Tom A's Stock Picks

Allstate - still a good buy

Rating: 0 not yet rated(0 votes)    Vote:

You are logged in as | Logout

Allstate (ALL) recently reported 2Q 2008 Earnings, .05 per share, a 98% decline year over year. The decline was caused by a combination of higher than usual catastrophe losses and change in intent write-downs on the investment portfolio. While the numbers are unsettling at first glance, they do not affect my view that Allstate is undervalued based on its strong industry position and long-term earnings potential. Before going into the conference call and current issues, here is a brief overview of historical performance:

Allstate has increased its tangible book value per share by a little over 5% per year for the past five and ten year periods. That includes some major hits from asbestos liability in 2001-2002 and Katrina in 2005. The dividend is 1.64, yielding 3.64% at a recent share price of 45.00. Share counts are in steady decline due to buybacks which have averaged 3.4% per year for the past 5 years. Over the long haul, this adds up to about 9% annual return. Buying the shares when they are trading low in their range, higher returns can be achieved.

Current issues include 1) the effect of the credit crisis on the investment portfolio, 2) the soft market in P&C insurance and 3) issues related to Homeowners/catastrophe exposure, to include regulatory backlash in affected states. What I heard in the conference call was reassuring with respect to all three concerns.

Net realized capital losses were 1.2 billion, consisting mostly of change in intent. Insurance companies, if they intend to hold an asset to maturity, can make their mark to market adjustments in Other Comprehensive Income, which is a balance sheet item and doesn't affect income. If they decide they do not intend to hold the assets until they recover, then the loss is moved from OCI and recognized in earnings. Allstate is implementing a risk mitigation program in their investment portfolio, and combining that with their opinion that the economy and financial markets will continue under pressure, they elected to recognize a large amount of mark to market losses into income. Many of the assets are performing.

I think it is healthy to recognize losses, provided it does not lead to a fire sale of temporarily impaired assets. What I heard on the conference call was that Allstate would like to reduce risk on MBS and CMBS but has no intention of conducting a fire sale. With the advantage of 20/20 hindsight, it would have been nice if risk mitigation had been put into effect a year ago, but it is good to accept the current situation and move on.

With respect to the soft market, what I heard is that the market is back to a trend where companies are taking small, incremental rate increases as needed. This usually leads to decent profits. The frequency of automobile losses has been trending down, due to improvements in vehicle safety, road design, and DWI enforcement. Reduced mileage due to the cost of gas may also reduce losses. This is offset by an increase in claim costs. Allstate notes that State Farm and others have higher combined ratios that they do, so the soft market should hurt others more than them. Allstate has been exerting price discipline.

Allstate writes a lot of Homeowners in catastrophe prone states. The solution is simple, a combination of reinsurance and rate increases. Unfortunately, insurance becomes a political football and rates have been reduced, or rate increases denied, in states such as Florida and California. I can remember in 1969-1970 when I first got into insurance as an underwriter, how dismayed and upset I was over a massive confrontation between the Governor of Massachusetts and the Insurance Industry over rates for state mandated automobile insurance. It seemed as if nobody would be insured, traffic in Massachusetts would halt, and we would all have to update our resumes. Of course, the situation was worked out, and life went on.
Over the long haul, state regulators cannot compel insurance companies to operate at a loss. The games of insurance as political football can be intense, spirited, wonderful press and a real shot in the arm for local politicians, but ultimately insurance companies just seem to find a way to make a buck.

For what is primarily an automobile insurance company, I think demographics provides a strong argument for long term profits. When I worked for Kemper Insurance in the 70's, they maintained loss experience for senior drivers and found that from 55 on up to 75 or more more drivers get safer as they age. So, the baby boomers as they age will be an ongoing source of profit for auto insurers, Allstate included. That is my opinion of the long term trend, and I would not let a slow year or two discourage me too much on Allstate.

In common with others affected by mark to market losses, Allstate now offers two versions of book value, with and without the mark to market losses. Because of their change in intent, my analysis uses the GAAP figure, which includes the mark to market losses. On that basis, and noting that Allstate has traded at a P/B of over 1.5 at some point during the year for ten years straight, my target would be 58. Projecting 2009 EPS at 6.50, and applying a P/E of 12, I get a target of 78. Between the two figures, 65 seems well within the realm of the possible.

I am holding Allstate in my SLO portfolio, with an unrealized loss of about 10%. I will continue to hold and look for a chance to enlarge the position as cash becomes available.