ALL Allstate Corporation

We have downgraded our recommendation on Allstate Corp. (ALL) to Underperform from Neutral based on its consistent weak operating performance in the third quarter of 2011, which raises a question on the current sustainability factor.

Allstate’s third quarter operating earnings per share of 16 cents came in a nickel higher than the Zacks Consensus Estimate of 11 cents but significantly lagged the year-ago quarter’s earnings of 83 cents. Operating earnings plunged to $84 million from $452 million in the year-ago quarter.

The company’s net income for the reported quarter came in at $165 million or 32 cents per share, compared with $367 million or 68 cents in the prior-year quarter, reflecting a radical decline.

Results for the reported quarter reflected higher catastrophe (CAT) losses that also led to increased claims expenses coupled with lower average premiums and policies-in-force in Property-Liability insurance unit and lower investment income. However, capital management and liquidity were quite impressive during the reported quarter. This is reflected from stability in book value per share and combined ratio, excluding the effect of catastrophes.

As pricing pressures continue to escalate, spreads between premium growth and loss cost inflation are expected to remain negative, while claims and operating costs continue to pose a rising trend, leading to further compression in underlying margins. Particularly, a weak P&C cycle continues to narrow down the growth prospects in the Property-Liability segment.

As a result, premium growth remains stunted and the company is experiencing a decline in underwriting results, policies in force (PIFs) and new issued applications.

Additionally, given the consistent occurrence of weather-related events, catastrophe losses surged to $3.75 billion in the first nine months of 2011, already exceeding from $2.21 billion in 2010 and $2.07 billion in 2009. Escalating losses from catastrophes have been weighing on the company’s claims and benefits expenses while also significantly deteriorating the combined ratio, bottom-line results and cash flows.

Operating cash flow reduced substantially to $1.7 billion from $3.0 billion, during the first nine months of 2011 and 2010, respectively. The ongoing sluggish and volatile economic dynamics besides weakening Allstate’s operating leverage even undermined its cash and balance sheet position.

Reduced cash flow also restricts the company’s scope for acquisitions or returning shareholder value. This is also evident from the latest $1.0 billion share repurchase program, which will be funded from the planned issue of preferred stock offering and senior unsecured notes, all worth $1.25 billion, rather than the company’s free cash. These factors could weaken its competitive leverage against arch rivals such as Berkshire Hathaway-A (BRK.A) and The Travelers Companies (TRV).

Nevertheless, Allstate is well poised to be a long-term gainer in personal lines, given its scale, pricing sophistication and product design. Moreover, the acquisition of the third largest online auto insurance seller in the U.S. – Esurance and Answer Financial from White Mountains Insurance Group Ltd., in October 2011 for $1.0 billion, will most likely boost online auto sales, and thereby generate cost synergies in the Property-Liability segment.

Allstate is also repositioning its product and distribution portfolio in order to enhance long-term growth. Also, the company initiated an active role in reducing future CAT losses through the establishment of an Enterprise Risk and Return Management (ERRM) system.

Besides, on an immediate basis, Allstate is working vigorously to maintain standard auto margins, improve returns in homeowners and Allstate Financial and manage capital aggressively. We expect these initiatives to support the bottom line in the upcoming quarters. Even a healthy ratings outlook bodes well for Allstate’s long-term growth.

Overall, though continued synergies are expected from Allstate’s industry-leading position, diversification and pricing discipline, we believe that the current volatile economy will continue to impact its fundamental growth until the markets regain momentum.

Consequently, the Zacks Consensus Estimate for the fourth quarter 2011 earnings is currently pegged at 93 cents a share, drastically up from 50 cents in the year-ago quarter, expecting a reduction or elimination in CAT losses. For 2011, however, earnings are estimated to be 79 cents per share, radically down from $2.84, given the overall yearly impact of CAT losses.

Additionally, the quantitative Zacks Rank for Allstate is currently #3, indicating no clear directional pressure on the shares over the near term. 

 
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