Recently I added Chesnara Plc (LON:CSN | ISIN: GB00B00FPT80) as a brand new position to my dividend growth portfolio. It serves as a high-yield, slow growth dividend investment replacement after I decided to sell my full position in AT&T. 

Actually, you could be already familiar with their name, because I discussed Chesnara in one of more recent #DividendTalk Podcast episodes.

At that time I didn’t own the stocks yet. So in this post I will briefly explain you my reasoning for starting a position in this small-cap UK dividend growth stock. I will do this in a manner most of you are familiar with by now.

Enjoy the read and let me know what you think in the comment section below this article 🙏

Please note: trading in small cap stocks typically means that there is less trading volume. Hence, there maybe higher volatility in share price on a single trading day while it may also be harder to sell your shares during a market crash.

Chesnara Plc Background

Chesnara is a life insurance and and pensions consolidator and a typical small-cap listed company. It currently trades for around 279 Pence per share and has a market cap of ~412 million British Pounds.

It actually only exists since 2004 and it is a result of a spin-off from Countrywide estate agency group. 

Since then it started it’s own life as a company and right now they have operations in the United Kingdom, Sweden and the Netherlands.

What stands out to me is their very clearly messaging and purpose as a company:

“Our primary focus is the efficient management of life assurance and pension policies to give fair outcomes to our customers, whilst generating profits to provide attractive dividends and value growth to our investors”

I don’t do this often, but in this case I would very much encourage you to check out their investor relations website and to read the first 30 pages of their latest annual report.

Now tell me whether you agree with me: 

Doesn’t this give you a similar feeling as browsing through the Realty Income Investors ($O) website?

Everything I read on their website and in their annual report is very focused on giving an income seeking investor exactly what it needs. 

It even lays out the exact risks their business faces without any bullshit or fluffy text. It also has a plan for every identified risk on how to mitigate it.

Just this approach to publishing information with the information seeking investor in mind made me already very excited when I first stumbled upon Chesnara Plc.

Business Model

The interesting thing first is to show how Chesnara Plc communicated their own business model to us as shareholders in their latest annual report:

As you can see, they are actually having more of stakeholder approach than a shareholder approach and I like what I’m seeing.

However, what I really mean with their business model is the way Chesnara earns their money. Hence, let’s have a look at that now.

How Chesnara Plc earns its money

Chesnara Plc is a relatively small company with a straight forward business model. They earn money in the following 3 ways:

• Maximize the return of their existing closed-book policies (mainly UK and a bit in NL)
• Acquire new businesses and policies at a discount to their fair value
• Underwriting new policies in the Netherlands and Sweden (open-book)

The first thing you need to notice is the following. The company very clearly makes a distinction between open-book business and closed-book businesses. 

The difference between the both is that closed-book businesses (i.e. in the UK) are Insurance Policies and Pension Plans that are now closed to new business and are no longer sold.

An open-book business are insurance policies and pension plans where the products are still sold and policies are underwritten.

From that point of view, it’s now important to read the following overview of their 3 geographical business units:

As you can see, only the more recent acquisitions are open-book underwriting businesses which allows the company to actually grow in revenue.

That’s also why growth through acquisition is one of the most important strategic actions on the agenda of the board of directors. 

Over time the value of the closed-book businesses will decline, because people will for instance simply pass away.

Hence, targeted acquisitions are a primary business process for this company and it’s something they have so far been quite successful in. 

And what I actually like is that their relatively small size allows it to acquire policies and businesses that other companies are not interested in anymore. Chesnara Plc seems to be company that can deal with such kind of “cigar-butts” very well:

Do they have a catalyst?

This is an interesting question that I ask myself before investing in any company and usually there’s always a bigger trend or so that comes to mind. 

I guess this is especially the case, because so far I have only owned large blue chip companies in my portfolio.

Hence, that’s why it might be a bit of a surprise that it’s hard for me to name any particular catalyst for this company.

I firmly believe that an investment in Chesnara Plc is mainly a bet on it’s management, just like with Berkshire Hathaway.

By no means I’m trying to compare the two companies in it’s quality, but it rather shows that these are both “holding” companies.

Hence, they are mainly known for its quality of investments and the environment it creates for those businesses to excel in their operations and to thrive in their markets.

Who is their management?

The Chesnara board of directors is introduced on their Investor Relations website. But what I found out is that the main man running the show is their CEO John Deane.

Unfortunately there’s not a lot else that I could find about him online as he has no profile on LinkedIn or so. 

But thankfully YouTube gives us also a bit more insight in the CEO, because I found a nice interview from 2 months ago. He is being interviewed there about their latest results and their most recent dividend hike:

As you can see, he comes across as a non-charismatic bookkeeper and that’s exactly what we need as a CEO for these kind of companies. 

But hey, boring and steady growth is what this company is all about and it perfectly matches my investor profile. Hence, I’m glad that the CEO is living proof of this.

Last but not least, I also looked into the compensation of the board of directors and in particular John Deane. I have not found anything excessive that worries me. 

To the contrary, I think his salary and bonuses are quite prudent and the long-term incentives are focused, among others, on total shareholder return.

Now that we know how they earn their money, let’s look at one of the main questions I would like to answer for every investment I make: is the dividend safe?

Chesnara Plc Dividend Safety

This is never a simple question to answer, because it really depends on many factors. However, my experience has taught me to look at several important factors which might decrease the likelihood of a dividend cut. 

Let me therefore explore several determining factors first and then get back to you with my personal opinion about it.

Dividend Policy

One of the first checks I do when considering an investment in a European company is to check their dividend policy.

Most of the time a European dividend policy mentions something like: we pay out a dividend in the order of 30% – 40% of our earnings.

What such a quote really means is that the board of directors allows themselves the space to cut the dividend when it has a single bad year. 

And this is what often happens and that’s why many investors shy away from investing in European stocks when following a dividend growth strategy.

However, there are also quite some companies with a long dividend growth track record even with such a dividend policy. Just have a look at the top 30 European Dividend Growth stocks for inspiration.

But let’s get back to Chesnara Plc, because this is one of those rare European companies which is really explicit in it’s purpose: to provide income seeking investors with a progressive and growing dividend.

I actually really like how they describe it straigth on their homepage:

… to provide shareholders with their least troublesome source of sustainable, attractive dividend yield.

Honestly, I have never heard such a commitment and quote regarding a dividend.

The least troublesome...

In my opinion Chesnara Plc already scores a 10 out of 10 just by their choice of words 😉.

Chesnara Plc Dividend History

But look, words mean nothing without a clear commitment behind it. So let’s have a look at their dividend history as well to build some more confidence.

It’s for instance important for me to observe their behavior during tough times. Two clear tests have been the Great Financial Recession in 2008 and 2009 and the most recent 2020 Covid-19 Pandemic.

Well, as you can see, they really walk the walk and talk the talk.

Their dividend has been growing since the inception of the company and they have weathered both crisises.

It must be noted though that their dividend grows relatively slowly.

But this should come as no surprise, because is the typical high-yield / low-growth dividend paying company.

Hence, the dividend yield currently stands at 7.98% and their 5 year dividend CAGR is 2.39%. 

This means that it will take us up to 10 years to reach a 10% dividend yield-on-cost just by dividend growth alone. However, reinvesting the dividends will get us within 3 years to a 10% YoC.

This, in my opinion, really shows the power of dividend reinvestment, especially when it relates to high yield dividend stocks.

Earnings / Cash Flow

This is where it becomes a bit tricky, because insurance companies are generally a bit more difficult to analyze. 

The company itself reports their “EPS” equivalent number in usual cash generation. Usual cash generation in their terms means:

Cash generation is a key measure, because it is the net cash flows to Chesnara from its life and pensions businesses which support Chesnara’s dividend-paying capacity and acquisition strategy.

Cash generation can be a strong indicator of how we are performing against our stated objective of ‘maximising value from existing business’. However, our cash generation is always managed in the context of our stated value of maintaining strong solvency positions within the regulated entities of the group.

So in laymen’s terms:

They require their business units to pay dividends to the holdings. Those dividends, after operational expenses and such, are then available to the Chesnara Plc shareholders in the form of a dividend. Page 46 in their 2020 annual report gives a really nice overview in the calculation and the composition of that.

Based on that metric, you can see their most recent 5 years including the dividend coverage in the picture below.

As you can see, the dividend was nicely covered in most of the years except last year which was impacted by covid-19. This was especially the case for their Dutch subsidiary.

But if we put it in historical perspective, then we can see that their dividends were covered for 152% by their generated cash over the last 5 years.

The fact that they continued growing their dividend just shows how committed they are. 

Honestly, from this point of view I believe that management is having the exact right metric as an alternative to EPS. 

There’s not a lot of sense to look at the income statement itself, because it feels like reading an REIT equivalent income statement. And we know that in the case of REITs we are much more interested in funds from operations (FFO) as the key metric to track and to see if the dividend is covered.

But having said that, let’s also briefly look at it from a Free Cash Flow (FCF) point of view. Last year the company generated 58,95 million in cash from operations. It had a CAPEX of 857 thousand, so it gives them an FCF of ~58 Mln. 

From that point of view the dividend seemed easily covered, but it’s important to know that this was not the case in 2019.

In that year they had a negative Operating cash flow and Free Cash Flow due to some financial asset and provision adjustments which they had to make.

I’m not too worried about it, because the underlying value of their investments changes from year to year (like the stock market) which means that they need to make quite some adjustments. 

This really blends the true underlying cash generation and therefore I’m in line with the management’s approach to reporting their usual cash generation figures.

All in all, I’m quite satisfied with what I’m seeing.

Their strategy of growing via acquisitions, operational excellence and underwriting new policies in Sweden and UK has seemed to do them well over the last 5 years.

Balance Sheet strength

It’s important to know when looking at a balance sheet of an insurer that their capital requirements and such are heavily regulated according to the European Solvency II framework.

While I’m by no means an expert in it, I can only tell that it’s there to protect customers and shareholders. 

But as you can imagine for instance, an insurance company should at least have enough funds to cover potential claims according to its risk profile.

This is one of the big reasons why I find that many European insurers have nice and clean balance sheets. 

This is no different to Chesnara Plc, because their debt to equity is very low with 6.2%.

we have to ignore all the items related to their insurance operations as they have a significant amount in holdings in investment schemes

This is invertedly also visible in their interest coverage ratio (the times earnings before interest and taxes covers the interest expense), because it currently stands at 11.69. 

This tells me that they have a prudent balance sheet and a conservative debt profile. I have neither found anything else that concerned me when looking at their balance sheet (i.e. exuberant goodwill).

Hence, I consider their balance sheet strong.

All in all I consider their dividend safe.

By design, high yielding companies have an increased risk at a dividend cut, because a single bad year can put a dividend under severe pressure. 

But in this case Chesnara is supported by a strong balance sheet and we have seen that a single bad year doesn’t straight away lead to a dividend cut. 

It is also a strong sign that management is truly committed to a growing dividend.

Valuation

As I always say, a good business doesn’t necessarily make it a good stock to own from a valuation point of view. So let’s start looking at their valuation right now.

What is important to know is that I’m not applying a Discounted Cash Flow model for the company, because I would find that highly unreliable based on what I described earlier.

Hence, I will focus in this case mainly on the dividend discount model DDM).

It allows me to establish a fair value price by looking at the sum of all of its future dividend payments when discounted back to their present value.

And this seems to fit well considering that this investment is almost a pure dividend income play.

So let’s look into it then. To calculate this I’m making the following 2 assumptions:

• The dividend will continue to grow as per its latest 5 year average: 2.39%
• I would like to have a 10% annual return on this investment (discount rate)

Based on these two assumptions, the fair value of the stock is estimated to be 287 Pence (calculation: 21.90 / (10% – 2.39%).

Increasing the dividend growth rate or decreasing your expected return will quickly increase the fair value of the stock, just in case you’re curious. 

As an example, if you decide to use the Weighted Average Cost of Capital as a discount rate then you would definitely use a percentage which is below 10%. 

Therefore my calculation already implicitly includes a margin-of-safety while at the same time making it less dependent on the low interest environment and the fluctuations in the stock market.

Having said that, according to me the stock is currently trading slightly below its fair value (p279 vs p287). 

It’s not a large discount, but it seems to be a quality business at a fair price based on all what I have studied

Risks when investing in Chesnara

As you probably noticed, I’m quite positive on the company based on all what I’ve studied and analyzed so far.

But I also need to make sure that I understand their risk profile quite well, so that I’m not becoming blind to the kind of operations Chesnara undertakes.

Therefore I would like to share with you the top 3 risks I see when owning shares in this company:

1. Too much single portfolio risk

In my opinion this company is still trying to build up it’s business by moving more into open-book insurance policies vs closed-book insurance policies. 

That’s why I find their portfolio still too little diversified while I know that they are working hard on it via their acquisition strategy. 

What it also means is that a single bad actor in their holding can have a severe impact on their overall earnings power and health of the company.

Or maybe to make this risk more clear: it doesn’t have 20+ billion dollar brands like Unilever has.

2. Investment and liquidity risk

As like many other insurance companies, Chesnara invest the collected funds from policies into financial instruments. 

These instruments are there to cover future obligations of policy holders. But fluctuations in the investment markets, currencies and counterparty defaults can severely impact their ability to meet those obligations.

That’s why it’s important to keep monitoring Chesnara’s balance sheet and cash generation to ensure that the commitment to the dividend doesn’t become a fools-game.

3. Competition on price by digital excellent companies

The “old-style” insurance industry is under pressure to invest heavily into digitalization to lower the operational costs and to enhance the customer experience. 

Chesnara Plc knows this and is having plans to get there within the next 2 years. However, this means investments into complex software projects come at a high risk of not realizing the benefits as envisioned.

There can be a deteriorating impact to it’s ability to generate new revenue via open-book policies if these investments fail.

Final thoughts about Chesnara Plc

I feel still not totally familiar with the company although I have read through many of their materials and studied most of the available information.

That’s why I have decided to only classify Chesnara Plc as a tier-4 company in my portfolio.

This might have been different if I would have been a consumer of their products or working within a close proximity to their business. I guess that’s the perspective I still feel a bit uncomfortable with.

From that point of view, this classification also means that my recent purchases already provide me with the target dividend income expected from a Tier-4 company. 

Hence, I don’t expect to add any further shares to my portfolio in the upcoming year.

I will now start to follow the company more closely to get a better feeling for the durability of their business while I also expect to start enjoying their juicy dividends.

What needs to happen to increase my conviction in the near-term future?

I would like to see some more accreditive acquisitions in the upcoming years which enhance their ability to generate cash and a growing dividend. 

Based on that I may decide to move it up the ladder into a teir-3 or even tier-2 company.

My one-liner for owning shares in Chesnara Plc

A high-yield / slow-growth dividend paying company with good management and a strong commitment to manage their business in such a way so that they can provide investors with a growing and sustainable dividend.

This is it from my side. I have provided you with my thoughts about Chesnara Plc and my reasoning for purchasing a stake in the company.

I’m curious to hear from you what you think about it.

Do you also own Chesnara Plc or do you own any other small cap stock?

Let me know, I’m more than curious about it!

Yours Truly,

European Dividend Growth Investor