Published by Bob Ciura on October 12th, 2017
Cincinnati Financial has increased its dividend for 57 years in a row. It is a Dividend Aristocrat, a group of stocks in the S&P 500 Index, with 25+ consecutive years of dividend increases.
Not only that, but Cincinnati Financial is also a member of the Dividend Kings, an even more exclusive group than the Dividend Aristocrats. Dividend Kings have increased their dividends for 50+ consecutive years. There are just 22 Dividend Kings, including Cincinnati Financial. You can see all 22 Dividend Kings here.
Cincinnati Financial’s dividend track record is the stuff of legends. And yet, the stock does not appear to be a strong buy right now. The reason is because its valuation has expanded considerably in the past few years, above its underlying earnings growth rate.
Cincinnati Financial is an insurance company, founded in 1950. It offers business, home, and auto insurance, as well as financial products including life insurance, annuities, and property and casualty insurance. Revenue is derived from five sources:
Source: 2017 Chairman’s and CEO Letter, page 4
The company has a profitable business model. Instead of focusing solely on high-margin products, Cincinnati Financial is willing to write lower-margin policies. It earns a high level of profit by issuing high volumes and taking market share.
In addition, as an insurance company, Cincinnati Financial makes money in two ways. It earns income from premiums on policies written, and also by investing its float, the large sum of premium income not paid out in claims.
This has led to steady growth over many years. From 2012-2016, Cincinnati Financial grew earnings-per-share by 6.7% each year. There should be room for continued growth up ahead.
In 2016, Cincinnati Financial increased total revenue by 6%, but higher costs drove earnings-per-share down by 7% for the year.
Financial results have remained mixed to start 2017. Total revenue increased 6% over the first six months, driven by a 5% increase in revenue from policy premiums. But earnings-per-share declined by 3% over the first half, compared with the same period last year.
Cincinnati Financial has a positive growth outlook moving forward. Growth should continue to come from new policies written. Price increases helped grow revenue from premiums over the first two quarters.
Rising interest rates will also give the company a boost.
Interest rates are already on the rise, which will help Cincinnati Financial earn more income from its investment portfolio.
Source: 2017 Investor Handout, page 13
Investment income has risen steadily since 2013, and increased 2% over the first half of 2017. In 2016, Cincinnati Financial earned an average pre-tax yield of 4.6% on its bond investments. If interest rates continue to rise, the company could generate higher yields from its investment portfolio.
One potential negative catalyst is the recent severe weather in many parts of the U.S., including the recent floods. This has impacted multiple customer regions, which has caused elevated losses.
Loss expenses increased 11% over the first half of 2017, a big reason for the decline in earnings-per-share in that time.
Sharp increases in losses could continue to hamper Cincinnati Financial’s earnings growth over the remainder of 2017.
Competitive Advantages & Recession Performance
There are not many identifiable competitive advantages in the insurance industry, other than brand recognition. There are not very high barriers to entry in insurance, which leads to fierce competition.
Fortunately, Cincinnati Financial has decades of experience, and has built a close relationship with its customers.
Insurance companies are not immune from economic downturns. Cincinnati Financial does not have a highly recession-resistant business model. Earnings-per-share during the Great Recession are below:
- 2007 earnings-per-share of $3.54
- 2008 earnings-per-share of $2.10 (41% decline)
- 2009 earnings-per-share of $1.32 (37% decline)
- 2010 earnings-per-share of $1.68 (27% increase)
As you can see, earnings declined significantly from 2008-2010. That said, it did remain profitable during the recession, which allowed it to continue increasing dividends each year.
And, the company enjoyed a strong recovery in 2010 and thereafter, once the recession ended.
Valuation & Expected Returns
Cincinnati Financial stock has performed very well over a long period of time. Shares have doubled in the past five years. Looking back further, $1 invested in the stock in 1987, would be worth more than $50 including reinvested dividends.
Source: 2017 Annual Shareholder Meeting Presentation, page 25
The stock has trounced the broader S&P 500 Index in the past 30 years. However, its growth has been subdued in recent years, which means it now trades for a relatively high valuation.
Cincinnati Financial currently holds a price-to-earnings ratio of 22, which is above its multi-year average. According to Value Line, the stock held an average price-to-earnings ratio of 16 since 2001.
This means Cincinnati Financial currently trades at a 37% premium to its 16-year average.
Aside from changes in the price-to-earnings ratio, returns will be generated from earnings growth and dividends. A potential breakdown of total returns is as follows:
- 3%-5% insurance revenue growth
- 1%-2% investment income growth
- 1% margin expansion
- 2.6% dividend yield
Assuming a steady valuation multiple, total returns could reach approximately 8%-11% per year. However, if Cincinnati Financial’s valuation multiple contracts toward its historical average, it could significantly reduce shareholder returns.
Cincinnati Financial stock enjoys a strong reputation for its long history of dividend growth. Over the past several years, its rate of dividend growth has slowed, along with earnings growth.
For example, from 2012-2016, the company raised its regular dividend by 3% each year, compounded annually. With a 2.6% current dividend yield, the stock does not offer an appealing mix of dividend yield and growth.
Cincinnati Financial is a steady company with a consistent dividend payout, and the ability to raise the dividend modestly each year.
While the company has a strong business model and is solidly profitable, it does not seem to be a particularly attractive stock from a value, yield, or growth standpoint.
Overall, investors interested in buying this stock should certainly wait for a lower valuation and higher dividend yield