Avoid Travelers Insurance

| About: The Travelers (TRV)

Summary

Insurance companies are often considered a great defense play for Dividend Investors due to the predictability of the industry.

The Fed kept interest rates unchanged in July and the probability for rate hike of 0.25% before the end of 2016 is low.

Low interest rates and a tepid business outlook, combined with a relatively low dividend yield make Travelers an unattractive defensive play for Dividend Investors.

Analysis

Fed Leaves Rates Unchanged. The Federal Open Market Committee (FOMC), the Federal Reserve's policy-setting body, elected to leave its target rate unchanged during its meeting on July 27. Currently, Fed funds futures are predicting that there's only a 12% chance that the FOMC will hike rates by 0.25% at either of its September and November meetings while there's a 34% chance that the FOMC will do so during its December meeting.

This is bad news for insurers like Travelers (NYSE:TRV), which rely on income from interest rate instruments like bonds and treasuries. While rising bond prices brought on by low interest rates are generally good for bond investors, this isn't necessarily the case for insurers. Higher interest rates mean higher coupon payments on debt instruments. These coupon payments, in turn, contribute to the cash pool that insurers use to settle customers' policy claims.

Dividend and Outlook. The impact of low interest rates was evident in Travelers' second quarter earnings. Despite reporting a profit of $2.20 a share and beating analyst estimates by $0.13 per share, Traveler's reported its lowest profit since the fourth quarter of 2012 (when Hurricane Sandy hit the East Coast). Travelers' net investment income during this period was $1.09 Billion - or 11% lower than it was a year earlier.

Despite a somewhat disappointing quarter, Travelers continues to pay a robust quarterly dividend on $0.67 a share, for an annual dividend yield of 2.68%. This means that investors who purchase $10,000 worth of Travelers shares can expect passive income of around $268 a year just by holding the stock and collecting dividend payments. That said, this yield puts Travelers in the bottom third of Dow Jones Industrial Average components by dividend yield.

Travelers' shares are up by just 3.5% this year, putting its return below that of both the Dow and S&P500, which have both returned at least 5% in the year-to-date. With a relatively tepid dividend yield but a fairly pedestrian stock price, investors might be wondering whether Travelers is a good investment at this time.

In our view, now may not be the best time to buy Travelers shares. Here's why:

First, interest rates may remain low for some time yet so Travelers' won't find any relief from higher investment income. To be sure, the Fed released its "dot plot" during its June FOMC meeting and it that suggested that the majority (15 of 17) of FOMC members saw the appropriate level of the Fed Funds rate falling between either 0.5% to 0.75% or 0.75% to 1.00%. This means that the majority of people who decide the path of U.S. interest rates anticipate one or two 0.25% rate hikes this year.

However, the Fed released its June "dot plot" ahead of the U.K.'s Brexit vote, when a Remain vote still seemed like a very good possibility. Uncertainty caused by the triumph of Leave has put the Fed in a defensive stance since then. This was no doubt compounded by recent signs of a persistently weak US economy. Indeed, the US economy is currently on pace for its slowest rate of expansion since World War II, which gives some justification for the market's view that there's only a 34% chance at a 0.25% hike by the Fed before the year ends. Based on current Fed Fund Futures, it appears that the market is now betting that there's a fairly good chance (47%) that the Fed will keep interest rates unchanged at least until a year from now.

Second, while Travelers does have the capital resources to continue paying its current dividend and has solid credit ratings, its liquidity and leverage measures are merely average when compared to its peer group. In that sense, it may have to be more judicious with its resources going forward, particularly since its operating cash flow has dwindled in each of the last three quarters.

To wit, Travelers' cash flow from operations at the end of the second quarter was at $443 million - 75% lower than the nearly $1.9 Billion it generated the third quarter of 2015. A lot of the drop can be explained to catastrophe losses from fires and natural calamities but some of this goes back to the poor investment performance we mentioned earlier. Regardless, with interest rates expected to remain low and its cash generation not as robust as it previously was, it's entirely possible that Travelers will at least consider a slower pace of dividend hikes - not a good sign for a blue chip stock that has a bottom-third dividend.

Third, the outlook for the stock is tepid. Analysts expect Travelers to register 4.8% revenue growth this year and 2.5% growth in 2017. What's more, over the next five years, analysts are forecasting that Travelers will report average revenue growth of just 4.5%. That just half of the 9% growth rate forecasted for its peer group.

Some of this can be traced to Travelers' lower pricing power - Travelers CEO Alan Schnitzer admitted during his company's second quarter conference call that the trend for pricing is downwards. This is significant because, as the potential for calamities mount due to global warming, it implies that Travelers is not getting compensated as much for insuring against the rising likelihood of adverse events.

Whatever the case, these lukewarm revenue growth expectations have contributed to the median "HOLD" rating on the stock - as well as its low price target of $114. In our view, this target is justified by the outlook for interest rates as well as the potential for more weather-related catastrophes as the world continues to experience ever-higher temperatures.

Conclusion

All things considered, we would encourage investors to hold off on buying Travelers shares for now. A low dividend yield, low interest rate environment and tepid business outlook suggest that investors seeking a strong defensive play are better off looking elsewhere.

Disclosure: I/we 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.

Additional disclosure: Black Coral Research, Inc. is a team of writers who provide unique perspective to help inform dividend investors. This article was written by Jonathan Lara, one of our Senior Analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article. Company financial data is taken from the company’s latest SEC filings unless attributed elsewhere. Black Coral Research, Inc. is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.

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