Published on July 9th, 2015
Investors love acquisitions, and for good reason.
If you own the acquired company, your holdings typically see large returns. If you own the acquirer, potential synergies promise ever-higher earnings-per-share in future years.
ACE Limited (ACE) recently announced it will acquire Chubb Group (CB) for $28.3 billion. Chubb stock jumped from around $95 a share to around $121; a gain of around 27%.
Chubb stock has long been a Sure Dividend favorite. In June of 2015, it was the 2nd highest ranked stock in the Sure Dividend newsletter (prior to the ACE acquisition announcement).
I told my readers to sell Chubb now and reinvest the proceeds into other high quality dividend growth stocks. The rationale for that decision is explored in detail below.
In 1882 a father-and-son team founded Chubb. Since that time, the company has grown to become a large multinational property and casualty insurer with 10,200 employees and $2 billion in annual income.
The company has grown over the last 133 years by being a conservative insurer that never risks ‘blowing’ up by writing unprofitable policies. Chubb’s slogan is “never compromise integrity”.
The combined ratio in insurance is the sum of expenses and claims paid divided by premiums received. A combined ratio under 100% shows that an insurer is writing profitable policies before accounting for investment gains from invested float.
Chubb has maintained a combined ratio under 100% every year since 2002. All investment income has gone straight to the bottom line for Chubb over the last 13 years.
Chubb is able to maintain a combined ratio below 100% by focusing on niche property and casualty insurance markets. The company looks for profitable policies rather than growth-at-any-cost.
Before the ACE acquisition, Chubb was actively buying itself through share repurchase. The company has repurchased about 6% of shares outstanding in the last 12 months. This combined with the company’s dividend yield of ~2% gave investors a shareholder yield of 8%.
Chubb was able to return virtually all of its earnings to shareholders due to its conservative policies. The company operates a low-risk business that produces substantial free cash flows.
Chubb is a Dividend Aristocrat thanks to its 33 years of consecutive dividend increases. The company tends to perform well through all types of economic environments. Chubb was not significantly affected by the 2007 to 2009 recession. The company’s book-value-per-share through each year of the Great Recession is shown below to illustrate this point:
- 2007 book-value-per-share of $38.56
- 2008 book-value-per-share of $38.13
- 2009 book-value-per-share of $47.09
Merger Arbitrage Details of ACE-Chubb Acquisition
The terms of the pending ACE acquisition are as follows:
- $62.93 in cash per Chubb share
- 0.6019 shares of ACE per Chubb share
ACE shares are currently trading at a price of $103.31. This implies a transaction price of $125.11 per Chubb share. Chubb shares are currently trading at a price of $121.23. The transaction is expected to close in during the 1st quarter of 2016.
If ACE’s share price remains constant, the transaction will give investors a return of 3.2%. Shareholders will also receive dividends from Chubb stock of $0.57 a share in September and December of 2015. This boosts Chubb stock’s total return to 4.1% if held until closing.
If the deal does close around the midway point of the first quarter of 2016 (around February 15), there are a total of 222 days between now and the close. On an annualized basis, holding Chubb stock until the acquisition closes will return around 6.8% a year.
This analysis assumes the acquisition will close without a hitch, which is not guaranteed. I am not an expert in merger arbitrage, so I don’t know the odds of this acquisition closing on time, or closing at all. Either delays or a cancellation of the deal will result in investors not getting their 6.8% annualized return from holding Chubb shares. Therefore, we can now that Chubb stocks expected total return is less than 6.8% annualized.
Investors who sell Chubb stock now eliminate the risk that the acquisition will not close or will be delayed. Selling now locks in gains from the acquisition while eliminating risks. Holding Chubb to the date of acquisition reminds me of an old investing adage:
“Don’t pick up pennies in front of a steamroller”
ACE Limited Business Overview
For investors who do want to roll their Chubb holdings into ACE, the company is examined here.
ACE is a $34 billion global insurance and reinsurance business. The company was founded in 1985 and has paid steady or increasing dividends for 22 consecutive years.
ACE stock currently has a dividend yield of 2.6% and has a price-to-book ratio of 1.15. The company has experienced rapid growth over the last decade. ACE Limited has compounded book-value-per-share at 13.5% a year over the last decade.
The Chubb acquisition will very likely result in continued growth for ACE shareholders. Like Chubb, ACE has maintains a low combined ratio. Over the last decade, ACE’s combined ratio has averaged 91.3% versus 89.8% for Chubb.
Chubb and ACE are both large insurers. The acquisition will result in significant cost savings from overhead reductions (meaning layoffs). The company expects to save $650 million a year from better efficiencies by 2018. This is no insignificant amount. The combined company will have net income of around $4.8 billion before cost savings. Cost savings could boost the company’s bottom line by around 14%.
Additionally, ACE (and other insurers) stand to gain from rising interest rates. The Federal Reserve is widely expected to raise rates in the next year. When rates rise, insurers will be able to invest their float in securities with higher yields than are available today. This will boost the bottom line and should increase insurer share prices.
The acquisition of Chubb by ACE will likely be accretive for ACE. ACE shares appear to be fairly valued at this time, and the company has attractive total return potential given expected synergies from the pending acquisition.
The reason to sell Chubb stock now rather than hold to gain access to ACE shares is to lock in share price gains from the recently announced acquisition. There is a chance the acquisition could fall through – resulting in Chubb’s share price declining significantly.