Mercury General (MCY) Has More Room to Fall

Mercury General Corporation (MCY) is an auto insurer that traditionally focused on California. It took a beating the past couple days after the latest earning release, dropping from $60 to $53 per share. I think it has more room to fall.

Anyone who followed this company even peripherally can te­ll it was (and still is) way overvalued. The only thing propping up the stock price is the high dividend payout, and that is hardly sustainable. The last 2 days of price action shows that dividend investors may finally be coming to their senses. If MCY finally get valued on earnings like its peers, we could see a ~40% drop.

Mercury General is obviously a less attractive business compared to peers Progressive (PGR) and Allstate (ALL). I will provide a list of reasons here.

• Unattractive business model. Mercury General relies on independent agents, which I consider less attractive compared to the direct channel or using captive agents. Independent agents can sell other brands, which means MCY will pretty much have compete on price, provide much better service or advertise to build brand equity. This puts MCY in a tough spot versus the big boys. Clearly, it's no easy task for them to compete on an ultra-low cost structure against GEICO and Progressive. On the other hand, if they go for better service and brand name, that will exert pressure on margins due to higher expenses. This brings me to the next point. Judging by MCY’s combined ratios, this is simply not working.
• Above average combined ratio of high 90 to 100% (PGR and ALL both in the low 90%’s). Mercury General is the high cost producer in the group, with expense ratio approaching 28% of premium earned, compared to Progressive at ~20%. Lower expenses allow insurers to give a better price to consumers as well as bear higher losses. On the loss side, MCY has a history of adverse reserve developments - obviously there are worse insurers out there but this is no PGR.
• Geographic concentration in California. The company is trying to expand to other states but that does not seem to be working too well, particularly in NY/New Jersey. In the near term they plan to ramp up advertising, which gets us to the next point..
• Lack of advertising fire power to compete effectively against the insurance giants. This is important as auto insurers are pretty much in a constant advertising war. How is Mercury General going to compete with the Geico gecko and Flo?? 
• Investment portfolio has high exposure to energy sector which is clearly not well in this environment.
• Insiders have been selling more than buying 
• Founder/Chairman George Joseph is highly respected in the industry but he is 92.
• Stock trades at 19x forward P/E and 1.6x P/B. 
• Dividend is not sustainable. They have about $135mm of annual dividend obligation, I calculated 2014 normalized net income (adjusted for non-recurring items) of $125mm 

So yeah, I have been eyeing this one as a short for a while. The only reason I did not short this sooner was the high dividend yield, and the lack of a catalyst to shut off that dividend (debt to capital is only 12% so they can keep borrowing to fund dividends, even in the absence of any cash flows from opco). The catalyst to start a short position would have to come from signs of business deterioration. Only then the dividend investors might wake up and see this is a bad deal.

The latest earning provided that. 4Q14 combined ratio was over 100%, even adjusting for prior year developments, catastrophes, and non-recurring expenses. In the conference call, management basically acknowledged that dividend payout is unsustainable if current performance continues. Analysts questioned how Mercury can compete on the advertising front. With some of the weaknesses I listed above being exposed, the stock price dropped 5%. I started a short position then. Today it dropped another 6% and I added more to my short. Hopefully, this is the start of a change in how the market values MCY.

MCY still trades at 19x P/E even after the latest drop. Progressive and AllState trade at 14.5x and 12.2x 2015 earnings, respectively. MCY deserves a discount, not a premium to these better run, better positioned competitors. Taking consensus 2015E earning of $2.7/share at 12x multiple would value MCY at $32.5 a share, a 39% drop from its current level of $53.

The other way to play this is to a pair trade: short MCY and long PGR or ALL (or both). I am also long PGR - although not intended as a pair trade.

** Updated 2/12/2015

KBW find it hard to justify MCY's stock price. So, people whose job is arguably to justify high valuations are struggling to justify those valuations. If you still own MCY you need to take a serious look.

Santander Consumer USA (SC) – Update on Normalized Losses and Volume

A few months ago I wrote about Santander Consumer USA ("SC", "SCUSA") in an article. My long thesis was twofold. First, losses will get worse but still be manageable, so eventually reserve releases will serve as a positive catalyst. Second, volume growth will lead to steady earnings. After the 3Q14 results yesterday, my views have shifted. I now see little upside from both credit and volume, while management credibility is getting questioned. Accordingly I exited my already small positions.

Normalized Losses

In my old write up, I estimated normalized net charge-offs to be around 7.5% or 8%. Now it looks like charge offs for 2014E will be at higher end of that, meaning normalized levels could be higher depend on competition. The core auto installment loan business is actually still running within my expectations. What I completely missed was the deterioration in SC’s unsecured loans business.

SC missed its 3Q14 earnings due to a larger than expected credit provision, and that was mostly driven by unsecured consumer loans. Of the $770mm in total provision, consumer loan provisions contributed $167mm, a big jump from $70mm and $62mm in 2Q and 1Q, respectively. This is despite net charge-offs for that business being ~$80mm for the quarter. So management is either being super conservative or they see consumer loans getting destroyed in the future, perhaps both. The earning call offered little visibility, but management did explain that they see the consumer business making money from both fees and interest, so they’re ok with high charge-offs levels.

Regarding the auto loans portfolio, I now see average net charge-offs for 2014E to come in at low 7%s – a fairly comfortable level. We’re looking at 2 year average life so the worse 2013 vintage should be worked off sometime 2015 and there’s actually some credit upside there.

However the lack of visibility in unsecured loans is a big issue and I can no longer count on credit stabilization as a positive catalyst.

Volume

The company is running below target penetration of Chrysler’s originations. Management says this is due to lack of subvention support from Chrysler so they won’t be held accountable for that: 

“And I think at this moment, the amount of subvention that we have access to is not very similar to some of the other OEM captives and therefore these penetration rates for the contract would not be something we would held to. ... the actually penetration rates for the contract are tied to us being treated like other captives and I think today it's clear that we are not.”

That may be true, but it also means we can no longer assume that volumes will grow due to the Chrysler relationship, removing some of the upside. I also see SC’s value proposition to Chrysler diminishing. During the summer SC changed their strategy to selling most of the prime Chrysler loans, so at the end SC is no longer providing the financing but is more as a servicer.

Management credibility

Management continues to lose credibility in my eyes. For example, back in June SCUSA put out a press release saying that reserves are expected to come down slightly and expenses to increase due to higher compliance cost. Now the opposite has happened - reserves are actually increasing and expenses decreasing. Another example - in the 3Q14 call Dundon said that unsecured loans were not a big part of variability, when the 10Q clearly showed that it was in fact the key driver this quarter (it was even cited as a factor in the earning slides). Reading through the transcript, it appears that sell-side is also increasingly skeptical of anything management says.

The stock still looks cheap and I may get back in at some point. But I need to see of the drivers above improving first.

A TrueCar Short Case - Victim of Its Own Success

Situation

(I started looking into shorting this when stock was trading at $20 but did not pull the trigger. Now it is around $17 going toward $16, have I missed the boat?  I’m hoping for TRUE to go up so I can short it... )

At $20/share, TRUE’s stock trades at 8x sales, ~150x forward P/E. LTM EBITDA and cash flows are both negative. As a result people have started looking into shorting the stock. A couple of short articles here:

http://seekingalpha.com/article/2542615-short-truecar-first-mover-first-loser

http://seekingalpha.com/article/2549955-8-reasons-truecar-is-a-sell

Here I will layout my own short case from a different angle. My thesis different from others in that I think TRUE is an innovative company with a real value add, but ultimately will be undone by its lack of competitive moat.

What TrueCar Does and How it Makes Money

TrueCar (TRUE) does online lead generation for car dealers (mostly new cars). Its main property is TrueCar.com website where car shoppers can see a range of prices that other people paid for the same car in their area. Where TrueCar differs from other website is the idea of binding price. Users can click a button on the website to get a price offer that dealers have to honor. In terms of revenue model, TrueCar is free to customers and dealers pay $299 for each successful transaction. The company also gets traffic from affiliates such as USAA, and TrueCar splits the fees there.

Understanding the Bull Perspective and Reframing the Question

The over-valuation problem is exaggerated. The market is clearly looking at something else aside from > 100x P/E. Management’s stated long term goal is raising market share from 3% to 10%, and raising EBITDA margin from 2-3% to 35%. If these goals are achieved, they would more than double their revenue and generate about ~$175mm of run rate EBITDA. With < $2bn of enterprise value, all the sudden you're looking at low teens multiple –arguably cheap for a business with high return on capital (if they hit that margin goal).

These plans are not as crazy as they sound. Revenue has been growing at 50%+ pace so doubling in a few years is not unreasonable. The biggest expense is sales and marketing. The idea is to slow down marketing spend once the company reaches a critical mass of customer recognition. In fact, the company can actually grow advertising dollar amount slightly and still decrease the percentage cost due to operating leverage.

So that’s what the market is looking at. As a potential short seller here, the question should be reframed as “do we have a high degree of confidence that revenue can't double and margin can't hit 35%?”

TrueCar’s Value Add – Why Customers Use Them and How That Can Change

I don’t doubt revenue can double but I question the ability for a company to taper down marketing and advertising expense, and still maintain or grow site traffic and drive car transactions. Ultimately, this can only happen if your product is that much better than everyone else’s (and able to sustain that advantage through the period we’re evaluating).

Why do customers use TRUE and not a substitute or a competitor? And what would change that? There are two customer sets here:  potential car buyers and dealers.

·         Car buyers.

o   Target customers are those who do not like to negotiate and distrust dealers. These car buyers are “satisfiers” instead of “maximizers” – they are not looking to buy a car for the absolute lowest price possible. Rather, these customers just want a fair price and not walk away with some lingering suspicion that they’re ripped off.

o   Where does this fear of getting ripped off comes from? It comes from wide dispersion of prices among dealers.

o   Arming customers with information is also a value-add but competitors do this as well. The “marginal value add” of TRUE is upfront, committed pricing (via price certificates).

·         Dealers. 

o   TrueCar replaces less efficient advertising spends.  TRUE will never replace all of dealer marketing because dealers still want to build their own brands, so TRUE can only aim to replace less efficient advertising budgets (most obviously less efficient lead generation firms)

o   convert ad spend to variable cost (because dealers pay only for successful transactions)

The points above imply that TRUE’s edge goes away if:

For car buyers, TrueCar’s value add goes away when the day comes that price dispersion is minimal. The industry is already moving toward One Price, with KMX, Sonic, Tesla…etc. all pushing some variant of pricing commitment. AutoNation has even talked about moving to directly selling cars online. If pricing transparency and commitment becomes the industry norm then TRUE is useless.

Similar things happen if competitors implement pricing commitment. CostCo and Edmunds already try to do no-haggle pricing, it’s not too far of a step toward offering a price commitment like TRUE does.  One can argue TRUE’s advantage here is tying into dealers inventory systems, but perhaps others can get information from DealerTrak or other sources.

For dealers, TrueCar’s comparative advantage goes away if other sources of advertising becomes more efficient, either by copying TRUE’s model or if they are forced to cut prices. As the market share of these relatively inefficient forms of advertising gets taken by TRUE, it’s hard to imagine they won’t increase quality to compete better

Ultimately, TRUE will be a victim of its own success because it is innovative but easy to duplicate. In the next few years, I can see the company push the car industry further toward One Price paradigm, force competitors to offer pricing commitment or becoming more efficient.  All these things are great for consumers, but diminish the necessity of using TrueCar. Without product advantages, it’s hard to keeping advertising down and still double revenue. In some ways, not shorting TRUE requires you to think that auto sales processes are still the same in 5 years and that other player can’t improve their game despite being eaten alive by TRUE.

  

Appendix:

Bear argument

·         The Industry is already moving toward one price and TRUECAR's value-add will diminish as price divergence decreases.

·         Unlike sites such as Yelp or Facebook, TRUE does not have the benefit of user networking externality. People use TrueCar because they want a fair price, not because all their buddies are hanging out on it, nor because they want extensive dealer reviews. As soon as the proposition of “fair price” diminishes (due to everyone already offering that), TRUE becomes unnecessary.

·         What happens when new car sales go south? 

o   Used car pricing are coming down due to increasing off-lease supply. This can spill over to new vehicle market. OEMs will defend sales with incentives but eventually lower pricing should cut into dealer margin.

o   When dealer gross margins are under pressure, Truecar's $299 per sale look less attractive. Dealers will push for lower cost lead generation or take advertising in house. Dealer consolidation would give them even more bargaining power.

o   As TRUE wins over other sources of advertising, these sources will lower their prices to compete.

o   Lower industry volumes will hurt the company.

·         Operational failures

o   I read that some dealers have dispute with TrueCar about how a successful lead is defined and how dealer has to pay.

o   Bait and switch at unscrupulous dealer can become legal liabilities for TrueCar

Bull argument

·         TRUE is an innovative and visionary company with a history of disruptingthe industry. When TRUE first came out, the transparent pricing caused dealers to undercut each other and customers got the cheapest prices possible. This led to an industry-wide boycott by the dealers and near death for TrueCar. TRUE has since changed its business model to not let each dealer see each other’s pricing (so they don’t undercut each other).

o   Incredible track record of turnaround in dealer relationships. The company has doubled dealer participation from its trough. In fact, the leader of this dealer revolt, Jim Ziegler, is holding an upcoming conference and will have the President of TRUE as a keynote speaker.

o   TRUE is a cutting edge big data company. They are transforming a mom and pop business by leveraging new technologies such as Hadoop. 

·         TRUE as a potential M&A target

o   Combining with lead generation competitors would decrease the need of an advertising arms race and allow margin gains.

o   Vertical integration (True+ KAR = TrueKar?) TrueTrade is trying to compete with CarMax (KMX) by enabling a network of used car dealers to offer committed pricing on trade-ins, but without the need to hold inventory. Now, one reason KMX can do this competitively is because they run their own auctions, which helps KMX dispose unwanted trade-ins economically. A merger between TRUE and Kar Auctions Services (KAR) can replicate KMX’s functions. This might be interesting for KAR because its main competitors Manheim (owned by Cox, which also runs AutoTrader and offer upfront pricing on trade-ins) and KMX are already parts of larger entities. Also, TRUE owns ALG which would be extremely valuable to KAR.

·         Increasing part of a dealers marketing budget. Dealers still spend on newspaper, radio, and TV so there could be some low hanging fruits there. If automobiles demand decreases, TRUE may actually gain market share because dealers would want to shift marketing to TRUE’s variable cost model (they only charge for successful deals)

·         Margin increase can be achieved by lowering marketing cost once a critical market share is achieved.

·         Opportunity to go beyond dealer advertising spend and grab a share of manufacturer’s advertising and incentives.