

Tim Boyle

The Allstate Corporation (NYSE:ALL) has experienced poor stock market performance over the last five years, but has shown improvement over the last year. The company has experienced revenue growth and profitability throughout much of its history. This is because it has leveraged its competitive advantages to succeed in a very fragmented industry where the essential product, insurance policies, are largely non-differentiable. The company has made investments in technology and digital capabilities to enhance its business model and meet customer needs. Although profits have come under severe pressure in the last year, the firm’s competitive advantages will see it through and allow it to return to profitability.

The Business Model

Allstate is a large insurance and financial services company operating primarily in the United States and Canada. The company earns revenue through a diverse portfolio of insurance products, including property and casualty insurance, life insurance, and retirement products.

At its core, Allstate operates on the insurance business model, which involves collecting premiums from customers in exchange for protection against specified risks. Allstate sells a variety of insurance products, including auto insurance, homeowners insurance, and commercial insurance, to both individual customers and businesses. These policies protect customers against various risks, such as damage to their property, liability, and loss of life.

In addition to its traditional insurance products, Allstate also offers various financial products and services, such as life insurance, annuities, and retirement products. These products are designed to provide customers with long-term financial security and peace of mind.

One of the key features of Allstate's business model is its focus on risk management. The company uses advanced analytics and technology to underwrite policies, assess risk, and develop pricing strategies that are profitable for the company and fair for its customers. Allstate's risk management expertise and strong financial standing allow it to weather the ups and downs of the insurance market, helping it to consistently deliver value to shareholders over the long term.

Another important aspect of Allstate's business model is its commitment to customer service. The company places a strong emphasis on building relationships with its customers and providing them with personalized and high-quality support. Allstate's customer-centric approach is a key differentiator in a highly competitive market, helping the company to retain its existing customers and attract new ones.

In recent years, Allstate has made significant investments in technology and digital capabilities to enhance its business model and meet the changing needs of its customers. The company has developed various digital tools and platforms, such as its mobile app, to help customers manage their policies and file claims more easily. These investments are helping Allstate to better serve its customers and maintain its position as a leading insurer in a rapidly evolving market.

Allstate's business model is built on a foundation of risk management, customer service, and technology. By consistently delivering value to its customers and shareholders, Allstate has established itself as a strong and well-respected player in the insurance and financial services industries.

Poor Stock Market Performance

Over the last five years, Allstate has trailed the stock market, gaining nearly 44.5% in the last five years, compared to nearly 58% for the S&P 500.

Source: Google Finance

However, over the last year, the firm has gained nearly 5.3%, as the S&P 500 has declined nearly 7.8%. The firm’s stock market struggles are a result of its tepid growth, which, in an era of growth, made it unattractive. In the last year, as investors have become more conservative and searched for profits over growth, the firm has finally begun to do well on the stock market. Although Allstate’s fourth quarter 2022 results revealed a loss of €1.4 billion in 2022, on the back of deteriorating auto insurance profitability and mark-to-market losses on stock market investments, the report also showed that the firm’s actions to improve its position have started to take effect. While Q4 results were poor, they were better than expected, and that explains the share price bump since. The market is increasingly appreciative of the strong business model and competitive advantages Allstate has.

Profitability Under Pressure

Revenue grew from $39.8 billion in 2018 to $51.4 billion in 2022, at a 5-year revenue compound annual growth rate (CAGR) of 5.25%. According to Credit Suisse’s The Base Rate Book, 24.2% of firms achieved a similar rate of growth in the 1950-2015 period, highlighting how unexceptional the firm’s revenue growth has been. Indeed, the mean 5-year revenue CAGR for the 1950-2015 period was 6.9%, and the median was 5.2%.

Source: Credit Suisse

Revenue is derived from four sources: property-liability insurance premiums; accident and health insurance premiums and contract charges; net investment income; and net gains (losses) on investments and derivatives. Property-liability insurance premiums make up the greater part of revenues. In 2022, property-liability insurance premiums were responsible for 85% of revenues earned.

Source: Q4 2022 Earnings Presentation

Gross profitability was approximately 0.13 in both 2018, and 2022. This is well still short of the 0.33 threshold that marks out the most attractive stocks, and reflects the firm’s struggles with growing its profitability.

Operating profit (before income tax expense) declined from $2.74 billion in 2018 to -$1.8 billion in 2022, reflecting a deteriorating core business. Operating margin rose from 6.89% in 2018 to -3.6% in 2022. The firm’s results put it well below the median and average operating margin for the 1950-2015 reference period.

Source: Credit Suisse

Net income declined from $2.52 billion in 2018 to -$1.36 billion in 2021. Once again, the theme is of deteriorating profitability.

Free cash flow (FCF) declined from $4.88 billion in 2018 to $$4.77 billion in 2021. Full year cash flow results for 2022 have not been released. For the TTM period, Allstate earned $4.6 billion in FCF. Return on equity declined from 10.5% in 2018 to -7.3% in 2022.

Despite these results, the market’s positive reaction suggests that the firm’s executive comprehensive plan to improve auto insurance profitability, has been viewed positively. The plan, which calls for raising insurance rates, reducing expenses, implementing underwriting restrictions, and modifying claims operating processes to manage loss costs, relies on Allstate’s possession of a strong business model and significant competitive advantages. As part of its plan, management has already pushed through a 16.9% increase in Allstate brand rates, including a 6.1% increase in the fourth quarter alone. Management has indicated that further significant insurance increases will be implemented in 2023. Half the targeted savings have already been achieved and advertising spend has been temporarily decreased to allow the firm to adjust to new business volume. Future cost reductions will come from further shifting to the cloud, sourcing and operating efficiency, and from the distribution model. The firm has begun restricting new business in unprofitable or challenging markets. This has affected 37 states in varying ways, including California, New York, and New Jersey. Allstate’s deep investments in technology will be used to enhance predictive modeling and to make resolutions more efficient, and identify represented claims. Finally, the firm will lean into its economies of scale to secure strategic partnerships, and improve parts procurement. The market has recognised that the firm has strong competitive advantages and that it can defend itself in this period of deteriorating profitability.

Source: Q4 2022 Earnings Presentation

These competitive advantages have allowed Allstate to enjoy sustainable profits and keep costs down. Historically, the lowest cost insurers have been Progressive, GEICO and Allstate and only GEICO has had lower costs than Progressive. However, the firm’s underwriting margins have come under pressure as a result of rapid severity escalation.

Source: Q4 2022 Earnings Presentation

According to the 2022 First Half Report by NAIC, the property & casualty industry-wide loss ratio, expense ratio and combined ratio are 73.5%, 25.7%, and 99.7% respectively. Rising loss costs have also affected Allstate’s auto insurance business, whose combined ratio has soared past 100.

The firm’s announcement that it was raising insurance prices given inflation, demonstrates the essentialness of insurance, as well as the competitive advantages Allstate has. Management believes that it can counteract rising loss costs through rate hikes and the other measures in their plan and push the 110.1 combined ratio down toward the mid-90s.

Source: Q4 2022 Earnings Presentation

Indeed, the measures have already led to a decline of 10.5, and also led to growth in average earned premium per policy. The measures taken still lag behind 6-month policy terms, so the full impact is still to be felt. Allstate believes that earned premium growth will rise by $2.6 billion in 2023 and $0.3 billion in 2024.

Source: Q4 2022 Earnings Presentation

A further sign of the impact of the actions management has taken is that, adjusted for increases in full year severity, 2022 auto quarterly underlying combined ratio is essentially flat.

Source: Q4 2022 Earnings Presentation

Insurance is Special

It should be said that insurance makes people wealthier. As Daniel Bernoulli and later, Ole Peters, argued, if we assume that bad things will happen at some point in our lives, causing us to lose economic value, the payout we will receive, less the payments we will have made, will make us wealthier, having suffered that economic decline. This is an important point that explains why, despite no laws forcing people to take out insurance, people who own assets almost invariably pay for insurance. Somewhere in the policyholder’s lifetime, something bad will happen and they will need insurance to make them wealthier.

This point explains why, despite being a highly fragmented industry, revenue tends to be very stable, and the industry is, therefore, non-cyclical. Insurance is a highly attractive business due to its supply-side economics. Insurance policies are largely non-differentiable, and very much like traditional commodities. Barriers to entry are low. The fragmentation is especially true of property & casualty. Nevertheless, the nature of insurance makes it possible for actors to earn sustainable profits.

The 2022 report on the property & casualty industry by the National Association of Insurance Carriers (NAIC), demonstrates the extent to which the industry is fragmented. Leading the industry is State Farm, with just 9.1% of the market, followed by Berkshire Hathaway (BRK) subsidiary, GEICO with 6.4% of the market. Allstate comes in at fifth with 4.7%.

Source: NAIC

The fragmentation in the industry reflects our earlier point about commodification of policies. In order to succeed, businesses have to rely on their ability to keep their costs down, and build relationships with agents, and the strength of the brand. This is true also of auto insurance, where Allstate trails market leaders, State Farm, Berkshire Hathaway, and The Progressive Corporation (PGR).

Source: NAIC

Market share is essentially driven by cost, agent relationships and brand awareness. Allstate has several key advantages that set it apart from its competitors in the insurance industry. Firstly, the company has a strong brand recognition and reputation, having been in business for over 85 years. This helps them to attract and retain customers, as well as build trust in their products and services.

In addition to this, Allstate offers a diverse range of insurance products across multiple lines, such as auto, home, and life insurance. This allows them to cater to the various needs of their customers, providing a one-stop-shop for all their insurance needs.

The company also has a dedicated and experienced workforce, who are well-equipped to handle customer inquiries and provide expert advice on insurance products. Allstate invests in technology and data analytics capabilities to make sure they stay ahead of the curve in the ever-changing insurance industry.

Allstate values its relationships with its agents and other distribution partners, and works closely with them to ensure they provide the best possible customer experience. The company's financial stability and focus on long-term value creation provide peace of mind to its customers, knowing that their investments are in good hands.

Also, Allstate is committed to making a positive impact in the communities it serves, through various social responsibility initiatives and volunteer work. This further strengthens their reputation as a responsible and trustworthy insurance provider.

Enlightened Capital Allocation

Allstate's capital allocation policy aims to maximize value for its shareholders through a balanced approach that considers both its financial strength and strategic priorities. The company uses its capital to support its insurance operations, invest in its subsidiaries, and pursue growth opportunities.

Allstate's insurance operations are the primary source of its capital generation, and the company uses this capital to fund its ongoing operations, pay dividends, and buy back shares. Allstate is committed to maintaining strong capital levels to support its insurance operations and protect policyholders.

In terms of growth, Allstate invests in its subsidiaries, including Allstate Benefits, Encompass, and SquareTrade, to drive profitable growth and diversify its revenue streams. The company also seeks to invest in strategic acquisitions and partnerships that complement its existing businesses and provide growth opportunities.

Allstate evaluates potential investments based on rigorous due diligence, including financial analysis, market research, and a thorough understanding of the target company's operations and management. The company's investment process is guided by its commitment to risk management and financial discipline, with a focus on generating attractive risk-adjusted returns.

Overall, Allstate's capital allocation policy is designed to support its long-term financial stability and growth, while also maximizing value for its shareholders. The company remains committed to balancing its financial strength with its strategic priorities, and its rigorous investment process ensures that it is making smart, well-informed decisions with its capital.

Despite the struggles Allstate has had, its financial position remains strong, and it is likely to return to its 14-17% return on equity target range, as a result of its executive plan to improve auto insurance profitability and reduce costs.

Source: Q4 2022 Earnings Presentation

Compensation Policy Aims to Align Shareholder and Management Interests

Allstate uses compensation as one of the ways to align shareholder interests with those of management. The company's compensation programs are designed to incentivize executives to focus on long-term value creation for shareholders. This is achieved through a combination of base salary, cash incentives, and equity awards that are tied to the company's financial performance and stock price.

For example, a significant portion of senior executive compensation is tied to the company's financial performance, such as revenue growth and return on equity. Additionally, Allstate has implemented a "pay for performance" philosophy in its equity compensation programs, which aligns executives' interests with those of shareholders by linking a portion of their pay to the performance of the company's stock.

Overall, Allstate's compensation philosophy and programs are designed to incentivize executives to focus on long-term value creation for shareholders and to align their interests with those of the company's owners.

Nevertheless, using ROIC as a measure of management’s performance would be a better way to align interests. Furthermore, requiring managers to be significantly invested in Allstate would create an owner-operator mentality within management.

Risks

There are several key concerns that the company faces in the insurance industry. One of the biggest concerns is the impact of natural disasters and catastrophic events on their financial results. These events can cause significant losses and disruption, and can impact the company's overall financial performance.

Another major concern is intense competition in the insurance industry, which puts pressure on pricing and underwriting margins. This requires Allstate to be constantly innovating and differentiating their offerings to stay ahead of the competition. Additionally, changes in consumer behavior, such as the shift towards digital channels for insurance purchases, require Allstate to be flexible and adapt to the changing landscape.

The ongoing impact of the COVID-19 pandemic also presents a significant concern for Allstate, including potential changes in consumer behavior and economic conditions. The company must be prepared for the potential impact of these changes on their business and customers.

Regulatory and compliance challenges, including new and changing regulations at the federal and state levels, are another area of concern for Allstate. The company must stay compliant with these regulations while also balancing growth with the maintenance of strong underwriting discipline and financial stability.

Finally, the continued development and deployment of advanced technologies is a crucial concern for Allstate, as they strive to stay ahead of the competition and provide the best possible customer experience. Allstate must continue to invest in technology and innovation to stay ahead in an ever-changing industry.

Valuation

Allstate has a forward PE ratio of -106.52, compared to the S&P 500, which has a PE multiple of 22.11. Not only is the firm undervalued relative to the market, its FCF yield is very attractive. With $4.6 billion in FCF for the TTM period, and an enterprise value of $41.25 billion, Allstate has an FCC yield of 10.95%, compared to an FCF yield of 2.1% for the 2000 largest firms in the United States, as measured by New Constructs.

Conclusion

Allstate has flown under the radar over the last few years, without investors focusing on the firm’s poor revenue generation, rather than its history of profitability. Despite pressure over the last year, the market has recognised that Allstate is profitable and that the business is built on sustainable competitive advantages. This will see the company through this challenging period. With an attractive relative valuation and very attractive FCF yield, the company should be considered as a long-term investment.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.