39
A Perfect Warren Buffett Business
By: Christian Solberg
MBA Candidate at MIT Sloan, Private Investor
“Wait, you’re offering
me more low-cost insurance float, from a
company with an enduring competitive moat? I haven’t been
this happy since I first tried Cherry Coke!”
Disclosure
All values from here on out are reported in USD
All calculations/ratios, unless otherwise noted, are as of 12/31/14
This report contains forward-looking numbers that could differ from actual results
Progressive is not a suitable investment for all investors and individual circumstances should be taken into consideration
This report is intended to provide the investor with research relating to Progressive and is not a solicitation to buy the stock
I own shares of PGR, MKL, AIG
Quick Progressive stats (12/31/14)
Annual revenue: $19B
Revenue growth quarterly YOY: 12.07%
Net income: $1.3B
ROE: 19.25%
Diluted EPS: 2.15
Market capitalization: $15.86B
Price-to-book: 2.29
P/E: 12.52
Intrinsic value per share estimate: $34.48
Share price as of 4/7/2015: $26.81
Source: Ycharts.com
The competitive landscape
Top insurance companies by net premiums written. The purpose of showing this chart is just to orient ourselves to the competitive landscape.
As Charlie Munger said, “Determine wealth apart from size.” Meaning, don’t take the fact that
Progressive is #8 and not closer to the top of the list as a bad thing.
Source: A.M. Best, via InsWeb: http://www.insweb.com/insurance-tools/insurance-companies.html
Thesis: Progressive Meets All of Buffett’s
Criteria for a Large Stock Position
These are Buffett’s strict criteria for long-term investments in a business. If a business doesn’t meet these criteria, then he doesn’t bite, no matter how attractive it may look in other ways. He keeps the process simple, so we will too:
1. Competitive moat Very similar competitive moat to GEICO, one of his favorite businesses:
PGR and GEICO have clear advantage in underwriting & operating expenses, plus best brands in the direct online market
2. Compounding machine $1 of retained earnings has led to $1 of market value Little capital needed to be reinvested to maintain current business Low debt
3. In his circle of competence He knows (and loves) property & casualty (P&C) insurance better than
anything
4. Management he admires Focused on long-term and growing shareholder wealth High employee retention Have stuck to core strategy, values, principles from founding
5. Trading at reasonable price Trading 28% below intrinsic value Has been lagging the market for several years even though consistently
beats analyst expectations. Mean reversion will occur.
Progressive’s enduring moat It is an incredibly rare thing to have an enduring moat like that of GEICO and
Progressive
Progressive’s cost advantage Lowest combined ratio in industry (tied with GEICO)
The lower the combined ratio, the greater the profit and “float” that can be invested for long-term growth. Insurance companies that are great at the combined ratio can be among the best investments, those that aren’t are terrible investments
Combined ratio has two components: Underwriting ratio (basically the insurance business’s COGS as % of premiums). If this is good (low)
that means the company is great at selling and pricing profitable business
Expense ratio (operating expenses as % of premiums)
Culture that doesn’t sell unprofitable business. This is very rare and very difficult in
the P&C insurance business, and a quality that Buffett adores
Selling a lot of business direct online, and not through agents, is a major cost advantage and a game-changer vs. all competitors but GEICO
Progressive has great employee retention, which contributes to the low cost structure
GEICO’s Moat Progressive’s Moat
Cost advantage Cost advantage
An enduring moat: cost structure
GEICO and PGR have developed an early lead in the direct online market, due to quick and strong brand-building via advertising, that will make it very difficult for others to catch them. Thus it will be very difficult for others to get their expense ratios down to PGR and GEICO levels because they’ll have to continue selling through agents. I think some competitors have given up trying to catch PGR and GEICO in the direct online space.
Chart source: Value Walk: http://www.valuewalk.com/wp-content/uploads/2014/05/geico-expense-ratio-0514.png
Progressive’s cost structure eerily similar to
GEICO’s
The chart demonstrates GEICO has an advantage in operating efficiency while PGR has a slight advantage in underwriting prowess, yielding similar combined ratios:
2014 combined ratios: GEICO: 92.3%1 PGR: 92.3%2
Chart source: The Rational Walk: http://www.rationalwalk.com/?p=11625
1: Author’s calculations from Berkshire Hathaway 2014 annual report 2: Progressive 2014 Annual Report
1: Author’s calculations from Berkshire Hathaway 2014 annual report 2: Progressive 2014 Annual Report
Pricing discipline
As Buffett has said many times, writing the most premium isn’t necessarily a good thing, because the market often prices irrationally. PGR and GEICO are the only insurers with proven history of consistently not writing business when market prices decline below profitable levels
This makes their “cost of float” (the money Buffett would get to invest if he bought all of PGR) very low
PGR management says their non-negotiable #1 priority is beating their combined ratio target of 96%
Their significantly lower cost structures allow PGR and GEICO to price profitably in semi-difficult markets when other competitors will see future losses from writing new business
Progressive has great employee retention
Source: Progressive 2014 Investor Relations Meeting
Progressive employs the “Service Profit
Chain” approach
Most purchased Harvard Business Review article of all time Demonstrated two things:
1. Customer and employee satisfaction yield high levels of profitability through retention, referrals, repeat sales and “R&D:”
2. Customer satisfaction comes from employee satisfaction
Employees who are engaged in their job, understand their mission, and care about their customers attract and retain customers
Progressive’s engaged workforce will lead to higher levels of customer satisfaction, retention, etc.
Profit Drivers Customer Employee
Retention Lowers customer acquisition costs Lowers employee recruiting costs; improves productivity
Referrals Increases sales, lowers sales costs, improves hit rate
Bring in employees who are better suited to the job
R&D Customers offer constructive feedback to make products/services better; company
spends less on R&D
Employees offer constructive feedback to make products/services better; company
spends less on R&D
Repeat sales Cross-selling of products N/A
Reinvest retained earnings to drive growth
Buffett has said many times that $1 of retained earnings must lead to $1 of market value
Progressive has achieved that over the last 20 years. While Retained Earnings and Market Capitalization have grown (each ~10% CAGR), the ratio between the two has remained constant:
Year Retained Earnings as % of Market
Capitalization1
Book Value per Share2
Dec. 31, 1994 26.06% 2.2
Dec. 31, 2014 26.31% 2.2
1. Calculations are the author’s. 2. Source: Ycharts.com. Including Book Value per Share allows us to see that PGR had similar valuations on these two dates, which makes the
RE/MC ratios comparable.
Enablers for compounding machine
Best compounding machines are those that have great brands and require little capital investment
Brand Progressive has been very successful in building their brand through “Flo”
advertising campaigns. They and GEICO are the places that people go to when looking to buy P&C insurance online. A lot of insurance is difficult to buy/sell online (ex: life insurance), but P&C works well
Brand wasn’t big 10 years ago, and this has been a game changer for
them. Maybe this is one reason why they’re flying under the market’s
radar
Able to invest Retained Earnings in the right
things
Little additional capital needed to be reinvested to maintain current business Progressive doesn’t manufacture anything (they sell money!), so they
don’t have equipment, beyond IT, that requires consistent capital reinvestment
Insurance is capital intensive in that when a policy is sold, capital must be set aside to pay any future claims. But this is their COGS, not CapEx, and the value doesn’t depreciate and then require reinvestment like CapEx would for a manufacturer. If they manage their COGS well (which they do: we saw their leading combined ratio), they create low-cost capital (float)
Their big discretionary investments are in marketing, IT and employees, all of which help drive new growth (not just maintain existing business). This is where they put Retained Earnings (they also engage in share repurchases when their stock price is low)
Low debt* Debt-to-Equity of 31.24 (12/31/14). Goal is to get and stay below 30 P&C industry average: 48.08 (4/6/15)
*Sources: Yahoo Finance; Ycharts.com
Progressive’s Return on Equity
ROE has generally been in the 15-25% range over the last 20 years, except for large declines during the market downturns of 2000 and 2008:
P&C industry average: 9.10% (4/6/15)*
*Source: Yahoo Finance
Chart source: Ycharts.com
Book Value Per Share In the insurance business, book value per share growth is the best (though not perfect) indicator of
how a company is doing at creating shareholder wealth. Stock price tends to track book value per share growth over the long term
20-year CAGR is lower than best-of-the-best shareholder wealth-building companies (BRK & MKL) but nicely above 10% and better than large competitors Allstate and AIG:
BVPS for Progressive would improve if they invested their insurance float differently. They invest much more heavily in bonds vs. equities than do Berkshire and Markel. They seem to handle their insurance float more as an underwriter would (matching assets to liabilities) than as an investor would (seeking to own a piece of compounding machines). If Progressive’s investments were handled in the manner of Buffett/Tom Gayner (Markel’s CIO), they would boost comprehensive income and thus BVPS growth. This is what Markel is doing successfully with their Alterra acquisition.
Buffett buys companies that operate well and have moats. He then makes all of the capital allocation decisions. Thus Progressive’s room for improvement here would be a great fit if Buffett wanted to purchase the entire business.
MKL BRK PGR ALL AIG (1996-2014)
Book Value Per Share CAGR (1994-
2014) 16.49% 14.34% 11.88% 8.64% 1.87%
Calculations are the author’s using data from Ycharts.com.
Customer segments and growth prospects
A “Robinsons” customer generates more premiums relative to others;
“Sam” generates least.
Source: Progressive 2014 Investor Relations Meeting
Robinsons are untapped for Progressive
Progressive currently generates high returns without a share of the most attractive customer segment
Once they capture this segment, returns will improve even more
Source: Progressive 2014 Investor Relations Meeting
A long-term approach to growth
Progressive’s customers are young. PGR’s focus is not on taking Robinsons
from competitors (Robinsons are too loyal) but on developing and retaining younger customers who will become Robinsons. This will drive growth as younger customers gain assets and require more insurance as they age.
Source: Progressive 2014 Investor Relations Meeting
Most insurance bought by older generations
Other insurers gain majority of their revenue from older, non-diverse customer segments. Those segments buy from agents (who are also older and non-diverse). These customers and agents won’t be around forever. This means high long-term business risk for PGR’s competitors if they can’t learn how to do non-agent distribution and attract younger generations (which are more diverse as well)
Progressive’s strategy is focused on gaining and retaining the younger generation. Progressive is well positioned to own the younger generation for their lifetime, to the detriment of their competitors. This has required a rare long-term management and cultural focus, which bodes well for a long-term investor like Buffett
The risk exists that the auto & home market has little growth left, as the largest segment, Baby Boomers, ages. Even if this is so, Progressive is well positioned for the future as their average customer is much younger than those of their competitors, meaning that Progressive will grow even if the overall market doesn’t
The US is in the good position, relative to the rest of the developed world, of slowly growing its population. This will continue as long as immigration policies do not become more strict. A growing population leads to insurance market growth
3. In Buffett’s Circle of Competence
Not much more needs to be said here. P&C
insurance is Buffett’s sweet spot and what helped
him build Berkshire to what it is today. He says he “treasures” his great insurance businesses. GEICO
and Progressive are eerily similar, so Buffett would have a very easy time understanding the business, it’s favorable economics and how to judge the
performance of its management team.
Management Focused on the long-term and growing shareholder wealth
“Underleveraged capital will be returned to shareholders.” -2014 PGR annual report.
Buffett has discussed this for years in his annual letter to shareholders of Berkshire: it’s rare to find companies that return capital to shareholders when shareholders can generate a better return than the company can with that capital.
CEO (Glenn Renwick) has an 88% rating on Glassdoor.com Employee reviewing website Out of over 500 reviews, which is significant. 88% rating out of 500 reviews is very
good, considering that there is a higher tendency of disgruntled employees writing reviews than happy employees
Renwick has led Progressive since 2000, almost 15 years, which is a much longer tenure than most CEOs. Buffett likes long-tenured management
High employee retention As discussed earlier. Will lead to high customer retention, a key lever for growth
into the Robinsons segment over time Have stuck to core strategy and values from founding
Buffett dislikes how most companies jump between different “flavors of the month,” what he often calls following the “institutional imperative”. He likes companies that focus on their strength and do it better than others
Valuing Progressive Buffett cares about intrinsic business value. He’s never been clear on how he
calculates this, but he came close in his 1996 shareholder letter when discussing purchasing the remainder of GEICO he didn’t already own:
“The excess over tangible net worth of the implied value – $2.7 billion – was what we estimated
GEICO’s “goodwill” to be worth at that time. That goodwill represented the economic value of the
policyholders who were then doing business with GEICO. In 1995, those customers had paid the company $2.8 billion in premiums. Consequently, we were valuing GEICO’s customers at about
97% (2.7/2.8) of what they were annually paying the company. By industry standards, that was a very high price. But GEICO was no ordinary insurer: because of the company’s low costs, its
policyholders were consistently profitable and unusually loyal.
Today, premium volume is $14.3 billion and growing. Yet we carry the goodwill of GEICO on our books at only $1.4 billion, an amount that will remain unchanged no matter how much the value of GEICO increases. (Under accounting rules, you write down the carrying value of goodwill if its economic value decreases, but leave it unchanged if economic value increases.) Using the 97%-of-premium-volume yardstick we applied to our 1996 purchase, the real value today of GEICO’s
economic goodwill is about $14 billion. And this value is likely to be much higher ten and twenty years from now.”
Source: The Rational Walk: http://www.rationalwalk.com/?p=11625
Valuing PGR continued…
We can apply the same methodology to Progressive, due to the similarities between it and GEICO. Rather than use the 97% that Buffett used for GEICO in 1995, I will use 75% due to presumably lower growth rates in future than between 1995 and now, the fact that Buffett would probably put higher value on GEICO than on PGR, and to be conservative in my estimate. I say estimate because it includes future assumptions, which are uncertain. PGR tangible equity: $6,471M
“75%-of-premium-volume yardstick” to estimate Progressive’s economic
goodwill: $13,798M
Intrinsic value estimate: $20,270M
Intrinsic value estimate per share: $34.48
PGR’s share price as of 4/7/2015: $26.81
Discount to intrinsic value: 28.6%
Source for this valuation approach: The Rational Walk: http://www.rationalwalk.com/?p=11625
Stock market is expensive overall
There aren’t many bargains in terms of buying whole companies nor stock: Prices for buying whole public companies are high
Stock market: one of Buffett’s favorite macro indicators is GDP/Total Market Cap. When
this ratio is around 80%, he says you’re safe buying stocks. When it’s above 100%, he
says that’s dangerous territory. Last two times above 100% were before the 2000 and
2008 bear markets. We’re above 100% now, and more than this chart indicates because
the market has risen more quickly than GDP since 2011.
Source: Greenbackd.com: http://greenbackd.com/2013/03/25/warren-buffett-and-john-hussman-on-the-stock-market/
But, Buffett still thinks some bargains exist
Progressive trading at discount to intrinsic value
Has also lagged the S&P over the last five years:
Mean reversion will eventually occur
Source: Yahoo Finance
Trading at reasonable price
PGR has been beating analyst expectations recently with higher revenue and earnings growth and yet stock price hasn’t gone much of anywhere. 4th quarter 2014*:
EPS increased 26% YOY
Net earned premiums increased 14%
Combined ratio improved from 93.8 to 90.9
Earned premiums adjusting for one more week in Q4 2014 than Q4 2013: 6%
Stock price will catch up eventually, and Buffett is patient. He likes opportunities like this to build a meaningful position before the price increases
PGR valuation doesn’t scream an overnight 50% upside with a short-term catalyst, but those aren’t the kinds of investments Buffett normally makes
anyway. He buys reasonably priced companies when they meet his strict criteria. PGR meets all of these criteria.
*Source: Progressive Quarterly Report (Q4 2014)
The Ugly
Buffett believes (as should we all) in full transparency on things that aren’t going so well. For Progressive: Although they’ve been buying back stock at less than intrinsic
value, which is great, they’ve only grown Book Value Per Share ~5% CAGR over last 5 and 10 year periods. This should be significantly higher for an insurer with such splendid combined ratio performance
Progressive doesn’t generate spectacular investment returns on their float
The risk exists that the auto & home market has little growth left in the US. International auto & home markets are also very tough to make money in, due to either established competitors (with established brands and distribution…it’s these same characteristics that create PGR’s moat in the US) or a poor market in terms of ratio of amount of claims vs. money customers can put towards insurance. Progressive will have to grow in an industry that might not grow quickly
Buffett owns much of GEICO, which is a
direct competitor to PGR: is this a problem?
Many might think buying Progressive stock would be a bold move. It would be. But how often has Buffett done things that others originally thought were crazy? You don’t earn the nickname “oracle” by doing what
everyone else would do. If he even decided to try to eventually acquire all of
PGR, there are many other auto & home players, so there wouldn’t be risk of a monopoly. But he would
have locked down the two auto insurers that have a real competitive moat.
Everyone trusts Warren Buffett, which is a boon when making bold and/or novel moves
Summing Up: Progressive Meets All of
Buffett’s Criteria for a Large Stock Position
1. Competitive moat
Very similar competitive moat to GEICO, one of his favorite businesses: PGR and GEICO have clear advantage in underwriting & operating expenses, plus best brands in the direct online market
2. Compounding machine $1 of retained earnings has led to $1 of market value Little capital needed to be reinvested to maintain current business Low debt
3. In his circle of competence He knows (and loves) property & casualty (P&C) insurance better than
anything
4. Management he admires Focused on long-term and growing shareholder wealth High employee retention Have stuck to core strategy, values, principles from founding
5. Trading at reasonable price Trading 28% below intrinsic value Has been lagging the market for several years even though
consistently beats analyst expectations. Mean reversion will occur.
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