Cincinnati Financial Corporation (NASDAQ:CINF) has increased its dividend for 54 consecutive years, an impressive streak that only eight U.S. public companies can match.
With a 3.4% dividend yield, a large base of recurring revenue, and excellent free cash flow generation, CINF is the type of stock we like to own in our Top 20 Dividend Stocks portfolio.
Even though the number of funds with long positions in CINF went up by five during the third quarter of the last year, the stock remains to be overlooked by the majority of investors in the Insider Monkey database. A total of 23 funds reported owning shares of the company as of the end of September, amassing 7.40% of the company. First Eagle Investment Management disclosed holding 9.56 million shares of CINF in its last 13F filing.
Business Overview
CINF was formed in 1950 and is among the top 25 U.S. property casualty insurers today, offering business, home, and auto insurance. Insurance companies make money by writing and selling insurance policies (which typically breaks even or loses money for most insurers), and investing policy proceeds for income until claims need to be paid out (this is where the money is really made). Local independent insurance agencies market CINF’s policies within their communities, which span across nearly 40 states.
The company’s mix by premiums written in 2014 was 67% commercial, 25% personal, 5% life, and 3% excess & surplus. By state, 18% of CINF’s premiums came from Ohio, 7% from Illinois, 6% from Indiana, 6% from Pennsylvania, 5% from North Carolina, 5% from Georgia, and 5% from Michigan.
Business Analysis
Insurance companies live and die by managing risk. If insurers fail to price risk accordingly in their policies, they won’t be around for long. Compared to some insurers, CINF’s underwriting process is somewhat more aggressive because the company targets a combined ratio of 95% to 100%, which means that it expects its policies to be slightly profitable at best (when a combined ratio is below 100%, the company achieves an underwriting profit).
However, as seen below, CINF’s combined ratio has outperformed the industry all but one of the past five years. The company has also produced 26 years of favorable loss reserve developments, which means it has conservatively booked more losses than it has actually realized each year. CINF’s reinsurance program also limits its losses beyond certain thresholds, and its pristine balance sheet provides additional comfort.
Source: CINF Investor Presentation
In addition to CINF’s proven risk management track record, the company has several other competitive advantages. Its large size (CINF is one of the 25 biggest U.S. P&C insurers) provides economies of scale in marketing, administrative operations, and support staff. CINF is able to spread these costs over a sizable pool of insurance policies to keep its prices very competitive. CINF is also able to price its premiums lower than smaller competitors because its risk is reduced with a larger pool of policies.
Furthermore, the company’s long operating history, range of insurance products, and size provides branding benefits and trust with the agencies that market CINF’s policies. Establishing and supporting relationships with agencies takes significant time and cost but provides CINF with relatively low-cost distribution advantages.
CINF has over 1,500 agency relationships in nearly 2,000 locations across the country and does everything possible to support them. The company doesn’t compete with agencies by selling online or direct to consumers and employs nearly 3,000 associates who provide support to field associates. As a result, CINF is the number one or number two carrier by premium volume in nearly 75% of agencies partnered with it for five years or more, although an agency may represent dozens of carriers.
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As seen below, Cincinnati Financial Corporation (NASDAQ:CINF) has also been effective at expanding its market share with agencies over time. CINF says that its net amount of agency relationships has increased by 28% since the end of 2009 and that it still only has about 11% market share of the estimated $39 billion total P&C premiums produced by currently appointed agencies, leaving plenty of room for future expansion of relationships.
Source: CINF Investor Presentation
In addition to effective distribution channels, the insurance market also requires strict compliance with regulations and substantial amounts of capital to compete. A large pool of policies and financial assets are needed for an insurer to be able to pay out claims and survive catastrophes, creating barriers to entry for new players.
While catastrophic events can strike at any time, some states are more prone to them than others. For example, California and Florida are frequently hit by earthquakes, hurricanes, and other natural disasters. One of the things we like about CINF is that it has no presence in California and a minimal presence in Florida. Most of its operations are in the Midwest, perhaps reducing its exposure to catastrophes.
Finally, the mature state of the P&C insurance market provides another advantage for CINF. When a market’s growth rate is low, new entrants have to steal market share from incumbents to gain a foothold. CINF’s policy renewal rate is between 80% and 90% most years, providing a solid base of recurring revenue that helps it keep its policy prices competitive and market share stable. Insurance is also a product that is always in demand regardless of economic cycles, which has helped CINF generate consistent results.
Key Risks
The insurance industry goes through pricing cycles, which significantly impacts its profitability. Insurance is essentially a commodity, so pricing follows supply and demand. Demand is generally stable given the non-discretionary nature of insurance, so supply is the main driver.
When insurers have a healthy pool of profits, strong capital reserves, and excess underwriting capacity, they are more apt to lower pricing to chase market share. This environment typically results from several years of minimal natural disasters and catastrophes.
After a period of catastrophes and tighter capital conditions, there is less underwriting capacity in the market as insurers look to improve their financial condition. These periods are marked by better profitability and more rational pricing. CINF must put up with this cyclicality and remain disciplined with its pricing of risk and balance sheet strength, regardless of market conditions.
Of course, unexpected catastrophes are the biggest risk faced by insurers. A “perfect storm” can wipe out smaller, less disciplined players completely. As we mentioned earlier, CINF is fairly well diversified with the states it does business in, avoids some of the riskier ones like California, and has a long operating history which adds to our confidence in its conservative underwriting process. Even still, record high catastrophe losses in 2011 caused CINF’s payout ratio to spike over 150% – you can never be too sure with insurers. A.M. Best also noted that 2013-2015 marks the first time since the early 1970s that the industry’s underwriting has been profitable in three consecutive calendar years – perhaps the next underwriting profit cycle is about to begin.
Underwriting aside, CINF does have more risk with its investment portfolio than many other insurers because it has around 30% of its portfolio in common stocks (most other insurers invest 10-20% of their portfolio in stocks). The portfolio is diversified (no stock is more than 3.6% of the portfolio) and invested in dividend growth stocks (all 50 stocks raised their dividend last year), but these investments are still more volatile than investment grade bonds.
Finally, it’s worth noting that while the insurance industry is generally slow to change, it is changing. Technology is leading to more advanced data models that are pricing risk more efficiently on a policy-by-policy basis, which will only result in more competition for accounts with the best risk profiles.
Furthermore, CINF is completely dependent on independent agencies to sell its insurance policies. According to the Independent Insurance Agents and Brokers of America, independent agencies write about 60% of overall U.S. property casualty insurance premiums today.
However, we expect more policies to be purchased online over the coming decade. Selling policies online can result in lower prices and greater profits for insurers because they do not need to pay commissions and can save labor costs as well.
Overall, CINF’s financial conservatism and long-standing customer and agency relationships help mitigate many of these concerns.
Dividend Analysis
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. CINF’s long-term dividend and fundamental data charts can all be seen by clicking here.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
CINF’s dividend is safer than most company’s dividends with a Safety Score of 65. Over the last four quarters, CINF’s dividend has consumed 59% of its earnings and 39% of its free cash flow. These are reasonable payout ratios, but we wouldn’t want to see them move much higher given the risk of unexpected catastrophe events hitting profits like they did in 2011 (see below).
Source: Simply Safe Dividends
Source: Simply Safe Dividends
One of the things we like about insurance is that it is always in demand regardless of economic conditions. We can see that CINF’s sales fell by 10% during fiscal year 2008 but increased by 2% in 2009. The stock also outperformed the S&P 500 by 14% in 2008 and raised its dividend.
However, CINF’s investment portfolio (remember its above-average exposure to equities?) performed poorly and the company was hit with underwriting losses that caused earnings per share and free cash flow per share to drop by 47% and 26%, respectively, in fiscal year 2008. While CINF’s sales don’t fluctuate too much, its profits are clearly impacted during recessions.
Source: Simply Safe Dividends
Importantly, CINF’s business model generates solid free cash flow in any environment. Even during the depths of the financial crisis, CINF generated enough free cash flow per share ($2.74) to more than cover its current annual dividend payment ($1.84). However, the chart below also highlights the impact that record high catastrophe events can have on the business (see fiscal year 2011).
Source: Simply Safe Dividends
While the insurance industry has numerous attractive characteristics, it is still a commodity product. As seen below, CINF’s return on invested capital has remained positive but under 10% since fiscal year 2008. While the company is still creating value for shareholders, its return on capital will always be constrained by the industry’s dynamics.
Source: Simply Safe Dividends
Finally, CINF’s balance sheet is in great shape. The company’s debt to capital ratio is a conservative 12%, and it could cover its entire debt balance with cash on hand and less than half a year of earnings before interest and taxes. CINF also has strong credit ratings with S&P and Fitch. This is important given the unpredictable nature of catastrophe events in the insurance industry.
Dividend Growth Score
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
CINF’s dividend Growth Score of 74 suggests that the company’s dividend has above average growth potential. CINF has raised its dividend for 54 straight years and is a member of the dividend aristocrats list and the dividend kings list. Fewer than 10 U.S. public companies have achieved such a lengthy dividend growth streak, putting CINF in quite the exclusive club.
The company has increased its dividend by 3-5% per year over the last five years but most recently rewarded investors with a special dividend in December 2015, resulting in 30% total dividend growth in 2015.
Source: Simply Safe Dividends
Going forward, however, we would expect dividend growth to match earnings growth, which will likely remain in the mid-single digits.
Valuation
CINF trades at 16x forward earnings and has a dividend yield of 3.4%, which is below its five year average dividend yield of 4.0% but not bad for investors living off dividends in retirement. The company also has a price to book ratio of 1.4, which is higher than its peer group’s average ratio of 1.2.
For a mature insurance business, CINF appears reasonably priced today but is not a bargain. We think the company can continue growing its revenue by 3-4% per year as it adds more agencies and new lines of insurance products (e.g. tailored policies for high network individuals; reinsurance).
With a reasonable amount of operating leverage and potentially some help from higher interest rates over the next 5-10 years, earnings per share could compound at a mid- to upper-single digit rate, resulting in total return potential of 8-10% per year.
Conclusion
Cincinnati Financial Corporation (NASDAQ:CINF) is a well-managed insurance business that has been a sound bet for safe, growing dividend income for more than half a century. The insurance industry experiences its fair share of performance cycles, but CINF has proven to be a disciplined risk taker with both its underwriting and investment portfolio. Overall, we think this blue chip dividend stock remains a reasonable bet for income investors.
Disclosure: None
