We are maintaining our BUY rating on Travelers Cos. Inc. (NYSE: TRV) but lowering our price target to $145 from $164. Although we are lowering our EPS estimates, we expect catastrophe losses to return to more normal levels after a spate of hurricanes and wildfires. We also expect margins to increase as the company raises prices on auto insurance and expands its data analytics and digital initiatives. We believe that Travelers can generate a higher return on capital, and note that it recently raised the dividend by 6.5% and announced an additional $5 billion share repurchase program. The stock has declined 17% from its 52-week high of $155, and we believe that the pullback provides a favorable entry point. Our revised target of $145 implies a multiple of 13.2-times our 2020 EPS estimate, compared to a five-year historical range of 9.9-19.7.
TRV shares have underperformed the broad market over the past three months, declining 10.5%, compared to a loss of 0.3% for the S&P 500. They have also underperformed over the past year, with a gain of 6.7%, compared to a 9.4% increase for the index. The beta on TRV is 0.86, in line with peers.
On October 22, Travelers reported 3Q19 core income of $378 million or $1.43 per diluted share, down 45% from 3Q18. The decline reflected net unfavorable prior-year reserve development due to an increase in lawsuit payments and jury awards for liability insurance. EPS missed our estimate of $2.02 and the consensus estimate of $2.34. Revenue rose 4% to $8.0 billion, above our estimate of $7.8 billion and the consensus forecast of $7.9 billion. Adjusted book value at the end of the quarter was $90.09 per share, up 4% from a year ago. Core ROE for the period was 6.5%, down from 12.6% a year earlier. TRV's pretax net unfavorable prior-year reserve development totaled $294 million in 3Q, compared to a favorable reserve development of $14 million a year earlier. The stock fell 8% following the results - the largest drop in a single day since the financial crisis in December 2008.
On the 3Q call, CEO Alan Schnitzer said the increase in liability insurance was an industry-wide phenomenon and that the company was taking action to mitigate changes in tort law damages. In particular, he cited a higher and more aggressive level of attorney involvement on auto claims. He also cited strong results in the overall business and highlighted the company's 7% growth in written premiums, with at least $500 million in new business in each of the company's segments. He also noted improvement in the consolidated expense ratio, with benefits from expense discipline and technology investments.
The Federal Reserve raised interest rates three times in 2017 and four times in 2018. In 2019, the Fed has decreased rates twice and we expect it to cut rates again at the end of October. The rate cuts may be a temporary setback for Travelers and other insurers, as most of their investment returns come from bonds. On the 3Q19 call, CFO Dan Frey said that investment income would decrease by $10-$15 million year-over-year for the first three quarters of 2020, hurt by lower interest rates. We note that many insurers have sought higher-yielding returns in riskier investments, including hedge funds and private equity, with disappointing results. However, Travelers' generated positive returns from private equity during the third quarter.
EARNINGS & GROWTH ANALYSIS
Current trends and outlooks by business segment are summarized below.
The Business Insurance segment - Travelers' largest - generated $179 million in operating income in the third quarter, down 56% year-over-year. Results were hurt by lower underwriting gains and investment income, and an unfavorable prior-year reserve development. On the top line, net written premiums rose 7% to $3.9 billion. The domestic segment retention rate was 84%, lower than the 86% rate during the prior-year period. The GAAP combined ratio (losses and expenses divided by premiums earned) worsened to 107.0% from 100.6% in 3Q18; the underlying combined ratio also worsened to 95.9% from 95.4%. (A combined ratio of 90% means that TRV keeps $0.10 of each dollar in premiums earned, for example.)
The Bond & Specialty Insurance segment generated income of $139 million, down 29% due to lower net favorable prior-year reserve development and a lower underwriting gain. The GAAP combined ratio worsened to 83.3% from 70.2% a year earlier. The underlying combined ratio also worsened, rising to 83.6% from 78.3%. Retention was flat year-over-year at 90%.
The Personal Insurance segment generated $131 million in income, down 22% from a year earlier. The results reflected a lower underwriting gain. Net written premiums rose 7% to $3.0 billion, driven by changes in renewal premiums and an increase in new business. The GAAP combined ratio was 98.0%, worsening from 97.2% in 3Q18. The underlying combined ratio also weakened to 94.0% from 92.9%. We expect low double-digit ROE from this business over time.
Overall, the company's GAAP combined ratio slightly worsened to 101.5% in 3Q19 from 96.6% in 3Q18. The underlying combined ratio worsened by 110 basis points to 94.1%. The higher GAAP combined ratio was again due to unfavorable prior-year reserve development. The company's investment portfolio generated pretax net investment income of $622 million in 3Q19, a decrease of 4%.
To generate our EPS estimates for the insurance industry, we focus on ROE, which is smoother and more predictable than catastrophe losses and net prior-year reserve development. TRV has an impressive ten-year average ROE of 13.0%. It posted operating ROE of 13.3% in 2016, 9.0% in 2017, and 10.7% in 2018. We expect ROE to stabilize and to stay above the peer average of 9.3%.
We think that the company has managed its risk exposure particularly well in the face of insurance losses from hurricanes, wildfires, and other catastrophes. Although insurance is TRV's primary business, its investment returns, which contribute significantly to ROE, have been hurt by low alternative investment performance - despite some improvement over the last four quarters. Returns have also been weak on the company's massive bond portfolio due to low interest rates. The company has also been raising prices for auto insurance, which we expect to improve results over the next two years. Dividend increases and a new share buyback program should also boost shareholder returns.
We are lowering our 2019 EPS estimate to $9.49 from $10.74 to reflect the 3Q miss relative to our estimate, slower premium growth in the Bond & Specialty Insurance segment, and consistently sluggish reserve releases. Our outlook nonetheless assumes 5% EPS growth this year. We are also lowering our 2020 estimate to $10.98 from $11.59.
FINANCIAL STRENGTH & DIVIDEND
Our financial strength rating on Travelers is Medium, the middle rank on our five-point scale, based on a review of the company's leverage, coverage ratios, and profitability.
As of September 30, the debt/capital ratio was 21%, below the peer median of 23%. In 3Q19, operating income covered interest expense by a factor of 6.1, below the peer median of 10.4. The 3Q adjusted profit margin was 4.7%, below the peer median of 8.3%. Core ROE was 6.5%, also below the peer median of 9.3%.
Concurrent with earnings, the company declared a quarterly dividend to $0.82 per share, or $3.28 annually, for a yield of about 2.5%. The dividend is payable on December 31 to shareholders of record as of December 10. Over the past five years, TRV has raised the dividend at a compound annual rate of 8.7%. Our dividend estimates are $3.23 for 2019 and $3.43 for 2020.
Travelers also has a share buyback program. The company repurchased 2.5 million shares in 3Q19 for $375 million. It has $2.2 billion remaining on its current authorization.
MANAGEMENT & RISKS
Alan Schnitzer became CEO in December 2015 after joining Travelers in 2007 as chief legal officer. He previously served as outside counsel to Travelers. Mr. Schnitzer led multiple Travelers businesses before becoming CEO. Of note, his wife's stepfather also served as CEO of Travelers from 2001 to 2004.
Management's long-term goal is to produce a superior ROE in the mid-teens. This means that in parts of the underwriting cycle, management may sacrifice growth in order to retain profitability, as is currently the case. However, with interest rates at historically low levels, management may not be able to reach its ROE targets even with its focus on underwriting. The company has not changed its long-term goals, but has acknowledged that persistently low long-term interest rates could prompt a review and potential change.
Travelers faces macroeconomic risks related to the impact of slow economic growth and volatile equity markets on its balance sheet, capital levels, credit ratings, revenues and income. Other critical metrics to monitor include the company's exposure to mortgage-backed securities, global bonds and real estate. As of September 30, the company's $77 billion investment portfolio consisted of 93% fixed-income securities, 1% equities, 1% real estate, and 5% 'other.' Approximately 97% of the fixed-income securities were investment grade, and the average duration was four years.
Travelers is a leading provider of auto, home and business property casualty insurance. The company is organized into three units: Business Insurance; Bond & Specialty Insurance; and Personal Insurance. TRV is included in the S&P 500 Index and the Dow Jones Industrial Average.
We think that TRV shares are attractively valued at current prices near $132, below the midpoint of the 52-week range of $111-$155.
TRV shares are trading at 12.0-times our 2020 EPS estimate, below the peer median of 12.5 and the midpoint of TRV's own five-year historical range of 9.9-19.7. They are trading at 1.3-times reported book value, below the peer median of 1.5 and the midpoint of the five-year range of 1.1-1.6. The current yield is about 2.5%, above the peer median of 2.0% and above the midpoint of the five-year range of 1.9%-2.6%.
Given the stock's recent strong performance (catching up to or surpassing peers in relative valuation) and management's growth initiatives, we are maintaining our BUY rating. Our revised target price of $145 reflects positive business expectations, partly offset by reservations about premium growth and reserve releases, and implies a historically modest multiple of 13.2-times our 2020 EPS estimate.
On October 23, BUY-rated TRV closed at $132.16, up $2.01.
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