Dividend growth investing is a popular, and largely successful approach to generating wealth over long periods of time. Investors typically do well, focusing on companies with long streaks of dividend increases in part because of the positive qualities a business needs in order to be able to continually afford what is ultimately a cash layout to shareholders. However, many of the companies known as “dividend champions” – those with 25 consecutive years (or more) of dividend growth – are mature companies. By identifying strong companies earlier in their life cycle, we can benefit from strong total returns while these companies build their dividend growth reputation. We will be spotlighting numerous dividend up and comers to identify the best “dividend growth stocks of tomorrow.”
The Allstate Corporation (ALL) is an insurance company that provides a variety of types of services and insurance products such as casualty, property and others through its subsidiaries. These include a group of seven reporting segments listed below.
Source: The Allstate Corporation
Insurance is a very competitive business that in its simplest form revolves around taking in payments for insurance products (premiums) and mitigating risk, so that the business can generate profit by paying out less than what it takes in. Insurance companies will pool these premiums (called the float), and invest it to generate investment income. Because of liquidity requirements (a company needs to be able to pay out its claims), these investments are generally very conservative in nature.
Because of this, growth is generally very “slow and steady.” Over the past five years, Allstate’s revenues have grown at a CAGR of 3.87%, while net income has grown at a CAGR of 2.32%.
We evaluate the performance of insurance companies a bit differently than most companies. Perhaps the best metric for measuring the operational effectiveness of an insurance company is the combined ratio. The combined ratio is measured as a percentage, and essentially measures the amount of funds paid out in claims against what is taken in by the company as premiums. A company with a combined ratio greater than 100% is paying out more than it is taking in, and a ratio less than 100% represents profit that the insurance is making from a favorable ratio.
Source: The Allstate Corporation
A consistently low combined ratio is a great indicator of strong management. It takes smart risk mitigation to operate profitably over the long term in a cut-throat competitive industry. For example, if a company were to under-price its policies over an extended period of time, the business would begin to realize losses on its float as claims piled up. We can see that Allstate has operated with a ratio below 100 for much of the past decade.
Another important metric for insurance companies is their return on equity. Because insurance companies don’t produce or sell goods, have CAPEX requirements, and are generally more complex due to their float and investments, ROE is a great metric because it reveals how much return the overall business is generating on its equity.
In the chart above, we have compared Allstate to a handful of its peers to gain a sense of how profitable it is compared to competitors. While Progressive Corp. (PGR) is leading the pack by a decent margin, Allstate’s ROE is competitive and currently second in its peer grouping.
When we look at the balance sheet for Allstate, we will compare the debt-to-equity ratio to its peer group to gain a sense of leverage. We can see that insurance companies must run in a fiscally conservative manner because they need to be able to cover their obligations to policyholders. Allstate’s debt to equity of 0.27 is right in the middle of its (tightly clustered) peer group.
Dividends and Buybacks
Allstate Corporation is rebuilding its dividend growth reputation after cutting its dividend during the recession in 08-09. Allstate has now raised its payout each of the past nine years. The dividend totals $2.00 per share annually, and yields 1.85%. While this is far from being a “high yield” investment, the dividend is roughly in line with 10-year US treasuries and you get the added benefit of potential capital gains.
Over the past five years that dividend has grown at a CAGR of 11.8%, which well outruns inflation. While the dividend is currently well covered, it’s not immune from external pressures. When the financial crisis happened a decade ago, you can see how the company’s earnings dropped to the point that the dividend payout ratio exceeded 100% of earnings. While the financial crisis was an extreme event, the conservative fiscal priorities of an insurance company will leave the dividend exposed at times such as 08-09.
Another factor to consider is the company’s dedication to buying back its stock. The competitive operating landscape and conservative way that these companies are run result in very modest organic growth. To help drive earnings per share growth, Allstate spends heavily on buybacks to amplify the earnings growth of each share of stock.
We can see that management has heavily reduced the number of shares outstanding over time. Buybacks are actually a vastly larger cash outlay for Allstate than the dividend. The company’s dividends total approximately $748 million, while buybacks in the past year were $1 billion more than that.
Growth Opportunities and Risks
While insurance companies can be a bit complex (especially one as large as Allstate), we are able to break down the company’s different avenues to growth in a simple manner. If we look at the company’s below five-year break-down of revenues, we see that insurance premiums make up the majority of total revenue.
Source: The Allstate Corporation
Premiums and contract charges have grown over the past five years from $31.08 billion to $36.5 billion. This can be done organically (growth is typically modest because of churn and how competitive insurance is). It can also be done through M&A such as its 2011 acquisition of Esurance. Allstate has also picked up some accessory businesses over time, such as its more recent deal to buy Squaretrade – a company that provides extended warranties for consumer appliances and electronics. Squaretrade revenues show up under “other revenue” on the above graphic. Allstate has been fairly active in M&A over the years, so it shouldn’t be a surprise to investors to see future deals come down the pipeline.
While a smaller contributor to the business, Allstate’s net investment income is the other manner in which insurance companies make money. This income is the returns generated from Allstate pooling all of its premiums collected, and investing to generate additional profits. These investments are very conservative because the company wouldn’t take on any type of risk that would threaten its ability to pay out its policyholders.
Source: The Allstate Corporation
Much of the types of investments you see above are impacted by interest rates. In the current market environment (low mortgage rates, low treasury yields, etc.), it is difficult for Allstate to generate investment income. Assuming that interest rates continue to work higher over the years to come, this will provide a bit of a tailwind for insurance companies such as Allstate.
The biggest risk that the company faces is more tied to the financial markets than the operational aspects of the business. Insurance companies are masters of risk analysis, so the type of scenario in which a spike of claims catches Allstate off guard would be apocalyptic.
However, look at how the company’s net income correlates with the S&P 500 over time. Allstate has a variety of investments, so disruptions to the financial markets typically impact Allstate as well.
The company lost billions during the financial crisis years ago, which is why management cut the dividend payout.
Shares of Allstate Corporation are currently trading at the top of their 52-week range ($77-109) at $107 per share.
We will look at valuation of Allstate from two perspectives. Based on analyst estimates, Allstate Corporation will earn approximately $9.80 per share for the full year. This puts the stock at an earnings multiple of 11.00X. This is a 16% discount to the stock’s 10-year median P/E ratio.
Additionally, we will look at the company’s price-to-tangible book value. Because insurance companies are in a way akin to investment holding companies, we want to gauge how much in assets we are getting per share. The current ratio of 1.77X is near decade-highs.
While the P/E multiple is attractive, we do find the price-to-book ratio to be a bit elevated. Shares are arguably near fair value, as there is value to be unlocked as interest rates rise. We would like to see a margin of safety, and would prefer to see shares in the 9X earnings range. This would imply a target price of around $91 per share. Should the overall market see a disruption, we believe that shares would easily arrive there.
Insurance companies are an interesting investment choice for investors looking for a conservatively-run business with a track record of steady returns. Allstate is a stable business with a decent yield that can sit in compound over time in a long-term portfolio. The stock isn’t cheap or expensive, making it a company to keep an eye on the next time a disruption in the market applies downward pressure to shares.
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Disclosure: I/we 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.