CNO Financial's Performance Is Improving, But The Stock Is Fairly Valued

| About: CNO Financial (CNO)
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Summary

CNO sales growth continues to ramp but return of cash flows is holding steady.

The firm's 9% ROE target looks achievable but not simple.

Higher interest rates and continued sales growth should boost earnings, but a lot of expectations here are already embedded in the stock price today.

CNO Financial (NYSE:CNO) is a holding company that owns various insurance companies selling supplemental health insurance, annuities, and individual life insurance. I first covered CNO last fall when I discussed the troubling demographics of the firm's customer base. Today the firm is in a somewhat better position, as the company's collection of business should all benefit from major trends going on in the economy from the increased focus on health insurance and the aging of the broader population to the likely trend of rising interest rates over the next few years. Despite these trends, it's hard to get excited about CNO at after the monster run the stock has had over the last year. The stock probably has more room to run so for momentum investors, it may be a fine trade, but I think long-term investors need more a pull-back or greater clarity on rising rates before pulling the trigger on the stock.

A brief note on the competitive environment in CNO's business is worthwhile here since I didn't talk about this much the last time I wrote about the stock. CNO's businesses are all extremely sales intensive. Selling supplemental health and life insurance require large sales forces that continually push the firm's products in a market with very little in the way of competitive differentiators beyond price. Put differently, CNO has no moat. While the firm has generally been able to increase sales since 2010, its 2013 are barely about the level the firm hit in 2009. Life insurance and supplemental health insurance simply aren't great growth industries and it's hard to see a route for massive profit improvement beyond higher rates in the next few years. Thus the only reasons to get excited about the firm at these levels are rising rates, and the fact that CNO is not expensive at ~9X ttm EPS. Earnings are frankly a poor measure of firm value in CNO's case though since accounting rules lead to a lot of inconsistency from year to year. Book value is a somewhat better measure, but it's still muddied by the deferred tax assets the firm holds which add substantially to the firm's book value (perhaps $3 a share). The story for CNO investors is one of improvement in investing results with higher interest rates. Over time this should lead to a stock price anywhere from $20-$25, but it will take a few years to get to that level, and along the way, the road will be bumpy.

Since I last covered CNO, the company has reassured me on certain aspects of its business, but for each of these positive aspects, there is a corresponding negative, particularly regarding the sustainability of CNO's sales growth and profitibility. The company's conference calls recently have been fairly positive in my view. Margins on supplemental and life have been pretty strong perhaps as a result of the industry in general not being all that attractive given the low interest rate environment right now. Despite the strength in margins, more work still needs to be done for CNO's ROE to move into balance with peers. While I am convinced that management's plan for the company will keep sales growth accelerating through 2015, but on the other hand the ramp-up in capital returns to shareholders seems to be taking a pause. The share repurchase plan for 2014 is broadly similar to the 2013 plan based on a $250mm number. Granted, this buyback represents a ~6.7% FCF yield which is ahead of many peers, but CNO's dividend is far from spectacular at $0.06 a quarter (recently ramped up from $0.03).

None of this makes CNO a bad investment from my point of view, but there are enough points of concern here for me that I don't necessarily buy into the hype which is embedded in the stock at these levels. Around $14 a share, maybe CNO gets interesting now that it has greater clarity on future rate increases, but not now. CNO's recent results point to an average quarterly EPS run rate ~$0.30 (after adjustments), which implies that the company is trading around 14-15X annual run rate now. This compares somewhat unfavorably with other firms in the sector like TMK and even industry giants like MET which offer better stability and consistency.

The continuing bull case for CNO rests on the continuing sales growth at CNO. As I said before, CNO could not have picked a more competitive segment in insurance at least based on the need for a strong sales team. To that end though, the company seems confident in its future having guided to 6-8% sales growth in 2014 and 8-10% in 2015. Hitting these numbers will take a little work in my opinion, but is far from impossible especially given that CNO is putting more resources into sales support with $45-55mm in investments in 2014. The next effect of the sales growth should be a higher ROE. CNO is targeting 9% ROE by 2015. If the company can really hit this level and provide guidance that suggests more growth to come, then the stock can keep moving higher into that $20-$25 range I mentioned before. This is especially likely if the Net Investment Income for CNO accelerates. Right now, CNO management seems to be looking for a flat NII vs. 2013. I think this might be conservative if the US economy displays the strength economists keep talking about (which in turn would lead to higher interest rates).

For at least the next quarter or so then, I expect CNO's fate to be driven by the expectations for near-term interest rates, and the level of progress the company is making in moving towards that 9% ROE goal. The stock already embeds a fair amount of optimism by investors - now that trust needs to be fulfilled by the firm. As I said before, the party in the stock will probably go on for a bit longer and momentum investors may be interested. Long-term value investors should wait though.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.