Good day, ladies and gentlemen, and welcome to the Allstate Investor Update. At this time, all participants are in listen only mode. Later, we will conduct a question and answer session, and instructions will be given at that time. If anyone should require assistance during the program, please press star then zero on your touchtone telephone. As a reminder, today's program is being recorded. I would now like to introduce your host for today's program, Mr. John Griek. Please go ahead.
Well, thank you, Jonathan. With me today is our Chairman and CEO, Tom Wilson, and Chief Financial Officer, Steve Shebik. Yesterday, we issued a press release announcing Allstate's intention to acquire SquareTrade. After prepared remarks by Tom, we will have a question and answer session concerning this acquisition. We will not be covering current operating results, so please hold those questions for the fourth quarter earnings call. We have posted a slide presentation for use in today's discussion that can be found on our website at allstateinvestors.com. As noted on the first slide, our discussion today will contain forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2015, the slides, and our most recent news release for information on potential risks.
We are recording this call, and a replay will be available following its conclusion, and I will be available to answer any follow-up questions you may have after the call. Now I'll turn it over to Tom.
Good morning. Thank you for joining us. I'll begin with a summary of the transaction, which is on slide two, and then we'll go through some more background on SquareTrade and our strategic rationale on the next slides. The acquisition of SquareTrade expands our consumer protection offerings with additional products and new distribution. The acquisition price of $1.4 billion will be funded with holding company cash and the issuance of debt. SquareTrade, you don't know, is a privately held company, so it's not that well known in the marketplace outside of retailers. It is a rapidly growing, highly innovative, customer-focused company that offers protection plans that cover a wide range of consumer electronics and personal devices, and that's distributed through many of the nation's top retailers.
Their exceptional customer service, highly innovative product design, analytics, and supply chain logistics has led to a fourfold increase in revenue over the last five years. This acquisition will expand Allstate's customer relationships with over $25 million active protection plans, putting our total items in force over $70 million. This transaction is economically attractive for Allstate shareholders, but it is modestly dilutive to income for the next three years, which includes the amortization of intangibles. Importantly, the acquisition will have no impact on our share repurchase program. Let me provide some background on the company. If you go to slide three, SquareTrade provides protection plans for a wide range of consumer products such as computers, televisions, cell phones, and appliances, as you can see at the top of the slide.
These plans are largely sold through retailers at the point of sale, such as Costco, Sam's Club, Target, Staples, Office Depot, and Toys R Us, or through electronic retailers such as Amazon and eBay. Slide four covers the value proposition to retailers, which importantly does two things for them. First, it helps them raise their customers' satisfaction levels. Secondly, it generates additional revenues. What SquareTrade does is they provide fully integrated solutions for this wide range of products, and their programs then are customized for each retailer in each major product category. They are particularly good at integrating into each retailer's unique go-to-market approach. The in-store programs then use point-of-sale design and merchandising. The online programs use highly sophisticated analytics to both maximize growth and profitability. This approach to the market has led to improved results for retailers switching their programs to SquareTrade.
Their fabulous claims service just keeps customers satisfied, and many retailers also end up with higher penetration rates, which increases revenues. This business model has led to a highly successful track record in expanding distribution and growth in market share. If you go to slide five, this talks about the acquisition, how it enhances Allstate's strategy by providing additional high-growth, market-facing businesses. SquareTrade will join this growing list of high-growth businesses, which is shown on the bottom, which is outside of our auto, home, and other property insurance offerings on the bottom left there. The strategic benefits to us are shown on the right-hand side of the slide. SquareTrade has built a branded business that is capturing market share through a focus on the customer and innovative claims processes. Near-term growth will come through a continued focus on expanding the retail distribution.
Retail distribution is particularly important for protection plans because this is when consumers are actively considering buying coverage, and it's easier to underwrite the condition of the product at the point of sale. We are really excited about the opportunity to join forces with many of the nation's top retailers. There are several other growth opportunities which look promising, such as international expansion or selling directly to consumers as well. This acquisition enables Allstate to provide protection for personal devices, which we expect to continue to grow rapidly as consumers become more and more connected throughout their lives. In fact, as you know, many customers are more attached today to their devices, their phones, their tablets, their computers, than they are their cars. SquareTrade's focus on customer satisfaction and creating branded experiences also consistent with Allstate's strategy and our go-to-market approach.
Culturally, we in SquareTrade's leadership also see strong alignment between the companies. We're both focused on meeting customers' needs, investing in innovation, and operating our businesses with precision. The operational and financial implications are shown on slide six. The acquisition price of $1.4 billion will be funded with a combination of cash and $1 billion of newly issued senior debt, which will bring our debt-to-capital ratio up slightly to 22%-23%, which still leaves us with exceptional financial strength. We do not expect there to be any impact on our debt ratings. As I mentioned, there is no impact on the existing share repurchase program. There's essentially no impact on either SquareTrade or Allstate's operations, since we'll run this business independently, much as we've done with Esurance.
Importantly, Ahmed Khaishgi , one of the co-founders, was an enthusiastic supporter of the transaction and will join the Allstate team with his existing team in place. Ahmed's been a driving force behind the growth of this business. He is an insightful business executive who will take SquareTrade to the next level of success. The acquisition is also economically attractive. Revenues today are in the hundreds of millions of dollars, and its core retail business has good margins. The purchase price does reflect the expectation that we'll maintain rapid growth, some of which will be realized through existing distribution relationships. As new distribution relationships are initiated, at which we think Allstate's backing will make even more likely, this will create additional profitable growth. The key economic drivers are continued retail growth and capturing additional margin, which the company has consistently been able to achieve.
In doing our economics, we did not attribute much value to international expansion, selling directly to consumers, leveraging the Allstate property and casualty customer base or distribution force, or increasing penetration of cell phone plans outside of retail distribution. The net of all this is we expect to realize a superior internal rate of return that is substantially higher than our cost of capital while strengthening our strategic position in the protection space. Overall financial results will not be significantly impacted. While we do not have final numbers on the amount of intangible assets that will be written off, or over what time period for that matter, we expect the transaction to be accretive after three years. Over time, we will also have the opportunity to deploy capital in underwriting the protection plan risk, which is currently outsourced to other insurance companies.
In summary, the acquisition of SquareTrade furthers our consumer-focused strategy, extends our protection offering, and gives us a new distribution channel. Financially, it has more upside than downside and has minimal impact on financial strength or reported earnings. I will now take your questions.
Certainly. Ladies and gentlemen, if you have a question at this time, please press star then one on your touch tone telephone. If your question has been answered and you'd like to remove yourself from the queue, please press the pound key. Our first question comes from the line of Kai Pan from Morgan Stanley. Your question please.
Thank you. Good morning. First question is about, sort of just understand a bit more about why do you need to diversify outside your core auto and homeowner business? When you consider diversification, why warranty business? Have you considered other adjacent areas such as small business insurance? Also, how do you compare using the money for acquisition versus return to shareholders?
Kai, you're breaking up a little bit. Sorry, we turned it up as you were speaking there. Let me see if I can paraphrase this. Why do we view this diversification as important? Would that be a summary of it?
Yeah. The question is really why do you need to diversify outside the core auto and home insurance business? When you want to diversify, why warranty business versus others, for example, small business insurance.
Oh, I got it. Okay. Yeah. Okay. That's helpful. Thank you. First, I don't think we need to diversify. I think it's smart to find ways to deploy our capital to leverage our skills, capabilities, and to further our strategy. The strategy stuff I just went through. It's consumer focused, it's protection focused. It's, we believe, an innovative approach to the market, and it gives us distribution to meet our customers where they want to buy this stuff. From that standpoint, it's very consistent with our focus. If you look at our skills and capabilities, certainly having the strength of Allstate behind SquareTrade will help them. They've already had great success with some fabulous names in retail, as you see. That was as a private company, growing quite rapidly. We think with our backing, it'll open even more doors.
Secondly, we think that identifying the company with Allstate will further strengthen what is an emerging brand. From a sheer operational horsepower of being able to expand call centers, use data and analytics, they are quite good at it, particularly in the claims side. We think we have some additional capabilities we can provide to them there. Lastly, we can deploy capital. Right now they outsource the underwriting of their protection plans to third parties, which squeezes their margins a little bit. We believe that either with us as an alternative, they can lower those costs, or we could actually do that ourselves through them. As it relates to other alternatives, we're always looking at alternatives in the marketplace, whether that be in small business. You mentioned small business commercial.
That business, as you know, we have some profit issues in that business right now, so I'm not particularly interested in expanding it until we prove we can make money in it. It obviously fits with our distribution, and we have a fairly large book of business there. Right now, we thought this was an attractive opportunity for us, and we went proactively at it. We worked directly with Bain outside of an auction process to try to buy this business.
That's great. My second question is that I really try to understand even more about the market, because you mentioned your press release is about a $20 billion industry. If you look at statutory filings from the warranty insurance premium, it's only about $3 billion annually. Could you explain a little bit the gap between these two, and what's the value chain and economics along the value chain?
Well, I think it depends. First, it always depends how you define the market, right? First there's a global market, and then the U.S. market is some smaller portion there, probably a little less than half of the total worldwide market. Secondly, there's warranty business, and then there's other protection plans. The cell phone insurance business, as you would expect, is quite a large business and would dwarf just even your $3 billion number.
Okay. In term of economics, are you planning to capture both the distribution as well as on the underwriting side as well?
We haven't firmed that up yet. SquareTrade will work with the current providers, either they'll get a better deal or we'll do it. It'll depend how economic it is for us. We don't have to deploy capital in there because it's available, if we feel like we can get a better return, it's better for the company for us to do it, we most certainly will do it. They'll have to work through that in the future. I would point out it takes some time, though, for that to run through income because we're not going to go back and insure everything that's already been written. Those reserves remain with the two other insurance companies they've been using to provide them capital.
Great. Thank you so much, Thomas J. Wilson.
Thank you, Kai Pan.
Thank you. Our next question comes from the line of Amit Kumar from Macquarie. Your question, please.
Thanks. Good morning. Maybe just going back to the first question, maybe just pushing a bit more. I think the question we're trying to ask and understand is, what exactly are the revenues of the business you're buying? What are the margins and what are the earnings? I think as outsiders, that'll probably help us better understand the rationale of this acquisition. I was wondering if you could provide some specific numbers related to the revenues, et cetera.
Amit, thanks for the question. We're not going to provide those today. I will tell you that the revenues are in the $hundreds of millions, not $billions. It's growing quite rapidly. As I mentioned, the core retail business does make money, and we think it's eminently scalable, and they can continue to grow that. I think what everyone's trying to back into is, plus you're trying to do your models, everyone's trying to figure out what the purchase price multiples are and is it economic.
Let me just cut to what I think is perhaps the chase on that one, which is you really have to look at, in high growth businesses, purchase price multiples, really, they change dramatically from year to year, right? For example, if a company grew at 50% from one year to the next, then if you use the forward multiple, that would be half of the trailing multiple. As a result, we don't believe that purchase price multiples are the best indicators of values for a high growth company. We think a better way to value the company is through discounted cash flows, which is the method that we utilize. Obviously the purchase price multiples, whether it's revenue or earnings for high growth companies, are always higher than big stable companies like Allstate. The economics of this business are quite good.
It's high margin, it's low capital, high growth, and our value does not include a lot of the other things we think we can do with this business. If we can pick up one or two of the other things I mentioned, whether that's be successful in international, be successful in direct to consumer, then this number will end up being more than double. The internal rate of return will end up being more than double our cost of capital. We think this has a lot of upside from where it is today.
Did you say the return will be double the cost of capital? Did I capture that right?
Yeah. First, the retail business has got to grow. That's Amit's current focus is they're really good in retail, they're good in U.S. retail, and they need to continue to pick up share in that space, and they're highly focused on that. That is the core value that we estimate we looked at when we bought the business, and we need to be successful at it. When you're looking at our revenues for this year, next year, when we break it out, you should see growth in that core retail side. There are two other things we can do with this business. One is they started to expand internationally, particularly working with some of the telco carriers to get into the cell phone business through telecoms. They have a unique fulfillment model over there, which is one-day replacement, which is not standard in Europe.
If that takes off, if we are successful at getting into the direct-to-consumer business, we know a lot about direct-to-consumer through Esurance. If we can find ways to expand the protection plans sales for those people who choose not to buy it in store, but then they're back at their home and they wish they would buy it, we can drive additional volume that way. The returns will be more than double our cost of capital. In all cases, we would not buy anything if it was below our cost of capital. That just is a given.
Got it. That's actually helpful. The second question, you sort of alluded and talked about the underwriting income impact. Over time, you'll start underwriting this business. If I understand it correctly, based on what I've read, I think CNA and Starr are some of the few carriers who are underwriting this business. Can you talk about the timeline as to when are those phased out and this starts getting written, I guess, on your balance sheet?
I think you could assume sort of a three- to four-year rolling period in terms of before you get up to. The duration of the reserves are in the three- to four-year range, depending on the product and stuff like that. Some of the products are shorter than others. Does that make sense?
Got it. That makes sense. Yeah.
Just final question.
Jack, Amit, there are a couple other people waiting. Can we come back to you?
Yeah, absolutely.
if they don't get to it?
Absolutely. Thanks so much.
Thank you.
Thank you. Our next question comes from the line of Joshua Shanker from Deutsche Bank. Your question please.
Yeah. Good morning, Tom, and everyone.
Good morning.
Can we talk about the growth rate of the first nine months of the year versus the nine months of 2015 on revenues?
For SquareTrade or for Allstate?
Yep. For SquareTrade.
We'll lay all that out when we do next year. We're trying to make sure we do it on an apples-to-apples basis. We have some work to do to make sure we account for it the way we want to account for it.
Is there a range you can give us?
I'll tell you what we'll do is we'll give you some sense for how rapidly we think it'll grow when we get to the first quarter. We'll just talk to you about the growth rate in 2017. They just added Target this season, just a couple of weeks ago.
In October.
In October. As that rolls out, there'll be embedded growth in the business next year, almost no matter what happens. The question will be how do we get more new retail distribution beyond that?
Can we get a sense of how good Allstate will be at underwriting these businesses? Maybe I don't understand it. I assume the underwriting is done by Starr or CNA, mentioned before, and that you would become the underwriter, and that would be the price setter. Is that the right way to think about it? Is the reason to understand that Allstate would be good or needs to gain a skill set in order to do this?
It's a good question. That skill resides with inside SquareTrade today. The underwriting is basically an excess of loss type coverage. The way the arrangements with CNA and Starr are is basically SquareTrade has an excess of loss cover, and that the reserves get transferred in total, but it's an excess of loss cover. The basic economics of making sure what your pricing is, giving you a margin by SKU, by retailer, resides inside SquareTrade.
Okay. That makes sense. You mentioned three years. In three years, should we give Allstate three years to prove the value of this transaction? What's the timeline on us trying to understand whether this was a great idea at the time or not?
Well, I would expect our shareholders passively talking to us and us to be constantly talking to you about what we like about the business, where our successes have been, what things our challenges are. When we said talking about accretion dilution, there are some people who look at transactions like this only based on its impact on reported earnings. Our board, we choose to take a broader perspective of that, which is how does it help our strategy? What do the cash flows look like? What are the ways we can add value and make it a stronger business? We put that out there just for those people who are interested in what the impact is on reported earnings.
Well, good luck to you.
Thank you.
Thank you. Our next question comes from the line of Bob Glasspiegel from Janney. Your question please.
Good morning, Allstate. I'm going to push Josh's last question a little harder. You've done $3 billion type acquisitions since I've been following you, American Heritage and CNA Personal Lines in 1999, Esurance five years ago, all for roughly a billion-dollar range. It gets harder and harder to track how those deals do as they get folded in, but I'm sure you guys go through a self-graded exam of assessing it. It seems like the CNA Personal Lines, you bought it at a good price, but it really has never achieved the underwriting quality or growth of your core franchise. American Heritage got lost in sort of the numbers, but I think that was an okay deal. It doesn't seem like Esurance yet is achieving your cost of capital, but maybe there's strategic value in it.
Talk me up or down from my perspectives on the historic quality of the acquisition team that you've done in integration of billion-dollar deals.
Hey, Bob, I don't know about talking you up or down. I'll give you our view, because it's a good question, how have you done historically? Let start with Esurance. We bought it five years ago, and under our ownership, it's become a much stronger competitor in the direct-to-consumer branded customer segment. Premiums are twice what they were five years ago. The product portfolio expanded it to include homeowners insurance, and I think actually that's one of the reasons why Progressive felt like a need to start to move into that space. The brand measures have all improved. The cost structure, particularly in claims, we've done a much better job on resolving claims for the right amount. We expanded it into the preferred risk category by using Allstate's price experience.
Some people don't like the accounting, where all the advertising expenses are expensed up front, that negatively impacts profits, particularly when you're doing a rapid investment in building a brand. That's an accounting convention. We chose to just deal with that. Esurance has had to deal with the impact of higher auto frequency and severity over the last 18 months, just as GEICO had to. Net-net, over all that, the economic returns on the deal and the economic returns on the business we've written since then are above our cost of capital. The impact on reported earnings has been less, but as you know, we try to manage for long-term value. We feel good about where we are with Esurance. Would I have preferred that auto frequency and severity did not spike 18 months ago and we had made additional money? Of course.
Do I feel good about the business we built, how it's expanded our strategy, give us an ability to compete directly with GEICO and Progressive direct, force them to make changes in their strategy? Yes. Encompass, you're right, you missed a little gap there. Encompass, overall economic returns have been in the low teens. I don't have today's number, but we look at it about every two years just to make sure we still have it. You're right, we bought the business at a low price, that was because it had a combined ratio of north of 115. I think it might have been like 117 at the time. We immediately began to improve profitability, for a period of years, it generated a tremendous amount of cash for us. Current earnings, you're right, that's the part I'm slipping into the story.
Current earnings have suffered. We basically did not update our pricing or adapt our distribution in the face of increased use of comparative raters in that independent agent channel. Our profits are down. That said, we made so much money early, it's really not had much of an impact on returns. We need to get it fixed. We need to make more money and get that business growing again. From an acquisition standpoint, it's turned out okay. American Heritage, which is now Allstate Benefits, you can actually see those numbers in the supplement. This may be the deal that's most similar to SquareTrade. Its revenue across $1 billion this year. It's four times what it was when we bought it. We now have 3.7 million shares or policies outstanding.
Returns are in the high teens on economic capital on everything we write, they're in the low teens when you just look at the book returns, you factor in goodwill and all that kind of stuff. We've also had good results from the acquisitions of, we had some smaller ones you didn't mention, Pembridge, which is a non-standard company up in Canada. Partnership Marketing Group, which expanded our roadside business into the white label market. Not nearly. We did have one failure, which was Sterling, a collision repair business we bought in 2001. You may remember, we had assumed it would help us lower our claim costs with new operating practices inside the collision repair shops. Neither of those turned out to be true. It didn't help us lower our claim costs, nor did the new manufacturing methods inside the repair shop really work.
That we paid a little over $109 for that business, we sold it in 2014. Of course, we've also had, I think, our decent track record is knowing when to sell businesses like our VA business. Is that helpful?
Great answer. One quick follow-up. What's the cash flow dynamics of SquareTrade? Is it cash flow positive?
It is, yes.
Thank you.
They've actually run the business over time on a cash flow positive basis, which has been funding a fair amount of the growth of it to date.
A decent bit of cash or just close to zero for practical purposes?
Well, it's above zero, but relative to Allstate, it's not going to make a big deal there.
Thank you.
We're not running it for cash. We're running it to grow it. I think we have time for one more question because I think we're only scheduled for 8:30 A.M. I want to keep the cognizant of your own time. Can we do one last question?
Certainly. Our final question comes from the line of Paul Newsome from Sandler O'Neill. Your question, please.
Thank you for the call. I assume that when you're looking at the returns relative to cost of capital, that's on a cash basis and not a GAAP basis. Is that true? Could you talk about how we should think about the difference between the two for this transaction? Is it fair to say that it's going to be past the three years, where on a GAAP basis, we would see it above your cost of capital?
I missed a little bit of that last part, Paul. First, I'll give you an answer. Steve can talk a little more about dilution. I think that's what you're asking, the difference between economics and reported.
Yes.
We do value it on a cash flow basis. We seek to deploy it, and we run most of our business on cash.
Yes.
The logic being, we get enough cash turns into book value, and book value turns into growth in share price. You got to make money to have cash. That's also a measure for us. In this particular case, we look really at the cash flow generation capacity of the business. Both what it would generate on a yearly basis, and then as it grew, how much would it be worth? We tried not to do the economics with it all jazzed into the terminal value. It's sort of like buying a sports team. As long as you sell it to somebody else for more money. We don't buy that concept. We got to make money and get cash each and every year. Steve, maybe you can make a comment about dilution.
Yes.
I think that's also where Paul is headed.
Actually, when you think of dilution, the amortization of intangibles is the biggest driver of dilution on net income. As you know, many people do not look at that as a true measure of current earnings power. In our case, you and many of our investors focus on underlying combined ratio. As you know, we exclude the amortization intangibles from both our underlying combined ratio and operating income. Let's put that aside. We still need to do a fair amount of work to determine how much that purchase price will be classified as intangible assets that are subject to amortization and the periods can be written off, and the rate at which it'll be written off.
While we do not have a really firm number today, we expect dilution, excluding intangible amortization, to be less than 2% in 2017, reflecting primarily the financing cost of the transaction. We anticipate, as Tom noted, accretion after three years. Depending on the amount and timing of the amortization of intangibles, this could be up to 5% in 2017, and once again, accretive after three years. To put that in perspective for you, 5% net income based on next year's, what I believe are street estimates, equal to about half a percentage point on a reported combined ratio. That's reported, not underlying, obviously. Which is relatively small compared to the volatility we have normally in our business on the basis of frequency and severity.
Okay. Thank you all for participating. Just in summary, we think this is a great acquisition to help expand our consumer-focused strategy. We get into a whole new set of products and services. Gives us new distribution. Financially, it has more upside than downside. We get a great management team that can take this business to the next level because they're going to stay with us. If you have any questions, John is available all day today. Thank you very much.
Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.