Why pay more than $1 billion for a business with revenues in the hundreds of millions of dollars today?

Analysts questioned executives of Allstate yesterday about the $1.4 billion deal announced Monday for SquareTrade, a provider of consumer protection plans for mobile devices, laptops and other consumer electronics, as they probed for the insurer’s rationale in moving outside core auto and homeowners insurance businesses.

According to Chief Executive Officer Tom Wilson, the deal logic flows from the customer-focused strategies of both companies. Acquiring SquareTrade not only expands Allstate’s consumer protection offerings to electronics and connected devices, it also represents a potential jolt in the number of customer relationships through new distribution, he added during a conference with investment analysts.

“Many customers are more attached today to their devices—their phones, their tablets, their computers—than they are their cars,” Wilson observed.

“This acquisition will expand Allstate’s customer relationships with [SquareTrade’s] over 25 million active protection plans, putting our total items in force over 70 million,” he said.

“SquareTrade’s focus on customer satisfaction and creating a branded experience is…consistent with Allstate’s strategy and our go-to-market approach,” he said. And the two leadership teams are culturally in sync, with both focused on “meeting customers’ needs, investing in innovation and operating [their respective] businesses with precision,” he said, referring at several points to SquareTrade’s innovation in claims handling and product design.

Working the Numbers

As for the financial value of the deal, while Wilson declined to give specific figures for SquareTrade’s revenue or earnings, he did say that deal economics are based on the high-growth potential of the business and that SquareTrade’s core U.S. retail business has “good margins.” Through existing relationships with major consumer electronics retailers—Costco, Sam’s Club, Target and Staples, among others—and online retailers like Amazon and eBay, SquareTrade has already seen a fourfold increase in revenue over the last five years.

Wilson_Thomas J.

“Many customers are more attached today to their devices—their phones, their tablets, their computers—than they are their cars.”

Allstate CEO Thomas Wilson

“In high-growth businesses, purchase price multiples change dramatically from year to year,” Wilson said, explaining that Allstate’s management team used a discounted cash flow approach instead of a multiple of revenue or earnings to value the company. And in figuring the numbers, Allstate did not even factor in potential growth rates from efforts already underway to expand internationally or from the prospect of direct-to-consumer sales in the future. Instead, the value is based solely on the expansion of U.S. retail, the core driver of growth to date.

“The purchase price reflects the expectation that [SquareTrade] will maintain rapid growth, some of which will be realized through existing retail relationships. As new distribution relationships are initiated—which we think Allstate’s backing will make even more likely—this will create additional profitable growth,” Wilson said.

Allstate’s valuation also doesn’t figure in a lot of value for leveraging the Allstate property/casualty customer base or distribution force, the CEO reported.

As it stands, “the economics of this business are quite good: high margin, low capital, high growth…Our value doesn’t include the other things we can do,” Wilson said, noting that SquareTrade has already started working with telecoms to distribute cellphone protection plans outside the U.S. “They have a unique model of one-day replacement over there, which is not standard in Europe.”

Within the U.S., there’s a potential for growth beyond point-of-sale retail. “We know a lot about direct-to-consumer through Esurance,” he said, suggesting that the companies together might find ways to expand warranty sales for those customers who chose not to buy protection plans for their devices in a store but regret the decision when they return home.

“If we can pick up one or two of those other things”—be successful in international or direct-to-consumer business, for example—”then our internal rate of return will end up being more than double our cost of capital,” Wilson said.

What About Underwriting Income?

While Wilson highlighted the strategic benefits and an expected overall return on the deal, he said the near-term impact on Allstate’s financial strength and earnings is likely to be minimal—and, in fact, moderately dilutive to net income for three years and accretive after that.

He did not spend a lot of time talking about the prospect of gaining additional income by taking over the underwriting of the protection plans risk, initially saying only that it was currently outsourced to other insurance carriers and that the opportunity to deploy capital in this capacity might emerge over time.

Queried further about whether Allstate had the expertise to underwrite and price the plans during a question-and-answer, Wilson said that the insurers currently involved—CNA and Starr Indemnity—actually provide an excess-of-loss coverage, with the reserves transferred in total to the two insurers. But “the basic economics of making sure that your pricing is giving you a margin by SKU and by retailer resides inside SquareTrade,” he said.

Whether Allstate will take on an underwriting role is yet to be determined, he suggested. “We haven’t firmed that up yet…We don’t have to deploy capital in there, but if we feel like we can get a better return, if it’s better for the company, then we’ll do it,” he said, noting that outsourcing to third parties has squeezed SquareTrade’s margins a little bit.

If Allstate does underwrite the plans going forward, it will take time for any income benefits to show up for the Northbrook, Ill.-based insurer “because we’re not going to go back and insure everything that’s already been written.” In other words, the “reserves will remain with the two other insurance companies,” rolling off in a period of three or four years.

Forcing Strategic Moves at GEICO, Progressive

At one point, an analyst questioned Allstate’s track record on acquisitions, asking Wilson to review past deals in the same price range: a deal for CNA’s personal lines business in 1999; a deal for American Heritage Life in the same year, now Allstate Benefits; and the 2011 deal for Esurance.

Wilson suggested that the positive outgrowth of the Esurance deal has been to force strategic changes at competitors Progressive and GEICO.

“Under our ownership, [Esurance] has become much stronger in the direct-to-consumer branded customer segment.” Premiums are twice what they were five years ago, and the product portfolio was expanded to include homeowners, he said. “I think that’s one of the reasons why Progressive felt a need to start to move into that space.”

While Esurance’s brand measures have all improved, and cost structures too—particularly in claims—the online insurer “has had to deal with higher auto frequency and severity over the past 18 months, just like GEICO.”

The economic deal returns are above our cost of capital” despite recent hiccups on reported earnings. “Would I prefer 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’ve built and how its expanded our strategy [to] give us an ability to compete directly with GEICO and Progressive Direct and force them to make changes in their strategy? Yes.”

As for Encompass, economic returns have been in the low teens—with much of the value coming in the early years when Allstate worked to immediately improve the profitability of a book that had a combined ratio above 115.

Current earnings have suffered, Wilson conceded. “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…

“We need to get that fixed. We need to make more money and get that growing again. But from an acquisition standpoint, it’s turned out OK,” he said, crediting the success in the early years for the decent overall return on the deal.

Finally, describing American Heritage as the deal most similar to SquareTrade, Wilson said revenue crossed $1 billion this year—four times what it was at the time Allstate bought it.

Wilson voluntarily brought up one deal that failed—the acquisition of Sterling, a collision repair business purchased in 2001 for over $100 million and sold in 2014. Promised benefits of new operating practices inside collision repair shops “didn’t help lower claims costs, nor did the new manufacturing methods within the repair shops really work,” he said, noting that knowing when to sell is as important as knowing when to buy.

Why Not Small Business?

Another analyst wondered why Allstate opted for an acquisition in the warranty world instead of a hotter area of small business commercial insurance if the intent was to diversify outside of auto and home.

“I don’t think we need to diversify,” Wilson said, first responding to the premise. “I think it’s smart to find ways to deploy our capital to leverage our skills, capabilities and further our strategy,” he said, going on to reiterate the strategic benefits of finding a consumer- and protection-focused target with “an innovation approach to the market and distribution to meet our customers where they want to buy this stuff.”

Elaborating on the innovative product design SquareTrade brings to the table for retail store sales, Wilson said that the company offers “fully integrated solutions” for a wide range of products with programs that are customized for each retailer in each major product category. Online, the company uses “highly sophisticated data and analytics to maximize growth and profitability,” he said

In terms of M&A, “we’re always looking at alternatives in the marketplace,” but Wilson isn’t enthusiastic about small business commercial. “We have some profit issues in that right now. So I’m not particularly interested in expanding until we can prove we can make money in it.”

Expanding on the strategic benefits of the SquareTrade deal for both companies, he said that having the strength of Allstate behind it will “open even more doors” for SquareTrade, which already has great success in garnering some of the biggest names in retail consumer products sales for distribution. “We think identifying the company with Allstate further strengthens an emerging brand.”

“From a sheer operational horsepower standpoint, being about to expand call centers, use data and analytics—they are quite good at it on the claims side, but we think we have some additional capabilities we can provide to them,” he said.

Although Wilson mentioned SquareTrade’s innovation in the claims area several times, he did not provide specifics on the short conference call. A check of SquareTrade’s website reveals that customers can file claims 24/7 online or over the phone, have their items fixed in five days or less (two days for mobile phones), choose how their items get repaired (by sending it to SquareTrade or taking it to a local repair shop, for example), and get frequent updates throughout the claims process.

And the company is gathering some data on likely claims in advance too. “We have a robot that drops electronic devices and teaches us how they break,” one page of the website says.