Travelers Is Undervalued And Growing Healthily (NYSE: TRV)

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The Travelers Companies, Inc. (NYSE: TRV) is one of the largest property & casualty companies in the country. Although the property & casualty industry is highly fragmented and competitive, the peculiar nature of it allows insurers to earn economic profits. The industry has shown positive results despite struggling with a return of non-catastrophic losses to pre-pandemic losses. Travelers is an elite performer in the industry, with underwriting profits and healthy investment income providing the basis for the creation of shareholder value. Management’s interests are aligned with investors and they have given cash back to investors in the form of dividends and share repurchases at aggressive rates. Travelers’ free cash flow is substantial and supports the business’s dividend and share repurchase program. Free cash flows are also undervalued, along with the company as a whole.

Insurance: Where Competition Doesn’t Hurt Profitability

Peter Thiel rightly argues that “competition is for losers”. Competition drives returns toward the cost of capital, making it hard, if not impossible to create economic value. On the face of it, the insurance industry should be a highly unprofitable industry. According to the National Association of Insurance Commissioner (NAIC), Travelers is the sixth largest property and casualty firm in the United States, with just 3.96% market share. The insurance industry is highly fragmented. NAIC’s 2020 Market Share Report lists 125 major property & casualty insurers offering products and services across all lines.

Source: NAIC

Source: NAIC

In Travelers’ 2021 10-K filing, they cite statistics from AM Best showing that there are around 1,100 property and casualty groups in the United States, comprising approximately 2,600 property and casualty companies. In 2020, the top 150 insurers account for around 94% of the industry’s total net written premiums. If competition is for losers, then on the face of it, the insurance industry is a loser’s industry.

However, the insurance industry is special. Insurance is required by law, so the business tends to be relatively stable. Regardless of the business cycle, people and businesses need insurance. This gives insurers pricing power which they would otherwise not have.

Insurance products lack any real differentiability. Success is won through a combination of agent recommendations, costs and brand awareness. Agent recommendations matter because most people get their insurance through an agent. Insurers need agents to swing business their way. Because differentiation does not really exist, insurers have to be able to price their products at cheaper rates than their competitors. Brand awareness matters because insurance is about trust and strong brands tell consumers that they can trust the insurer.

Property & Casualty Is Recovering From the Pandemic

The industry showed good premium growth and solid financial results in 2021, despite the disruptions the industry suffered from.

The industry accelerated its adoption of new technology, spurred on by the pandemic, and the need to adapt to supply chain disruptions. These innovations are aimed at helping insurers better price policies, enhance efficiencies and drive down costs.

According to Aon (NYSE: AON), total premium growth in the first nine months of the year was 9.5%, up 7.3 points from the same period in 2020. Commercial lines grew at 9.8%, compared to personal lines which grew at 4.8%. As the economy rebounded, the sector also experienced growth in commercial and personal auto as well as worker’s compensation. Travelers is the market leader in workers’ compensation, with 6.84% of the market. It is also the second largest insurer in total commercial auto, with market share of 6.22%. It is the tenth largest insurer in total private passenger auto, with a market share of 1.96%.

The industry experienced a $ 5.6 billion net underwriting loss due to a return of non-catastrophe losses to pre-pandemic levels. However, net income for the industry grew by 8% in the first nine months of 2021, from $ 35.5 billion in 2020 to $ 43.5 billion in 2021, fueling a growth in policy surplus to 73%. Total expense ratio stayed at 38.4%.

Aon’s reporting also shows that direct loss ratios across the bulk of lines in the first nine months of 2021 were lower than in the same period the year prior.

Source: Aon

Source: Aon

The Path to Profitability

According to Travelers Fourth Quarter 2021 Results, in 2021, Travelers had a loss and loss adjustment ratio of 65.1%, unchanged from 2021, and an underwriting expense ratio of 29.4%, down from 29.9% in 2020, for a combined ratio of 94.5% compared to 95% the year prior. For reference, according to a report by Verisk, the property & casualty industry had a combined ratio of 99.5% in the first nine months of 2021.

An insurer earns its money from underwriting and investment activities. The premiums paid by policyholders make up a float that insurers can use to invest. Underwriting profits arise when the insurer receives more in premiums than they pay out in claims.

Travelers earns a profit from its underwriting activities and invests these profits into a portfolio made up largely of fixed income instruments. Travelers has grown premiums from more than $ 28 billion in 2018, to nearly $ 30.9 billion in 2021. At that time, net investment income has grown from approximately $ 2.5 billion to over $ 3 billion.

The company’s combined ratio reflects the business’ profitability and its 5.5% underwriting margin.

The company’s underlying combined ratio, which is less catastrophic losses, was 90.3%, which shows that the company’s writing has been particularly good, having improved on an already impressive underlying combined ratio of 90.7% the year prior.

Management’s Interests Are Aligned With Those Of Shareholders

The company’s 2004 Incentive Plan resulted in a Performance Share Awards Program. Under this Program, performance share awards are tied to the achievement of an adjusted return on equity (ROE) over a three-year period. When management does not meet these targets, it cannot vest performance shares. When it does meet these targets, or exceeds them, then a range of performance shares are vested (50% to 150% for awards granted in 2020, 50% to 200% for awards granted in 2021 and 2022), depending on the attained ROE .

Although ROE is an imperfect metric, and I prefer return on invested capital (ROIC), it is useful in aligning the interests of management with those of shareholders. In doing so, shareholders know that management will make decisions that will create value for the business, or at least will be aimed at doing so.

Travelers’ History of Profitability

Travelers has grown revenue from $ 27.6 billion in 2016 to $ 34.2 billion in 2021. In that time, it has grown net operating profit after-tax (NOPAT) from nearly $ 2.9 billion to almost $ 3.6 billion.

Source: Company Filings, & Author Calculations

Source: Company Filings, & Author Calculations

Travelers’ NOPAT margin was 10.4% in 2016, falling to 7.9% in 2017, averaging 8.15% between 2017 and 2020, before returning to 10.4% in 2021. The balance sheet shows invested capital turnover of 1.02, showing excellent capital allocation efficiency. The combination of these two has driven an improvement of ROIC from 9.7% in 2016 to 10.6% in 2021.

Source: Company FIlings, Author Calculations

Source: Company FIlings, Author Calculations

Travelers’ profitability allows it to generate substantial free cash flows (FCF). However, FCF has been erratic, falling from nearly $ 2.8 billion in 2016, to over $ 1.8 billion in 2021, for a cumulative FCF of over $ 10.4 billion, or 25% of its market capitalization.

Source: Company Filings and Author Calculations

Source: Company Filings and Author Calculations

Travelers’ ability to generate substantial FCF has allowed it to raise its common equity dividends for each of the last 18 years, from $ 1.16 in 2004 to $ 3.49 in 2021.

The company’s FCF has historically been attractively priced, which speaks to the company’s general state of undervaluation. Large FCF generation and attractive prices suggest that the company’s economics are strong and that future stock price performance will be good. At present, the company has an attractive FCF yield of 4.2%.

Travelers has a generous dividend payout ratio of 24.24%, which reflects its ability to grow without major investments. The company’s FCF can support the company’s dividend policy, where the yield is currently 2.04%. In April 2021, the company set in motion a share repurchase authorization that added $ 5 billion of repurchase capacity. In 2021, Travelers repurchased 13.9 million shares under its share repurchase authorization for $ 2.16 billion. As of December 31, 2021, Travelers’ had $ 4.01 billion of capacity remaining under its share repurchase authorization.

Valuation

Not only is the company’s FCF attractively priced, but the company itself is undervalued. Travelers has a price / earnings (P / E) ratio of 11.77 and a 5-year P / E ratio of 14.11. In comparison, the S&P 500 has a P / E ratio of 24.87. The implication is not only that investors can buy the company at an attractive price, but that shareholders can also earn attractive yields thanks to that very undervaluation.

Conclusion

Industry effects govern a business’s ability to sustainably earn economic profits. Despite the competitive nature of the property & casualty insurance industry, the fact that it is both largely mandated by law and essential for mitigating the risk of economic losses, makes the industry not just non-cyclical, but one in which rivals can earn economic profits . Added to that, the insurance industry has shown signs of recovery, despite the disruptions to the sector as non-catastrophic losses returned to pre-pandemic levels. The result is that Travelers operates in a favorable competitive landscape. In that landscape, the business has shown an ability to grow profitably and earn returns in excess of opportunity cost of capital. The insurer’s profitability allows it to generate free cash flows that have been attractively priced by the market. In addition, the company remains undervalued in relation to the broad market, making it a very attractive stock to buy.



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