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Slow Growth Mercury General Still Not a Buy

- By Holmes Osborne, CFA

Mercury General Corp. (MCY) is a slow growth, high dividend-paying stock. Insurance in California, Mercury"s main market, is extremely competitive. The wildfires will no doubt cause millions of dollars in losses for the company.

The stock trades for $52.54, there are 55.33 million shares and the market cap is $2.9 billion. Earnings per share are $1.79 and the price-earnings (P/E) ratio is 29.35. The dividend is $2.5 and the dividend yield is 4.76%.

Sales were $3 billion in 2014, $3 billion in 2015 and $3.22 billion in 2016. Finally, 2016 put up at least a small amount of growth. Unfortunately, earnings were $178 million, $74.5 million and $73 million over that time frame. If your sales do not grow, your expenses sure will.

Cash flow from operations was $287,473 million last year, capital expenditures was $16,979 million and free cash flow was an impressive $270,494 million. The free cash flow yield is 9.3%. That"s awesome!

For the nine months ended Sept. 30, sales grew to $2.388 billion from $2.33 billion in the prior-year period. Earnings per share grew to $2.26 from $1.79. It looks like old Mercury is finally putting up some growth. The combined ratio is 101.1%. That means for every dollar taken in in premiums, $1.011 is spent. Obviously, you want a combined ratio of less than $1. As of the end of October, Mercury estimated it would lose only $60 million to $100 million due to wildfires. The company only lost around 100 homes. A $10 million reinsurance payment mitigated the loss.

The investment portfolio has $3.7 billion and there is another $284 million in cash. With low interest rates, Mercury is obviously not making a bundle on its portfolio. The duration is 3.9 years, so management is keeping the portfolio of fixed income pretty short. The book value is $32.10 a share.

Mercury insures 1.121 million auto owners, 545,000 homes and 40,000 commercial policies. According to the annual report, 82.6% of premiums come from California, 5.7% Florida and 11.7% from other states. Most of the companies in Mercury are rated A+ by A.M. Best. The company was founded by George Joseph, who is still chairman of the board at the age of 95. It is amazing this billionaire gets so little coverage outside of Los Angeles.

If you look at analysis on Seeking Alpha, you will not find much coverage on this mid-cap stock. I wrote an article two years ago stating I would not buy shares. I was right--Mercury vastly underperformed the markets. I have attended a few annual meetings in the past and have spoken with Joseph and his management team.

Last year, the state of California ranked Mercury 19th in property and casualty insurance with a 1.5811% market share. There are hundreds of companies competing in our most populated (by far) state. Most of the companies operate under several names. Zurich operates under its own name in addition to Farmers, Foremost and many other divisions. The survey ranks State Farm as 29th, but I would guess it is much larger if you include all of its companies. This website lists Mercury as the fourth-largest auto writer in the state.

As I write this article, wildfires burn in California--some of the largest in history. The Thomas Fire is reportedly the second-largest ever. The Thomas Fire has scorched 272,000 acres as of Tuesday night--about 425 square miles, or 19 times the size of Manhattan. You can bet Mercury will have some losses. It does not seem the stock has sold off as much as one would think given this mayhem.

So what are my thoughts on the stock? The first is the dividend and free cash flow are great. But this is in a bull market. You would have made a lot more money buying the average stock in the American markets. What will Mercury do in a bear market? California is a boom and bust state. If there is a recession, people will move out or simply use less property and casualty insurance. I am not against buying Mercury, but it would have to be at a much cheaper price. Competition in California is cutthroat. Maybe these fires will encourage other insurers to pull out of the state. That could portend good things for Mercury. Still, I am not impressed with this slow grower.

Disclosure: We do not own shares.

This article first appeared on GuruFocus.