In part 35 of the Dividend Aristocrats In Focus series I take a closer look at the operations of property and casualty insurer Cincinnati Financial (CINF, Financial). Cincinnati Financial is a mid-sized insurer with a market cap of about $8.3 billion. The company was established in 1968 and has increased its dividend payments for 53 consecutive years. Cincinnati Financial sells insurance policies through its network of independent agents. The company’s operations are analyzed in detail below.
Business overview
Cincinnati Financial operates in five main segments: commercial insurance, personal insurance, excess and surplus insurance, life insurance and investment operations. The percentage of pretax income each segment has contributed to Cincinnati Financial’s total operations through the first nine months of fiscal 2014 is shown below:
- Commercial insurance: 17% of pretax profits
- Personal insurance: N/A, operating at a loss
- Excess and surplus insurance: 4% of pretax profits
- Life insurance: 7% of pretax profits
- Investment operations: 72% of pretax profits
Cincinnati Financial’s investment operations have driven earnings through the first nine months of 2014. The company invests insurance premiums collected but not yet paid out, called “float,” through its investment operations. The company holds about 27% of its investment portfolio in blue chip equities, with the remainder in corporate and government debt securities. Cincinnati Financial has benefited greatly over the five-year bull market as over 25% of its portfolio is in equities.
Competitive advantage
Cincinnati Financial has maintained a combined ratio over 100% for much of the last seven years. The company’s insurance operations have been operating at a loss in an effort to attract more business. The company has maintained its profitability and long streak of dividend increases through its investment operations. While the company’s investment operations aren’t a competitive advantage over other insurance agencies, they have helped Cincinnati Financial grow to its present size.
Cincinnati Financial does not stand out from other insurers as it has not been able to consistently maintain profitable underwriting operations. The company invests a sizeable amount of its float in equities, but this by itself does not make the stock stand out from other insurers, either. Finally, the company sells insurance through its network of independent agents. The company’s long history and relationships built with agents form a weak competitive advantage. It would be difficult for a new insurance business to replicate these relationships, though many of Cincinnati Financial’s competitors can and do have similar relationships and networks.
Cincinnati Financial has had a long run of success not because it has been able to consistently outperform other insurance companies but because it operates in the slow-changing insurance industry. Cincinnati Financial has focused on dividend growth and investment portfolio management to reward shareholders.
Growth prospects
Cincinnati Financial has seen poor growth over the last decade. The company has still not eclipsed its book value per share high it set in 2006. Cincinnati Financial benefits from bull markets due to its significant exposure to equity markets. The company may generate higher investment income when interest rates rise and it can reinvest its float into higher-yielding debt securities.
The company tends to write unprofitable insurance policies in order to build its float and generate investment income. Rising premium income will be the long-term driver of the company’s growth. The company has managed to grow premium income at about 5% a year over the last decade. I expect Cincinnati Financial to keep a similar pace over the next decade as it continues to leverage its network of impendent sales agents for new business.
Dividend analysis
Cincinnati Financial currently has a strong dividend yield of about 3.5%. The company also has a high payout ratio of about 74%. Worse yet, EPS have been highly volatile over the last decade due to over reliance on fluctuating investment income. If the business again sees earnings decline, the company’s dividend increase streak will be in jeopardy. Cincinnati Financial’s long-term growth prospects look relatively uninviting. I would not expect the dividend to grow faster than about 5% a year over the next several years.
Recession performance
Cincinnati Financial saw its earnings drop during the last recession as it wrote a significant number of unprofitable policies and suffered underwriting losses through the Great Recession of 2007 to 2009. The company saw EPS decline from a high of $3.54 in 2007 to a low of $0.74 in 2011. EPS have still not recovered to the high mark set in 2007 as the company has seen underwriting losses each year since 2007.
Valuation
Cincinnati Financial is currently trading at a PE ratio of over 20, above the S&P 500’s PE ratio of 19.6. The company has traded at a discount to the overall market for 8 of the last 10 years. In light of Cincinnati Financial’s lack of a strong competitive advantage and poor growth prospects, believe it should trade at a discount to the overall market, like most insurance businesses. It current prices, I believe Cincinnati Financial to be substantially overvalued.
Final thoughts
Cincinnati Financial is rated very poorly based on The 8 Rules of Dividend Investing and should be sold. The company has a relatively high price standard deviation of 30%, a high payout ratio of about 74% and lackluster growth prospects. As an alternative in the property and casualty insurance field, I prefer Chubb (CB, Financial). Chubb has maintained profitable underwriting operations for over a decade and trades at a PE ratio of just 12.5. Additionally, the company has stronger historical growth numbers than Cincinnati Financial and a lower price standard deviation.
