Erie Indemnity Company Margin Stabilization Should Lead to Stronger Earnings Growth

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Erie Indemnity Company reported operating earnings of $0.67 for the fourth quarter, $0.14 above our estimate of $0.53, as a modest margin upside and higher earnings from limited partnerships drove the earnings out-performance. The franchise continues to have great top-line momentum and an enviable business model, and we continue to see longterm upside in the name, but near-term results are likely to be choppy as the company reinvests for the future, and the valuation remains stretched.

We are increasing our 2014 EPS estimate from $3.20 to $3.30, up 8% versus 2013, based on 9% revenue growth and modest margin expansion, offset by lower investment income. We are also initiating a new 2015 EPS estimate of $3.62, up 10% year-over-year. These estimates could prove to be conservative if expense growth slows materially over the next 12 months or investment income picks up materially.

Premium growth rates hit 10% in 2013 but have likely peaked, and we expect moderate deceleration heading into 2014 and 2015 as the rate environment becomes more competitive. On the positive side, PIF growth and retention rates remain strong, which should help the firm maintain a strong position in both the personal and commercial books. Erie Indemnity earns a fixed management fee of 25% of net written premiums from the insurance exchange; thus faster written premium growth translates directly to higher top-line growth. We project 8.6% growth in management fees in 2014 and 7.3% in 2014, as we expect both policy growth and retention levels to remain favorable to top-line growth.

Management continues to reinvest in the business, and the results are clearly paying off as policy growth rates and retention levels are running better than industry averages. Unfortunately, the growth rate of expenses continues to outpace fast top-line growth, but the gap is starting to narrow. We believe the company will likely reach an inflection point soon, at which point the majority of systems and software upgrades and implementation will be complete and the company should finally stabilize or potentially improve margins. However, the timing of that inflection remains unclear, as the company is clearly managing on a long-term time horizon. Gross margin on management operations was down 90 basis points during 2013, but up 120 basis points in the fourth quarter, which bodes well for stabilization moving into 2014. We forecast an increase of 40 basis points in 2014, and a further increase of 50 basis points in 2015 (17% gross margin for 2015). This figure is still well below historical levels, so these estimates could prove to be conservative. Given strong top-line growth and the inherent operating leverage in the business, when incremental expenses begin to dry up, margin expansion could occur quickly and dramatically, resulting in far faster earnings growth.

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