Dividend Investing: Mercury General Corporation (MCY)

Investing in stocks that pay high dividends is an effective way for the conservative investor whose concern is mainly with the preservation of capital. When investing for a high dividend yield, the most important consideration for the investor is the sustainability of such dividends. Hence research into the underlying dividend payer is crucial.

Previously I highlighted telecom company CenturyTel (CTL) in this article, and have also covered Duke Energy (DUK) in this piece.

Mercury General Corporation (MCY) through its subsidiaries, is primarily engaged in writing automobile insurance in a number of states, principally California. It also writes homeowners, mechanical breakdown, fire, umbrella, and commercial automobile and property insurance. It offers automobile policyholders various types of coverage, such as bodily injury liability, underinsured and uninsured motorist, personal injury protection, property damage liability, comprehensive, collision and other hazards. The Company sells its policies through approximately 5,100 independent agents and brokers, of which over 1,000 are located in each of California and Florida. In addition the company has agents and brokers in Georgia, Illinois, Texas, Oklahoma, New York, New Jersey, Virginia, Pennsylvania, Arizona, Nevada, and Michigan.

The Company's operating results and growth have allowed it to consistently generate positive cash flow from operations, which was approximately $189 million and $65 million in 2009 and 2008, respectively. Cash flow from operations has been used to pay shareholder dividends and to help support growth. The dividend has grown over the last five years at a compound annual growth rate of 7.8%, and currently yields 5.29%.

At the current stock price of $44.48, Mercury is trading on an undemanding PE ratio of 6.11 and a somewhat generous price to book value of 1.38 times. Caution however must be warranted given the extraordinarily high profits the company realized in fiscal 2009 resulting from realized gains of $341 million. This was however after a realized loss of $551 million in 2008 during the height of the financial market crisis. On normalized basis earnings were around about $3 per share (this excludes unusual items such as realized gains or losses on large parts of an insurance company's equity portfolio, as well as a subsequently adjusted tax rate). That puts the company on a historical PE of about 14.82 times.

However the company is on a less than 6 times price to cash flow and a price to sales ratio of 0.78, which indicates investors can pick up more sales per share for a lower price. The outlook in terms of investment returns is set to prove and the underwriting margin should also normalize after relatively high claims during fiscal 2009.

The risks for Mercury General generally revolve around the fact that the company maintains no operations that generate revenue sufficient to pay operating expenses, shareholders' dividends, or principal or interest on its indebtedness. Consequently, Mercury General relies on the ability of the Insurance Companies, particularly the California Companies, to pay dividends for Mercury General to meet its debt payment and other obligations. The ability of the Insurance Companies to pay dividends is regulated by state insurance laws, which limit the amount of, and in certain circumstances may prohibit the payment of, cash dividends. Generally, these insurance regulations permit the payment of dividends only out of earned surplus in any year which, together with other dividends or distributions made within the preceding 12 months, do not exceed the greater of 10% of statutory surplus as of the end of the preceding year or the net income for the preceding year, with larger dividends payable only after receipt of prior regulatory approval.

There are in addition two risks investors need to be aware of. These are detailed in the company's 2009 10-K filing, or annual report. The Company has an aggregate of $263 million in the following long-term debt obligations. $125 million of which matures in August 2011. $120 million matures in January of the next year. This represents 93% of the company's outstanding long-term debt, and if they are not able to refinance at favorable rates the dividend will obviously be in jeopardy.

The second risk relates to some homeowners in southern Florida, who have experienced unpleasant odors and unusual air-conditioning problems, which have been linked to the use of defective Chinese-made drywall. The company could incur costs or liabilities related to this issue that could have a material adverse effect on its results of operations, financial condition, and cash flows.

Despite this, the company is upbeat about its dividend prospects. The 2009 10-K filing emphasizes the fact that the company has paid cash dividends on a consistent basis since the public offering of its common stock in November 1985. A well-managed insurance business is a cash cow, but any wrong move by management can wipe out not just dividends but stockholders too. However at current valuation and giving a low probability to any further outlier insurance-related events, I think Mercury General may prove a handy piece of any dividend seeking investors overall portfolio.

Disclosure: None