Interactive Investor

Stockwatch: how dependable is this near 8% yield?

1st April 2022 12:09

Edmond Jackson from interactive investor

Our companies analyst suggests the generous yield could make this financial services stock a useful defensive addition during market jitters.

The latest 2021 results from the £500 million life insurance and pensions group Chesnara (LSE:CSN) offer an opportunity to examine whether the market is justified in pricing the stock for what seems a generous yield.  

If Chesnara meets expectations for dividend per share of 23.3p in respect of this year – a 3% increase on 2021, in line with established policy (see table) – then with a current share price of around 300p, the yield would be 7.8%. 

A play on stock market sentiment 

As a first observation, both for tactical buying and to explain why this might be: the stock varied yesterday, like other insurers and also banks, according to volatility on Wall Street. By mid-afternoon it was down 7p at around 290p, but it closed up 5p at 303p. Insurers are sensitive to wider sentiment in equities and bonds given their substantial portfolios of investment assets to meet liabilities arising: in Chesnaras case, £9.1 billion of financial assets, up 7% on end-2020 partly as a result of rising markets. 

So if the US Federal Reserve follows through on its chairmans talk last week of raising interest rates incrementally by 0.5% instead of the 0.25% convention – then it will keep pressure on sentiment that later yesterday saw US equities sell off. 

If you believe equities deserve to trade materially lower, say because of stagflation, insurers are probably best avoided right now. But for holders and those watching with fresh money: they rebounded strongly, not only from the lows of March 2020 but this last March, after the initial shock of Russian tanks rolling. Chesnara leapt 21% from 256p during the latter period. 

Covid has dealt Chesnara a blow such that both its stock chart and the table of past yearsresults show a challenge to regain the performance of 2019 and before. Since March 2020 the stock has bumped along sideways, and 2021’s net profit of £27.3 million is well down on the £78 million or thereabouts achieved in 2017 and 2019. Consensus looks for around £30 million profit in 2022, and therefore a prospective price/earnings (PE) ratio of around 12x.   

Is yield really a tipping factor for insurance stocks? 

By this, I imply also that if it’s excessively generous relative to the risk profile, yield acts like a bungee cord that reliably means the stock rebounds from sharp falls; also, that in the medium term some mean reversion upwards should happen anyway. 

Aviva (LSE:AV.) and Legal & General (LSE:LGEN) are similar stocks to buy during market jitters for such an effect. At around 455p, Aviva trades on a projected 2022 PE of 10.3x with a prospective yield of 6.3% and also a 10% discount to net asset value (NAV). At around 270p, Legal & General is on a 2022 PE of 8.2x yielding 7.1%, though it is also at a 47% premium to NAV. 

Chesnara is somewhere in between: close to its asset value of 305p per share, with an 7.8% yield and 12x PE. 

A pragmatic response would be to average into all three during times of negative sentiment, although for total shareholder return none of these stocks have proved great to hold over the long run. Charts have trended volatile-sideways, which is why the market is pricing such stocks to appeal to income investors. 

If you are seeking income, then Chesnaras 2021 results indicates why it is worth considering for your buy” list.

A strong business model for shareholder returns?   

Chesnaras annual dividend growth goes back 17 years – so inclusive of the 2008 crisis – with the last five years showing over 150% growth in surplus funds over internally required capital.  

Of course, very loose monetary policy boosting asset prices will have contributed, and a sea-change looks to be underway in that respect.

Net cash from operations has also fallen from £53 million to £27 million in the context of 2021 dividend payouts costing £33 million, although some lumpy elements within Chesnaras cash flow profile are variable. Cash fell from £105 million to £71 million. 

Yet management proclaims a clear line of sight of future cash emergence in the form of real-world returns, solvency capital requirement run-off and management actions” able to fund both equity dividends and debt interest.

End-2021 borrowings were down 30% to £47 million, although total finance costs were £2.3 million relative to £31 million operating profit. This year, £200 million of further debt has been raised to provide flexibility for acquisitions, such that pro-forma net debt is now around £176 million for net gearing of 39%.

I rather question why debt had to be raised if management is so confident in the groups capacity for cash generation. Possibly they felt it appropriate to lock in a useful interest rate while they are still available. The apparent need for acquisitions – at least to meet investor expectations of growth – hints at a relatively mature and competitive market for insurance. 

Despite negative net debt, the income statement is swollen by nearly £1.2 billion of net investment return versus £255 million such in 2020. Adjusting for this, group income actually eased by 13% to £333 million.  

I draw your attention to this to illustrate just how material buoyant financial assets and their income have been to insurers’ cash flows. 

While insurance premium revenue rose 6% to £312 million, revenue ceded to reinsurers leapt 176% to £116 million, such that net insurance premium revenue fell 22% to £196 million. 

Net profit advanced 29% to £27.3 million, although consensus had been for £34 million. 

Aspects of the 2021 results are therefore mixed, but they do reflect my key point that insurers have benefited from the financial assets bonanza after central banks turned on the monetary spigot from March 2020.   

In a worse-case scenario for investment markets, is the dividend payout reliable here, as a bungee cord for the stock?  

Chesnara - financial summary
Year end 30 Dec

  2015 2016 2017 2018 2019 2020 2021
Turnover (£ million) 283 653 800 -14.5 1,409 598 1,506
Operating margin (%) 15.1 6.2 11.2 -186 6.8 4.1 2.1
Operating profit (£m) 42.8 40.7 89.6 27.0 96.1 24.6 31.2
Net profit (£m) 39.8 35.3 78.4 24.1 79.1 21.2 27.3
Reported earnings/share (p) 31.4 27.6 52.4 16.1 52.8 14.0 18.0
Normalised earnings/share (p) 19.2 27.6 40.5 16.1 52.3 29.6 18.0
Operating cashflow/share (p) 1.3 -46.7 39.7 40 -31.5 34.7 17.7
Capital expenditure/share (p) 0.2 0.0 0.2 1.2 2.1 0.6 2.4
Free cashflow/share (p) 1.1 -46.7 39.5 39.2 -33.7 34.2 15.3
Dividend/share (p) 18.9 19.5 20.1 20.7 21.3 21.9 22.6
Covered by earnings (x) 1.7 1.4 2.6 0.8 2.5 0.6 0.8
Return on capital (%) 0.8 0.7 1.1 0.3 1.1 0.3 5.4
Cash (£m) 138 134 86.5 104 54.3 105 70.1
Net Debt (£m) -57.7 -45.6 43.7 6.2 37.6 -33.5 -22.9
Net assets per share (p) 233 263 302 297 317 325 305

Source: historic company REFS and company accounts

A strong Solvency 2 ratio  

Those who believe it is might point to this key ratio, which measures the value of an insurers assets relative to its liabilities. While down on the 156% achieved at end-2020, Chesnara’s ratio of 152% remains comfortably within managements target range of 140% to 160%. 

But such assets are not strictly available for use as a distribution. I would therefore view this strong ratio more as implying that Chesnara equity is modestly valued relative to the essential financial risk of the group.  

A 6% prospective yield would imply a stock price of 390p – i.e. 30% capital upside – bringing it more into line with Aviva. The PE would be in the mid-teens, however, and the premium to NAV around 28%. 

Unless markets take a sustained dive, I think a medium-term target of around 350p is more realistic. There is scope for mean reversion upward, and Chesnara does meet for example the capital growth screening criteria set by US investment manager James OShaugnessy, whose 1996 book What Works on Wall Street aimed to balance growth, value and momentum indicators. 

This, together with the stocks history of rebounding from market setbacks, justifies at least a ‘hold’ rating. 

The dilemma for income buyers is whether to keep their power dry if markets are festering amid a cocktail of inflation, interest rates and extended war concerns.  

But unless the market falls dramatically to impair the value of this and other insurersasset backing and cash flows, I rather doubt it would rate Chesnara for say a 9% yield if the stock were to drift to 260p. 

Given that the results have provided no fresh catalyst, I would be inclined to wait. I am inherently cautious about the global picture, however; you may be less so. Hold. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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