Donegal Group Inc (DGICB) 2005 Q2 法說會逐字稿

Good day ladies and gentlemen, and welcome to the second quarter 2005 Donegal group earnings conference call. (OPERATOR INSTRUCTIONS). As a reminder, this conference is being recorded for replay purposes. I would now like to turn the presentation over to your host for today's conference, Mr. Ralph Spontak, Senior Vice President. Please proceed sir.

Thank you very much. Good morning everyone. Welcome to Donegal Group Inc.'s earnings release conference call for the second quarter and six months ended June 30, 2005. I'm Ralph Spontak, Senior Vice President, and I will be starting the conference call off by reviewing some of the highlights of the quarter's results. Jeff Miller, Chief Financial Officer of the Donegal Group, will provide some detailed analysis of the quarter's financial results. And Don Nikolaus, President and Chief Executive Officer, will then discuss some of the current trends we have been experiencing.

Before we get going I need to read our forward-looking statement. All statements contained in this conference call that are not historic facts are based on current expectations. Such statements are forward-looking in nature and involve a number of risks and uncertainties. Actual results could vary materially. Among the factors that could cause actual results to vary materially include the ability of the Company to maintain profitable operations; the adequacy of the Company's reserves for losses and loss adjustment expenses; severe weather; business and economic conditions in the Company's primary operating areas; competition from various insurance and non-insurance businesses; terrorism; legal and judicial developments; changes in regulatory requirements; and other risks that are described from time to time in the periodic reports that the Company files with the Securities and Exchange Commission.

In light of the significant uncertainties inherent in forward-looking statements, the inclusion of such statements should not be regarded as a representation by the Company or any person. The Company disclaims any obligation to update such statements or to announce publicly the results of any revision to any of the forward-looking statements included herein to reflect future events or developments. Undue reliance should not be placed on any such forward-looking statements.

The Company's string of successful quarters has continued in the second quarter of 2005 with the Company posting strong underwriting results, increased cash flow from operations, higher levels of investment income and solid premium growth. Underwriting results were strong in both the commercial line sector and personal line, and both sectors showed an improvement in their year-to-date combined ratios over a year earlier.

Net income for the second quarter of 2005 climbed 31.5% over the results from a year earlier to $8,903,275 or $0.48 per common share on a diluted basis. That compares to $6,770,187 or $0.37 per share on a diluted basis for the second quarter of 2004. The second quarter and year-to-date results represent for record earnings for the company before extraordinary items. Just a reminder that all prior year per share information has been restated to reflect a 4 for 3 stock split in the form of a 33.33% stock dividend that was issued on March 28, 2005.

The Company's excellent underwriting results continued during the second quarter of 2005, with the Company posting a GAAP combined ratio of 89.6% for the second quarter of 2005, compared to 91.8% for the second quarter of 2004. For the year-to-date, the Company's combined ratio is 90.1%, and that compares to 92.2% for the first six months of 2004.

At yesterday's board meeting, our Board of Directors declared a cash dividend of $0.10 per share for each share of class A common stock and 8.5 cents per share for each share of class B common stock. That dividend is payable August 15, 2005 to stockholders of record as of August 1, 2005. At this point, I would like to turn the conference call over to our Chief Financial Officer, Jeff Miller. Jeff?

Thank you, Ralph. Good morning. As Ralph already indicated, our net income for the second quarter 2005 increased 31.5% to 8.9 million or $0.48 per share on a diluted basis. Total revenues for the second quarter of 2005 were 79.5 million, an increase of 12.4% over the total revenues of 70.7 million in the second quarter of 2004. Premiums earned in the second quarter increased 12.1% to 73.4 million, compared to 65.5 million in the second quarter of 2004.

Our investment income showed an increase of 13.4%, growing to 4.4 million in the second quarter of 2005 as compared to 3.8 million in the second quarter of 2004.

Tax exempt interest continued to increase as we continued to shift our invested asset mix to include a higher percentage of tax-exempt municipal bonds in our portfolio. Tax-exempt income as a percentage of total investment income was 48.9% in the second quarter of 2005, and that compares to 37% in the second quarter of 2004.

Although the shift to tax-exempt bonds in results in slower growth in our investment income, we are obtaining attractive after-tax yields in the current market and are benefiting from a decreased effective tax rate as a result of the shift.

Turning to our underwriting results, our loss ratio improved significantly from the 61% we posted in the second quarter of 2004 to a record low 54.2% in the second quarter of 2005, with improvements coming from our commercial lines and personal lines segments. Mild weather reduced claim frequency and continuing favorable loss reserve development trends have all contributed to the excellent loss ratio.

As a result of the improved claim results, we're projecting increased costs for incentive compensation to our agents. These costs are the primary reasons for the increase in our second quarter expense ratio to 35% compared to 30.7% in the second quarter of 2004. Although this expense ratio is higher than we have historically targeted, when viewed in perspective with our record low loss ratio we are quite pleased with the second quarter GAAP combined ratio of 89.6%.

Combining the strong underwriting results of two consecutive quarters, our net income for the six months ended June 30, 2005 was 17.3 million, an increase of 32.7% over the net income before extraordinary item of 13.1 million in the first six months of 2004. Net income in the first six months of 2004 included an extraordinary item of 5.4 million related to an acquisition.

Earnings per share on a diluted basis for the first six months of 2005 were $0.94 per share compared to $0.72 per share for the six months of 2004, prior to the effect of the extraordinary item. Our book value per share increased to $14.37 as of June 30, 2005 and our annualized average return on equity for the first six months of 2005 was 13.8%.

At this point our President, Don Nikolaus, will discuss the trends we are experiencing. Don?

Thank you Jeff. Good morning everyone. Welcome to our conference call. Needless to say, we are again pleased with our second quarter and six months results. They are certainly, I would say, better than I guess even we would have anticipated as a result of our last conference call. But we think there are a number of good reasons for what has taken place.

One of the things that I would want to cover, which I know is of interest to all of you, is what is the status of pricing in the current market. I will divide that into commercial and personal lines, because they're certainly somewhat distinctly different.

There is somewhat of an increase in competitiveness on the commercial side that we would hasten to remind everyone that we do not write a lot of large, complex commercial accounts. Our understanding that that segment of the market has become more soft than it has been over the last two to three years. And the small to mid-market accounts that we write -- and we identify a small account as anything that is as small as $1000. And our definition of mid-market would be somewhere between $35,000 to $75,000 per account.

Although we're not able to obtain the kind of significant rate increases and premium increases that we would have been able to do in '02, '03, and '04, we are seeing a relative stability in pricing, although it certainly will vary from territory to territory or from a particular account to a particular account. So, we would identify it as sort of a plateauing of rates and not necessarily in our book of business any deterioration in premium.

On the personal lines side, there are states that we do business in where competitive companies have begun to take some modest decreases in premium, and modest been defined anywhere from 2% to 5%. We have not seen any significant rate reduction. We actually, in some product lines, have been able to continue to file for some modest rate increases.

In the personal auto area, what we have attempted to do, and this is somewhat repetitive of what we would have reported at the last conference call, we of course have not done any across-the-board price reductions. What we have done is we have expanded the various tiers that we offer, what many times is called segmentation, and we have attempted to develop new products that are attractive to the very best risk. And in those particular pricing tiers, we have become somewhat more price sensitive.

We think it's a more current way, a more intelligent way of refining a competitive posture without reducing premium in any way to any broad class of the book of business. We believe that premium adequacy (ph) remains. Depending upon their specific territory and product there are even opportunities for modest rate increases, and we would hope that environment would continue.

From the underwriting side, I would again pointed out that combined ratios and loss ratios do not totally depend upon the dollar amount of premium that you are charging. A lot of profitability depends upon the quality of underwriting, the risk selection process, and I would hasten to point out that we think that has been part of our success. So the whole success of property and casualty insurance business is a combination of factors and not solely related to one element that one can consider the key issue.

One of the other areas I would like to talk about is the continued roll out of our automated underwriting process for personal lines, which we have named Write Pro, W-R-I-T-E, second word P-R-O. We have fully implemented it in Pennsylvania. It's about 60% implemented in the State of Virginia. We are about to go live with it in Georgia. And we will continue to roll it out until we have accomplished that in approximately 12 to 14 states.

It basically puts us on an equivalent level with the very largest carriers and their technology. And it of course automatically at the point of sale gives the agency the opportunity to completely underwrite it electronically, including ordering of reports, so that when the quote is given by the agency to the insured it's a fully underwritten quote that they can stand by and that we can stand by.

It combines a combination of the electronics of all of it, but also refined products that broaden our market appetite and that we think put us in a good competitive position.

In the area of acquisitions, as you know, we have a two-pronged approach to the growth of our Company, both the organic growth and of course through acquisitions. I can only say to you that we continue to be active in pursuing acquisitions, and I think we are making progress on a number of fronts. Mr. Spontak now spends a significant amount of his time in that arena because we believe that there will be opportunities. There are opportunities and we certainly want to be in a position to capitalize on that.

At this point, I'll turn it back to Ralph and the moderator and we can pursue questions.

I think we're ready for questions at this point.

(OPERATOR INSTRUCTIONS) Eric Saxon (ph), Suntrust Robinson Humphrey.

Good morning. I'm taking the place of David this morning, who is in a meeting. I just had a few questions. One, can you talk about your expense ratio outlook for the second half of '05 given the spike in the quarter?

Certainly, let me handle that. We would expect the expense ratio to drift down from where it showed in the second quarter, even with the same type of loss ratio. We were playing a little bit of catch-up with the contingent commissions during the second quarter because of the fine underwriting results and have based the current accruals based upon actual preliminary calculations for the entire year. But we believe we are well accrued for those and that the expense ratio, hopefully, even given once again the same level of loss ratio will drift down from that 35% level going forward.

Regarding catastrophe losses, could you give us the total catastrophe losses for the second quarter of '04? And would I be right to assume it was the one -- did you only have one weather event in second quarter, that 1 million from the press release?

That is correct. There was only one what we consider a reportable event in 2004 second quarter, and that was the $1 million of net losses -- property losses that we had from the Midwest event. So that was the total of the catastrophe losses in the second quarter of 2004.

This is Don Nikolaus. I would like to just go back to your first quarter about the expense ratios for the second quarter -- or the second half of the year. We have traditionally been very focused on making sure that we can be as efficient as possible from an expense ratio standpoint. We certainly recognize that with the excellent loss ratio that it was going to produce an increase in expenses related to contingent commission. What we will be doing in the second half is we will be re-identifying opportunities as to how we can contain and hopefully move back our expense ratio going forward.

On the issue of the contingent commissions, the way our contingent commission works it's a very formula-driven thing. Until we would have actually run the reports at the end of June, because the loss ratios for any particular agent can change at the end of any particular month. So until we would have run that at the end of June, and we run it every month, we would not have previously known that there would have been that kind of very positive result from the standpoint of the agents -- the contingent efficient from their view of the world.

It's not necessarily a matter that we weren't on top of it. It was a matter that it changes every month based upon the computer runs that we do. And we will continue to do that to the extent that the contingent commissions would not produce as high of an amount in successive months. Of course, we would be in a position to adjust accruals accordingly. There is going to be a lot of emphasis going forward in terms of how we do all the things we currently do, but also contain the expense ratio.

One question on worker's comp. I hope I didn't miss it, but when you were talking about the pricing issues now, did you go over worker's comp, did I miss that?

I did not, but I would be happy to go over worker's comp. Worker's comp is a product that we are not seeing from our view of the world. We're not seeing loss costs go down in any material sense. As you probably know, the rating bureaus in a particular state determine the loss cost. And then we as a Company establish what is known as a loss cost modifier. In some states, the loss cost that the bureaus have determined may have gone down by 2% or 1.5% or 3.5%, but we have the ability to flex our loss cost multiplier.

In some states we have less than where they are in this year. Other states we have raised them moderately. And of all the commercial product lines, I would say to you that from our point book of business that the worker's comp premium levels remains strong, that certainly in our book of business there's not any deterioration in pricing levels, because that is a product line that continues to need to always be very sensitive to pricing levels and not be a product that is sensitive to a lot of competitive factors.

One more before I drop off. Regarding your net written premium outlook for the second half and probably also with 2006, this last time you mentioned around the 9% to 10% range. Would you expect it to stay in that range for earned premium, about the same?

Yes, I don't see anything that is impacting that original projection to any great extent. I think the 9% to 10% range is a very reasonable one at this point.

Mike Grasher, Piper Jaffray.

Good morning. Congratulations on an outstanding quarter. I wanted to follow up on the expense ratio. I understand it all. Don, very good color around that. But Ralph, did you say that in essence you are accruing, you have accrued for the remainder of the year --

No, what I meant was that on an annualized basis we try to look at what the contingent commission would project out to be by the end of the year as part of our analysis. I was misleading if I said that.

That helpful. And then I wanted to just ask a question as well on the reserves. They're basically flat from the end of the year, and you also mentioned -- I think Jeff mentioned positive development there. Any particular accident year that those reserves would be -- the positive development would be coming from?

Well, you have got us scrambling through our work papers here. So we will look here very quickly. I don't know that there is a particular accident year that is resulting from that. Actually, almost every one of our accident years going back four and five years is showing some redundancy at this point. Our overall reserve strength seems to be as we would hope it to be, spread throughout lines of business and accident year.

Okay. So it is fair to say it is coming from each?

Yes. I think it is pretty homogenized throughout our reserving.

Certainly to a varying degree. But as Ralph is saying, we have experienced redundancy in most of the prior years.

Okay. And then are you ready to comment at all? Or is there any extraordinary claims coming out of Hurricane Dennis?

To our knowledge, we would have very little if any claims out of Dennis.

(OPERATOR INSTRUCTIONS). Beth Malone, Advest.

Good morning. Congratulations on the quarter as well. I had a couple of questions. One in general, your structure is a mutual and a stock Company combination, and I was wondering does that structure have any bearing or impact on your ability to achieve loss ratios that appear to be superior to many of your competitors?

Beth, as you know and I think we have spoken about this in a number of these calls over the years, we think that our structure is a very positive one. It enables us, we think, to have a longer-term parameter in terms of how we look at the industry and the business. So I think the mutual public company structure have given us that kind of an environment, and within that environment I think we have been able to foster a conservative underwriting approach to things.

And as you know from the acquisition, side the mutual company cooperation can be very helpful because when we do affiliations with mutual companies, many times they start on the mutual company side, and when they are demutualized the public company in most cases has acquired them.

So, I don't know that you can say just because we have a public company mutual structure that all of that automatically results in the ability to have better results. I would say that in our case, it has helped to foster a structure that is conservative, a longer-term parameter on looking at things. That's how the mutual company has for 116 years has looked at things. So that is how I would answer that thing.

Beth, I would like to also add that although it is difficult to measure the effect of it, I think the fact that we do business through the independent agency system. In that system, each agent generally likes to have both mutual and stock companies, and many times they view that mutuals are very stable in their pricing and their approach to the marketplace, as we have tried to be over many years. It does help us foster very good relationships with the agents. Again, whether that results in a measurable result in the financial end, it is hard to ever say. But we certainly think it helps in those relationships.

Thanks. In regards to acquisition, would you say that the growth opportunities have been greater with the new acquisitions than in your established business, just because once you get them in there and you put them on your program, there is some kind of low-hanging fruit of accelerated growth that you can achieve when you make these acquisitions?

I don't know that we can say that the acquired subsidiaries in the early years necessarily grow by a greater percentage than the established company subsidiaries. However, when you get a few years out -- as I would give you an example, when we acquired Southern Heritage in the Southeast in Georgia in 1998, in the first couple of years their growth certainly would not have exceeded the overall Company growth. But certainly as we worked with that subsidiary and began to more develop our distribution system in the Southeast, we now have the Southeast as one of our strongest growing areas.

So I don't know that you can say just because of the acquisition or immediately following. It all is tied into what is the strategy of making the acquisition. And generally in our case, it is to gain access to a particular geographic area in which we want to expand, and that we generally utilize the acquisition as sort of a launching pad to be able to build on the nucleus of maybe what they have built and to grow it from there.

Thank you. The next question is on the investment income. It grew nicely in the quarter, and that has been pretty challenging for most companies due to the interest rate environment. Was that growth a combination of greater cash flows contributing to the investment income (technical difficulty) set (ph) of assets?

The investment income side certainly has been helped by strong cash flow, which would certainly be a function of the excellent profitability clearly.

As far as yields on the portfolio, did they change in the quarter relative to a year ago or the first quarter?

Our average investment yield was about 3.4% in the second quarter of '05. That would compare to 3.2% in the second quarter of 2004. So, a modest increase.

One of the things that I would want to add is that we have always taken a conservative view of our investment portfolio. I can assure you we're not reaching for yields. We have very little, if any, high-risk bonds as an example. We have always viewed that as a property and casualty insurance company, the underwriting business already is leveraging your net worth, your surplus. And if you are in any way aggressive on the investment side, you're doubling up on the risk and the leverage you're placing on your surplus.

So, we have traditionally been relatively conservative in how we have approached investment. So, it is no change in our philosophy other than, as Ralph would have announced, Ralph and Jeff, that we certainly have migrated to more tax-exempts given the profitability of the overall organization so that we can get the best after-tax return.

Also Beth, if you are comparing it back to year ago, you have to keep in mind that a year ago we had just acquired both LeMars and Peninsula. At the time of those acquisitions they had relatively high levels of short-term investments that we have very diligently been putting to work, so that the average short-term investments a year ago would have been about $55 million over the quarter. And now they're down to somewhere around 30 to 35 million.

We talked about that last year at a number of quarters that we were trying to put that money to work. And as we have shifted the investments to municipals, we have been able to do that. That move from short-term investments to slightly longer more permanent investments has also helped our investment income.

Thanks. Just one last question on acquisitions. It is clear that in many sectors of the marketplace there is a softening in the pricing for property/casualty. Does that environment increase the opportunities for acquiring companies? Or does it have any impact at all on your ability to (technical difficulty) these companies?

I think there's a multiple of factors there. Certainly as the pricing market softens, what it does is it compounds the problems that small to medium-sized companies encounter. And as you know, when prices and premiums are going up, it's like all boats rise in a rising tide. When things become more competitive, what it does is it also has impact and accentuates the other issues, such as whether those companies have the ability to have the right kind of technology platform.

And it makes those areas of competition become more apparent, because as I think we all know in these times, competition is defined in more than just price. It's defined in product, breadth of market, delivery systems, all of those as well as pricing. And as things become more competitive, it becomes -- there is more of an element of comparison that occurs.

So there is a greater amount -- and I don't want to overemphasize it. There is an increased amount of issues that smaller companies have to confront. And I think it's generally recognized that when things become more competitive in our industry that acquisitions tend to increase in the industry. And we would expect to see some of the same kind of results that might provide other opportunities to it.

Mike Grasher, Piper Jaffray.

Hi, just a couple of follow-up questions. First of all, where do you stand on the capital front in terms of making an acquisition? That is the first question.

We currently have a $35 million untapped line of credit. We also do have some money at the holding company level we can use. Between those two, we can pretty easily handle some modest acquisitions without doing anything dramatic.

Could you just update us on the class B shares, if there has been any change in terms of buying those back or I guess doing away with them?

Two things, two separate questions there. Number one, when you use the term buying back, we have actually -- the Company itself, Donegal Group Inc., has not bought back any B shares. Our mutual affiliate has over the last year been a purchaser of some class B shares and continues to be a potential purchaser of those. Those purchases have been relatively in very small lots, modest amounts.

I believe what you are referring to is -- at one time going back a number of years ago when the two classes were originally established, there had been some discussion about potentially doing some type of offer for all of the B shares, or allowing people to convert their B shares into A shares. Unfortunately, NASDAQ does not allow us to do that. They have determined that would not be in the best interest of the holders of the B shares. So at this point we are not actively pursuing any type of conversion.

Having said that, two elements to that. We are not -- have not currently been in the open market, my recollection is at any time this year, buying B shares on the part of the mutual. What Ralph described would be in the form of a tender offer for the B. But that does not preclude us in any way from the mutual being a buyer of B shares, as those might be made available through open market transactions.

David West, Davenport.

Good morning. First I was wondering could you comment on your good level of premium growth? Was that particularly strong in any particular state or region?

I would say that it varies by region, certainly. The southeast for us has had somewhat a higher growth rate. Some of the states, such as in the Delaware state and Ohio, in certain portions of Pennsylvania, we have grown it at higher rates than our overall average.

Very good. And then as a follow-up to some of the M&A discussion, it sounds like you're getting to look at a reasonable number of situations currently. Would you describe most of those as things within your current footprint or more as opportunities to possibly expand your operating territory?

I would say that they would be within our footprint as we define it. And we define our footprint as being the mid-Atlantic states, the Southeast, and not Florida, not places like that, and the Midwest, anywhere from Ohio west to Iowa and Indiana. So, defining it the way we define it, they would be within our footprint.

Eric Saxon, Suntrust Robinson Humphrey.

Do you all have the calculation for the pre-FAS book value, pre-FAS 115?

We sure do. The FAS 115 number is $0.23 for book value, which would give you a prior to FAS 115 number of $14.14.

Okay. Just one more modeling question. With net earned premiums up about a little over 13% for the first half, we talked about net written premiums being around the 9% to 10% for the remainder of the year. Would net earned premiums -- do you think maybe 10% or 12% or a little bit more?

Yes, I think more around the 10% range is probably a good number. There was some acquisition accounting last year that -- more in the first quarter, but to some extent in the second quarter was affected, the second quarter earned premium of a year ago. So I think the 10% number is a good one.

There are no further questions at this time.

Okay. In that case, they were all very good questions. We appreciate all of your attendance and participation in our earnings release conference call. Thank you all very much.

Thank you for your participation in today's conference. This concludes the presentation and you may now disconnect. Have a great day.