Chubb Corporation: Winning Slow and Steady

Chubb Corporation (CB) is an international property and casualty insurer.

-Seven Year Revenue Growth Rate: < 0% 
-Seven Year EPS Growth Rate: 6.4%
-Seven Year Dividend Growth Rate: 9.5%
-Current Dividend Yield: 1.99%
-Balance Sheet Strength: Strong

Chubb continues to be an excellent company, but with the recent stock price growth, I believe that some of the higher yielding companies out there are better values. I think the stock is still reasonable to purchase in the low $80′s where it is now, but that it’s not one of the best purchases on the market currently.

Overview

Chubb Corporation (NYSE: CB) was founded in 1882 as a marine underwriting business in New York, and now exists as an international property and casualty insurance company with over 10,000 employees.

The premise behind an insurance company is that they spread risk out over a wide number of people and businesses. They collect premiums (payments) from clients and in return those clients are covered in case of a serious loss. From an insurance business standpoint, it’s ideal to collect more in premiums than you pay out for losses. This is not the primary form of earnings, though.

An insurance business, after collecting all of the premiums, holds a great deal of assets that, over time, are paid out for client losses. Since they constantly receive premiums and pay out for losses, as long as they are prudent with their business, they get to constantly keep this large sum of stored-up assets as a float. As any investor reading this knows, a great sum of money can be used to generate income from investments, and that’s how an insurance company really makes money. They invest the insurance float in conservative and liquid securities in order to produce business income. Chubb, however, is unusually adept at ensuring that their premiums exceed their payouts, so compared to many other insurers, Chubb receives significant income from their underwriting businesses as well.

Chubb brings in 75% of its premiums from the United States and the other 25% from outside the United States.

Business Segments

Chubb has three business segments, and the executives expect an underwriting profit from each of them.

Commercial Insurance
This segment accounted for $5.1 billion in premiums in 2011, representing 43% of the total. Insurance products are offered for casualty, peril, workers compensation, property, and marine.

Personal Insurance
This segment accounted for $4.0 billion in premiums in 2011, representing 34% of the total. Insurance products are offered for fine homes, automobiles, and possessions.

Specialty Insurance
This segment accounted for $2.7 billion in premiums in 2011, representing 23% of the total. Insurance products are offered for specialty professional liability for companies, institutions, firms, and healthcare organizations.

Ratios

Price to Earnings: 14.6
Price to Book: 1.4

Revenue

(Chart Source: DividendMonk.com)

Revenue has been rather flat over this period, as investment income and premium growth have stalled. This is a common sight among insurers over the last several years ever since the financial downturn, since insurance pricing has been weak.

Year	Premiums Earned	Investment Income	Other Sources
TTM	$11.856 billion	$1.583 billion	$91 million
2011	$11.644 billion	$1.644 billion	$426 million
2010	$11.215 billion	$1.665 billion	$439 million
2009	$11.331 billion	$1.649 billion	$36 million
2008	$11.828 billion	$1.732 billion	($339 million)
2007	$11.946 billion	$1.738 billion	$423 million
2006	$11.958 billion	$1.580 billion	$465 million
2005	$12.176 billion	$1.408 billion	$499 million

Premiums and investment income over this period were basically flat.

Earnings and Dividends

(Chart Source: DividendMonk.com)

Chubb’s average EPS growth per year over this period is 6.4%. It has been somewhat erratic which has mainly been due to an unprecedented amount of storm activity along the northeast portion of the United States over the last few years. Two hurricanes worked their way up the coast to hit high-population areas that normally do not experience storms of that magnitude, and a summer derecho hit certain limited areas with even stronger winds than those hurricanes did.

Speaking from personal experience from living in an area that was hit directly by all three of these recent storms, it has certainly been unusual. There are thousands of fallen trees throughout towns in this area; trees that grew for decades and then fell under this series of storms. There have been some destroyed houses and buildings, power went out for over a week during the summer derecho, and the hurricane damage has been substantial overall. It’s very unusual activity for this area and for much of the northeast portion of the country.

Chubb has been growing the dividend for decades consistently now, but the yield is currently low at 1.99% as they are hitting an all-time stock price high and are due for a dividend increase this quarter. The dividend growth rate over the last seven years has averaged 9.5% per year.

Approximate historical dividend yield at beginning of each year:

Year	Yield
Current	2.0%
2012	2.3%
2011	2.5%
2010	2.9%
2009	2.6%
2008	2.1%
2007	1.9%
2006	1.8%
2005	2.0%

How Does Chubb Spend Its Cash?
Over the last three years, Chubb has spent around $1.4 billion on dividends and nearly $5 billion on share repurchases.

The company began reducing its share count in 2006, starting at around 423 million shares at that point and currently having only 275 million shares. Because Chubb stock tends to trade at a low valuation, their share repurchases have a significant impact on their EPS growth, their book value per share growth, and their reduction in share count. The company’s shareholder yield averages close to 10%.

In many of my reports, I point out mismanagement of money for use on share repurchases. Statistically speaking, most companies tend to buy back more shares when their prices are high, and fewer shares when their prices are low, which is the opposite of what is ideal. Even exceptionally well-run businesses such as Costco(COST) have been known to do this.

Chubb, on the other hand, is one of the rarer companies that make good use of buybacks. Current management consistently has the company repurchase its shares, even during the recession. Because the valuation is low, it continually has a large impact on all of their per-share growth. I’d prefer that their dividend yield was 1-2% higher than it currently is (which would bring the yield up to the 3-4% range), but it’s hard to argue with management’s track record of shareholder returns, and therefore I view the company as being one that makes good use of shareholder money overall.

Balance Sheet

Chubb Corporation maintains a rather strong balance sheet.

The total debt they hold is less than 25% of equity, and goodwill makes up a negligible portion of equity. Their credit rating is AA, their underwriting quality tends to be at the top of the industry

I don’t often chart book value for companies, but for Chubb it’s worth doing so:

(Chart Source: DividendMonk.com)

Investment Thesis

Chubb has a business model that is slightly different than some other insurers. The premiums they charge tend to be a bit high, but they typically offer superior claim service. They strive to be the gold standard of the industry, and are one of the largest businesses in the industry. Management insists on a culture where the company does not chase premium growth at the expense of having to under-charge on insurance products. The company conservatively allocates its resources, and has weathered mass asbestos claims, hurricane Katrina, and the economic crisis of 2008. The company has significant market share among high net worth individuals, which includes insurance of expensive homes and cars, as well as personal liability insurance of large amounts.

The company has stated that they focus primarily on bottom line growth; profitability. They look to boost premiums where possible, but not at the expense of profitability. Their business model has been summed up as follows by the son of the founder of the business:

The way to success is to select good risks and cover them. Obviously this does not lead to great size, but it should produce profitable business.
-Percy Chubb, 1857-1930

By offering great claim service for slightly higher premiums, the company hopes to be looked upon as the select company in their various niches. This is working quite well for their Masterpiece policy, which is an insurance product for the affluent.

I find that many insurers are having stagnant premium growth over the last several years. Many businesses have gone out of business or have decreased in size, which means less insurance demand. Less demand for insurance means lower premiums. In addition, interest rates have been held unusually low for an unusually long period of time due to the recession, and this affects the interest income on insurance portfolios, which is generally the primary source of income for an insurance company. Chubb is a bit buffered from that by their strong underwriting standards (they earn meaningful profits aside from interest), but the low interest environment still does negatively affect them.

Chubb’s policy of strong underwriting principles and an inflexibility with regards to lower premiums to capture market share leads to weakness in soft insurance markets, and leads to strength in stronger insurance markets. Basically the whole second half of the last decade was difficult for Chubb, but I believe that over the long term, their fortunes will improve. Their international expansion is good news, and I believe that Chubb will rebound as businesses become stronger. Over the long term (2+ years away), higher interest rates should act as a minor tailwind as well.

To contrast the lack of top line growth, Chubb stock has basically been priced for no growth, meaning that the entirety of shareholder returns have come from their shareholder yield (dividends + buybacks).

Risks

All companies face risk. Insurance companies are businesses about reducing risk and spreading it out, and they even insure their own operations against risk. Chubb faces the risk of a continued difficult global economy, as well as catastrophic losses, continued low interest rates, lack of premium growth, and currency risk. If their underwriting quality were to decrease, it would have a negative impact on profitability.

Insurance companies have little to no competitive advantages, or moats. Their insurance products are basically a commodity. What’s worse, is that customers often don’t get to appreciate the difference in quality of products until a claim is filed. Chubb specializes and has a great reputation in certain niches and is among the largest in its industry, which reduces risk, but it doesn’t provide a convincingly robust long-term competitive advantage in my view. Chubb is as good as its management is at any given time. Fortunately, the company has had a history of good management in my opinion, present management included.

Over the last few years, the heavily populated northeastern United States has been struck by an unusually high amount of storm activity. If this is a somewhat permanent shift in weather patterns rather than a large statistical anomaly over the last few years, then Chubb and other insurers will have to increase their premiums throughout the area to offset these losses and to maintain the excellent underwriting profitability that Chubb has been known for.

Conclusion and Valuation

The Chubb report I published over two years ago called Chubb a solid buy at around $56/share. Last year when the price was at $68/share, I stated that although it wasn’t quite as appealing, it was still a stock I’d buy at that price. Now that the stock is close to $83/share, I’m a bit less favorable towards the valuation. The stock is hitting its all-time high price, it has endured several strong storms, and the dividend growth rate is a bit underwhelming.

Using the Dividend Discount Model, we’d have to start with an estimate for the long-term dividend growth rate and an appropriate discount rate. The EPS growth has averaged under 6.5% for the last seven years while the dividend growth rate has been more like 9.5%. Last year’s dividend increase was a bit disappointing, at only around 5%. The dividend growth cannot outpace EPS growth indefinitely, but at Chubb’s low valuation, the dividend could potentially continue with a growth rate in the upper single digits.

An estimate of 7% dividend growth and a 9% discount rate (target rate of return) sets the fair price in the mid-high $80′s; a few dollars above its current price. But due to the low yield of this stock, the calculated fair value is very sensitive to estimated dividend growth rates and the discount rate that’s used. If we set a slightly more aggressive 10% discount rate, the fair value drops to under $60.

I believe that Chubb is a very well-run business, and would make a decent investment at the current price in the low $80′s to offer long-term returns in the high single digits. However, for investors targeting at least low double digit returns, I believe there are better investments out there, and it would be prudent to hold off for now and revisit Chubb on a stock price dip.

Full Disclosure: As of this writing, I am long CB.

You can see my dividend portfolio here.

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