Double Trouble Makes a Unique Bargain

05/07/2013 10:15 am EST

Focus: STOCKS

Ian Wyatt

Publisher & Chief Investment Strategist, Wyatt Investment Research

Superstorm Sandy and the dust-up with California regulators provide a unique opportunity to buy into this strong dividend-paying company, says Ian Wyatt of High Yield Wealth.

Mercury General (MCY) is a “has problems” insurer. But they are far from insurmountable—and have produced an opportunity to capture a 6.5% yield in a conservatively managed, well-run insurer.

The dividend has been increased every year since it was initiated in 1986. But both New Jersey (Mercury General's fourth-largest market) and New York were hit hard by Hurricane Sandy last October. For the quarter, Mercury General reported a 32 cent per share loss.
 
Instead of earthquakes, government bureaucrats in California are by far the bigger threat—and the immediate problem. The company was able to finagle a 4% auto-rate increase, implemented in the fourth quarter. Unfortunately, the benefits will be partially negated by a new regulation that prohibits insurers from “knowingly” using replacement parts of inferior quality.

This is a euphemism for less expensive non-OEM (original equipment manufacturer) parts, which means auto insurers will be pressured to pay for OEM parts, lest they risk a lawsuit. Stifel Nicolaus estimates the new regulation could boost Mercury General's claim costs by 1.7%, which would add 120 basis points to its combined ratio in 2013 and 2014.

To be sure, a 4% rate increase is better than nothing, but management has subsequently filed a 6.9% rate increase request with the regulators. The outcome is still to be determined.

California’s regulators have also taken aim at Mercury General's homeowner insurance business. Twelve percent ($318.4 million) of Mercury General's $2.65 billion in annual premiums is derived from insuring homes; 80% ($255.4 million) of that originates in California.

This past February, California's insurance commissioner issued an order that Mercury General cut homeowner rates 8.2% for its 270,000 California policyholders by no later than June. Mercury General responded, appropriately, by filing a lawsuit against the commissioner, challenging the rate reduction and asking the court to allow it to raise its homeowner rates by 7.3%.

On the one hand, these unresolved issues are weighing on Mercury General's share price. But the lower price has created an income and value opportunity for investors with nerve to endure the uncertainty.

In the worst case, I see the company's earnings taking a $30 million hit from the California insurance commissioner’s initiatives on auto parts and homeowner insurance rates. But I don't see a worst-case scenario here.
 
First, these regulatory disagreements are rarely settled with one side as the clear victor. There is always a compromise, and both sides move on.

I don't expect Mercury General will have to slash premiums. I would bet on a 1% to 2% reduction as the least favorable outcome. As for the positive, I see a rate increase of 3% to 4%.

As for Mercury General's California auto business, the cost to abide by the ruling that forbids “inferior parts” might be estimated on the high side, gauging by the analysts' commentary (mostly negative). It's also worth remembering that Mercury General already received permission to increase auto insurance rates 4% last year, and it's asking for another 6.9% this year. I realistically see a 2% to 3% increase as the likely outcome.

Despite Mercury General's recent travails, A.M Best, an insurance rating company, still affirmed the insurer’s A+ (superior) rating.

I also see a company that will continue to generate positive earnings. Most analysts still expect it to turn a profit. EPS for the year is expected to recover to $2.37 from $1.34 in 2012, and rise 9.7% to $2.60, in 2014.

The 6.5% yield also points to a value purchase. The bottom line is that I perceive Mercury General as a rare value investment in a market where there is a dearth of value.

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