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Why Market Trajectory Is No Guarantee for Profitability

April 23, 2014 | About:
Patricio Kehoe

Patricio Kehoe

7 followers

Once an industry leader in annuity products, Hartford Financial Services Group Inc. (HIG) has faced some hardship over the past years, as competitors like Berkshire Hathaway Inc. (BRK.A) and American International Group Inc. (AIG) entered the market with their life insurance and annuities offerings. Thus, the firm has recently started selling off these segments, in order to focus on the more profitable businesses: casualty and property, group benefits and mutual services.

While the company’s distribution system via financial institutions, direct Internet sales, affinity groups and independent agents is growing, Hartford’s significant losses during and after the financial crisis of 2009 has made many investment gurus like Diamond Hill Capital (Trades, Portfolio) and Jim Simons' (Trades, Portfolio) hedge fund sell out their company shares to avoid further losses.

Of Hurdles and Opportunities

Having sold off its life insurance and annuities business, Hartford’s new business mix is now upheld mainly by its property and casualty segment, which lacks competitive advantages, thereby making excess economic returns an unlikely matter. Furthermore, the company’s low equity to assets ratio could be a problem under financial stress, requiring the firm to raise capital once more and exposing it to a possible meltdown in the case of another economic crisis. However, Hartford has been taking reasonable measures to balance out its business and generate profits, like raising asset prices, hedging of its legacy variable annuity business and surrendering policies. But one of the most efficient and promising developments seen in the past quarters is the firm’s policy retention metrics. While these suffered severely in the past years, due to the re-priced business, the now solid retention and pricing increases combined might help stabilize the company’s core revenue.

Hartford’s quarterly earnings report showed some signs of improvement, compared to the same quarter for 2012, where the P&C segment suffered mainly due to the substantial losses incurred through Hurricane Sandy. However, for fourth quarter fiscal 2013, the segment’s combined ratio improved from 95.4% to an average 93.2%, and net income closed at $314 million on $6.1 billion of revenue. On another note, last week the company entered in a six-year agreement with IBM Corp. (IBM), in the hopes of increasing its operational efficiency and gaining a competitive advantage over other insurers. As such, the firm will pay IBM $500 million for a private, cloud-based infrastructure, which will reduce operational expenses and enable better data storage. And while I applaud management’s decision to increase effectiveness, I remain preoccupied about the company’s debt levels, which are currently at $6.2 billion compared to the $1.2 billion cash flow.

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Valuation

Despite Hartford’s efforts to increase profitability in the long run, I remain skeptical that it will be a worthwhile investment compared to other industry players. While the premium compound annual growth rate will average 3.5% until 2019 and mutual fund fee revenue will grow annually at a 6% rate, 2013’s reported operating margin, net margin and returns on equity all closed below the 1% mark, which is discouraging.

Furthermore, considering the low levels of profit seen over the past few years, the stock is trading at an extremely high price premium of 244% relative to the industry average of 10.9x. Therefore, I consider this company to be highly overvalued and believe investors stand a better chance at gaining profits from other (and cheaper) industry competitors.

Disclosure: Patricio Kehoe holds no position in any stocks mentioned.

About the author:

Patricio Kehoe
A fundamental analyst at Lone Tree Analytics

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