In the Q4 2020 Investor Letter, Wedgewood Partners highlighted a few stocks and Progressive Corp (NYSE:PGR) is one of them. Progressive Corp (NYSE:PGR) is an insurance company. In the last three months, Progressive Corp (NYSE:PGR) stock lost 4.2% and on January 14th it had a closing price of $93.45. Here is what Wedgewood Partners said:
“We purchased Progressive in late 2020.
The first American automobile manufacturing company was the Duryea Motor Wagon Company, founded in 1893 in Springfield Massachusetts. Henry Ford’s first attempt to manufacture an automobile didn’t end as planned. In late 1901, Ford sold his first car company to the Cadillac Motor Company. Ford’s second attempt at auto manufacturing began in 1903, as we all now know, was a booming success. By 1908, Ford’s Model T – the car for the masses – changed the automobile market forever. Over the next 20 years Ford would sell more than 15,000,000 “Tin Lizzies.” In all, almost 2,000 companies would try their hand at manufacturing that revolutionary technology.
The country’s nascent automobile industry would, in time, bring unimaginable societal change over the ensuing decades, but one of the first inevitable realities was automobile owners’ operating errors, better known as auto accidents. Accordingly, the first auto insurance policy was issued by Travelers Insurance Company in 1898. According to the Company, this policy was a $5,000 liability coverage for a premium of $12.25. Thus, the automobile insurance industry was not borne out of ingenuity, but legal necessity. Interestingly, back in the day, Massachusetts must have had some unique combination of terrible drivers, terribly difficult cars to operate, and terrible roads as the state was the first to pass legislation requiring mandatory auto insurance. Massachusetts held that rather ignoble first for over 30 years.
The top five auto insurers all have a rich (both storied and lucrative) history of selling auto insurance for decades: State Farm (1942), GEICO (1936), Progressive (1937), Allstate (1930) and USAA (1922).
In early 1937, Joseph Lewis and Jack Green founded the Progressive Mutual Insurance Company in Cleveland, Ohio. Their stated desire at the time was to operate a different kind of an auto-only insurance company, hence the name Progressive. Over the years, the Company would introduce a number of industry firsts, including the industry’s first drive-in claims office; monthly installment premium pay; public loss reserve reports; public monthly underwriting reports; and 24/7 claims reporting; comparison rates; buy by phone; 24/7 auto insurance comparison rating service; first industry website; online agent referral service; real-time buying; instant quotes for motorcycles, boats, watercraft, and RVs; and Name Your Price policy quotes.
Growth was relatively slow the first two decades with annual premiums reaching around $2.6 million. 1956 was notable in the Company’s desire to focus on high-risk drivers when they formed Progressive Casualty. In 1965, Peter B. Lewis, the son of cofounder Joseph Lewis (along with his mother) bought out the Green family’s interest in the Company and rechristened it as Progressive Corporation. Peter Lewis, who started at the Company at twelve years of age, would be the cultural driving force at the Company for the next 35 years. Lewis, the iconoclast, proffered a simple financial dictum, its North Star, that still serves the Company today: underwriting profitability over policy growth. Specifically, the Company’s long-held goal is to operate at a combined ratio of 96. In other words, the Company wants to earn 4 cents on every premium dollar. The Company went public in 1971. Since Lewis stepped down as CEO in 2000, the Company has had only two other CEOs – Glenn Renwick (2000-2016) and current CEO Patricia Griffith.
The table below shows the significant and consistent market share growth of the three direct auto-insurers (Progressive, GEICO and USAA). In 2009, the three direct insurers held a combined industry premium share of just 20% – about the same as State Farm and Allstate combined. Today, these three direct insurers command a combined share of 32% – almost 20% greater combined share of State Farm and Allstate. Notably, too, most of the other industry competitors have bled premium share. Specifically, today the five largest auto insurance companies by market share are State Farm (16%), GEICO (14%), Progressive (12%), Allstate (9%) and USAA (6%). The cost advantage of the direct insurers is simply too great to think that Progressive and GEICO (and to a lesser extent USAA) won’t continue to take industry share.
(An aside: GEICO continues to be the keystone owned company within our former, long-held portfolio holding Berkshire Hathaway. See this link for GEICO’s rags-to-riches-to-rags-toriches story. Wedgewood on GEICO)
Today, Progressive is the only public, pure-play auto insurer. Progressive is both a direct insurer, as well as an independent agency, with policies sold by independent agents. In other words, it is sold by agents who are not “captive” to Progressive and can sell policies from other insurance carriers.
Along with our long admiration for GEICO’s multi-decade juggernaut of growth and industry leading profitability, Progressive has long been GEICO’s kissing cousin on this financial score.
The following annotated transcript from Berkshire Hathaway’s Annual Meeting in May 2019 offers interesting insight into the lucrative rivalry between Progressive and GEICO:
Question: This question is on GEICO. Progressive is gaining the most market share among the major auto insurers, based on its presence in the direct and independent agency channels, as well as now bundling its auto and homeowner’s insurance coverage. How does GEICO plan on responding to competitive threats so that it can retain its place as the second-largest auto insurer?
Warren Buffett: Progressive is a very well-run business. GEICO is a very well-run business. And I think they will, for a long time, be the two companies that the rest of the auto insurance industry has trouble not losing share to. Progressive has been very well run. They have an appetite for growth. Sometimes they copy us a little, sometimes we copy them a little. And I think that’ll be true five years from now and 10 years from now. The big thing is auto insurance. And we grew in the first quarter about 340,000 policies, net, which will look quite good compared to anybody but Progressive, but I think that Progressive is an excellent company, and we will watch what they do, and they will watch what we do. And we will see, five years from now or 10 years from now, which one of us passes State Farm first. Ajit, would you like (comment)?
Ajit Jain (Vice Chair Insurance Ops): Well, the underwriting profit is really a function of two major variables. One is the expense ratio and the other is the loss ratio, without getting too technical. GEICO has a significant advantage over Progressive when it comes to the expense ratio, to the extent of about seven points or so. On the loss ratio side, Progressive does a much better job than GEICO does. They have, I think, about a 12-point advantage over GEICO. So, net-net, Progressive is ahead by about five points. GEICO is very aware of this disadvantage on the loss ratio that they are suffering, and they’re very focused on trying to bridge that gap as quickly as they can. They have a few projects in place, and, you know, sometimes GEICO is ahead of Progressive. Right now, Progressive is ahead of GEICO. But I’m hopeful they’ll catch up on the loss ratio side and maintain the expense ratio advantage as well.
Warren Buffett: I would bet significant money that GEICO increases its market share in the next five years. And I think it will, for sure, this year. So, it is a terrific business, but Progressive is a terrific business. As Ajit says, we’ve got the advantage in expenses, and we will have an advantage in expenses. They have a very sophisticated way of pricing business. And the question is whether we give some of that five points back… or six points back… in terms of loss ratio. We are working very hard at that, but I’m sure they’re working very hard too to improve their system. So, it’s a… to some extent it’s a two-horse race, and we’ve got a very good horse.
Charlie Munger: But Warren, in the nature of things, every once in a while, somebody’s a little better at something than we are.
Warren Buffett: Ha. You’ve noticed
Charlie Munger: Yeah. I noticed.
Warren Buffett: Yeah. I’d settle for second place in a lot of the businesses.
GEICO’s Jain is quite right to point out Progressive’s advantage in loss ratio versus GEICO. On that score, we don’t expect Progressive to cede much ground back to GEICO anytime soon as Progressive is relentless on its cost structure. (Chart below from Company reports.)
Understanding a bit of the auto insurance industry’s nomenclature will help to better understand the import of the discussion above, as well as understand both Progressive’s and GEICO’s long-held, considerable competitive advantages depicted below. But first a few industry definitions:
Loss Ratio: The formula to calculate loss ratio is essentially losses divided by company revenues, (total earned premiums). The complete loss ratio formula is insurance claims paid, plus adjustment expenses divided by total earned premiums. So, for example, if an insurance company pays $50 in claims for every $100 in collected premiums, the loss ratio would be 50%.
Expense Ratio: The expense ratio is a base measure of efficiency of an insurance company’s administrative cost of doing business before factoring in insurance claims on its policies and investment gains or losses within its float investment portfolio. The base administrative expenses are advertising, employee wages, and commissions for the sales force. Specifically, the expense ratio in the insurance industry is a measure of profitability calculated by dividing the expenses associated with acquiring, underwriting, and servicing premiums by the net premiums earned by the insurance company.
Combined Ratio: The combined ratio is a comprehensive measure of profitability gauging how well an insurer performs its daily operations. The combined ratio is calculated by taking the sum of incurred losses and expenses and then dividing them by an insurance company’s earned premium. A combined ratio of 100 basically means an insurance company breaks even. Any profits then must be generated by interest income, dividends, and capital gains from an insurance company’s investment portfolio. Such investment portfolios of float are essentially premiums in excess of claims and expenses. The auto insurance industry, as most commodity-like insurance, is a brutal business, typically generating a combined ratio of 100-102 (2018 was an unusually good year).
A quick glance at the graphics below (though a couple are dated, the same trends persist today) and the latest available industry stats (2018) note the standout performance of Progress and GEICO (Berkshire Hathaway) in terms of expense ratio and combined ratio. In terms of expense ratio, GEICO (12.9%) and to a large extent Progressive (19.6%) too, possesses a critical competitive advantage in that GEICO does not employ a sales force; so, zero commissions. Progressive utilizes both direct and commissioned sales channels. As mentioned at the 2019 Berkshire Hathaway annual meeting, Progressive has been an outstanding underwriter, employing state-of-the-art tools and technology.
In the aforementioned Berkshire Hathaway Q&A on GEICO and Progressive, Warren Buffett noted Progressive’s “very sophisticated way of pricing business.” Key to understanding Progressive’s competitive advantage over the industry – and other direct insurers too – is understanding the Company’s differentiated policy pricing algorithms and related pricing skill sets.
Given Progressive’s multidecade experience of insuring higher-risk drivers, the Company has amassed an incomparable data set that sits at the core of its cutting-edge usage-based policy pricing. In 2004, the Company introduced the usage-based TripSense. In 2008 MyRate was introduced, and it allows frequent changes in pricing based on how its customers actually drive. MyRate was rebranded in 2011 as Snapshot. Snapshot collects driving information during the first policy term. The customer will see a new personalized rate when the policy renews. Driver information includes the time of day a person drives, sudden changes in speed (hard braking and rapid accelerations), the amount driven, and, for customers using the mobile app in some states, how the drivers use the mobile phone while driving. Smart Haul is similar to Snapshot, but it’s for commercial trucking. September marked the largest monthly take rate (+24%) for Smart Haul. According to the Company, by 2014 it had collected over 10 billion miles of data. Just last month, the Company introduced Snapshot ProView, a usage-based, fleet management program for small business owners. Such initiatives should help to drive growth in the Company’s commercial business, which grew +30% between 2017 and 2019.
More recent innovations include Snapshot Road Test, an app-based program that logs realtime driving data for 30 days to ascertain a quote while still with your current auto insurer. The net result of such ongoing, usage-based, data analytics innovations lead to unmatched speed in adjusting risks, which has been the foundation of the Company’s industry-leading loss ratios.
Any discussion of Progressive (and GEICO) would not be complete without a few words on both Companies’ spirited and aggressive marketing. Creative marketing works. Creative marketing really works in auto insurance. One can hardly watch any network or cable-based television programming (particularly live sporting events) without being flooded by comedic car insurance ads. GEICO’s Gecko made his acting debut in 1998 – and its Caveman in 2004. Progressive’s Flo made her debut in 2008.
The impetus behind all the major auto insurance companies getting on board with massive advertising campaigns was the early move by GEICO (later Progressive) to directly market to consumers rather than through commission-based insurance agents. In 1995, GEICO’s marketing budget was a scant, but effective $35 million. The next year GEICO booked its best policy growth (+10%) in over 20 years. Policy growth in 1997 soared to +16%. Seeing a good thing, Buffett swung big in 1998 taking GEICO’s marketing to $100 million (Gecko). GEICO’s policy growth in 1999 was +23%. GEICO’s marketing budget soared over the next decade: 2001: $219 million, 2003: $238 million, 2004: $502 million, (Caveman), 2006: $631 million, 2007: $751 million, 2010: $900 million, 2011: $994 million (industry record), 2012: $1.1 billion. GEICO’s ad budget increased a minimum double-digit rate every year until 2019.
Buffett learned that after the upfront costs to acquire a new customer, if you can retain such customers, as both GEICO and Progressive can, returns on marketing spend can approach 30%. Buffett channeled his inner-Ted Williams .400 batting average and changed the marketing game forever through an intense amount of fat-pitch television advertising, which forced other car insurance companies to pick up their own games in order to keep pace with GEICO and then soon after, Progressive.
Progressive stepped on the marketing gas pedal in 2018 (largely in nontraditional media), increasing its advertising spending by +41% in the midst of the most rapid growth in the Company’s history as net premiums surged 39% from 2017 through 2019. Sensing opportunity again, the Company recently increased its ad budget (mostly in direct) by +29% and +20% year-over-year. In 2019 alone, the Company recorded premium growth of +14.7%, versus the industry’s growth of just +2.8%. It was only auto insurer that gained more than +10%.
Progressive has also been quite successful in bundling its policies across their product set, particularly after the Company acquired part of American Strategic Insurance in 2015, thereby allowing independent agents the ability to offer a competitive autohome bundled offering. The Company purchased the remaining share of American Strategic last May. Specifically, within the Platinum program – an invitation-only program for leading independent agents – these leading independents (top-10 in Company volume) earn higher commissions for home/auto bundles, as well as exclusive performance bonus opportunities and complimentary marketing tools and services to boost leads and make more sales. The success of these Platinum agents of late has been notable with agent-bundled sales up +75% during 2108 through 2019. Bundling for direct has been notable too as applications for bundled policies sold was up +250% in 2019.
Circa 2020, Progressive has about 23 million policies in force. About 20 million of those are auto policies (personal lines), split about 50/50 between direct and agency. These policies have grown around +8-10% in recent years. Commercial (trucking) policies in force are almost 800,000. Property policies in force are about 2.3 million. Before the upheaval of driving during the pandemic, the personal lines had been operating at a very profitable combined ratio of 90-91 due to price hikes. Commercial lines operated at 88 and property lines at 103. Most critically, customer retention over the past twelve months remained quite healthy +9%.
As would be expected, the auto insurance industry saw dramatic swings in all key industry metrics during the pandemic shutdown, including plunging miles driven (-40% at the trough), plunging premiums, and concomitant plunging loss ratios. The industry responded with a series of rebates, credits, and lowered premiums. For its part, Progressive credited 20% of April premiums in May and 20% of their May premiums in June. The sum of those two credits amounted to approximately $1 billion.
As of the Company’s most recent monthly (November) earnings release, it looks like business is starting to return to normal. Companywide policies in force increased +11%, year-overyear. Total personal auto policies in force increased to 16.5 million, +11% – with direct policies up +13% and agency policies up +9%. November net premiums written of $2.96 billion increased a healthy +14% year-over-year, while net premiums earned of $3.2 billion increased +11%. Lastly, the Company’s combined ratio snapped back to a smart 86.6 from 94.1 in October. The Company will likely exit 2020 with +$38 billion in net premiums written and +25 million policies in force.
Due to the relative consistency of the Company’s business model, our expectations of future annual profitability and growth largely mirror that of the recent past. Specifically, we expect both policies in force and revenues to grow at a high single-digit rate and a combined ratio of 93-95. We expect more variability in returns on capital and earnings growth. The last few years have been exceptional with returns on equity ranging from 26% to 32%, above the more typical range in the high teens. We would be thrilled with sustainable ROE’s from 20% to 25%. We also would be happy with earnings growth, lumpy as it typically is, between a high single-digit and low double-digit range.
At current valuations, the stock is far from a screaming bargain (what is these days?), hence our initial position size of just a 2.5% weighting. Future risks to consider that the Company must navigate are margin compression and/or if growth in policies in force decline due to heightened competitive pressures, including fluctuating fears of autonomous vehicles (AV). We look forward to building our position in Progressive as opportunity knocks.”
In Q3 2020, the number of bullish hedge fund positions on Progressive Corp (NYSE:PGR) stock decreased by about 6% from the previous quarter (see the chart here), so a number of other hedge fund managers don’t believe in Progressive’s growth potential. Our calculations showed that Progressive Corp (NYSE:PGR) isn’t ranked among the 30 most popular stocks among hedge funds.
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