CLSA Warns About Cover-More’s Future

This story features INSURANCE AUSTRALIA GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: IAG

-Price sensitivity prevails in travel
-Internet offers easy, low barrier market entry
-Insurers likely to bypass in future
 

By Eva Brocklehurst

Broker CLSA has taken a contrary stance on recently-listed Cover-More ((CVO)). The subject of travel insurance irks the broker, which finds it a business that delivers no benefits to the consumers. Moreover, the value ascribed to the arrangers of travel insurance, from an investment perspective, creates a problem. Why? CLSA thinks it is all to do with the barriers to entry being low – easy start up for competition, the commodity being singularly price driven and the margin growth having a definite life cycle.

Cover-More is considered at the top of this cycle, the valuation rich at $1.88. Hence CLSA, not surprisingly, has a Sell rating. This goes against other evaluations of the stock. Two brokers, Macquarie and UBS, recently reflected on the stock's inaugural first half earnings and came up with Buy ratings and targets of $2.30.

Expanding on the thesis, CLSA notes price and ease of transaction are the only drivers in travel insurance. Hence, scale wins. The main contention is that Cover-More is not an insurer. The company is an arranger of insurance and makes it accessible to distribution companies which would never have thought of insurance as a source of revenue. So, Cover-More has the scale advantage at present. What CLSA's Sell rating hinges on is that, in the future, risk carriers, the actual insurers, will use the internet and combine distribution and underwriting more and more, providing a transparency that ultimately means Cover-More's model will be under pressure. Cover-More sources its Australian risk underwriting from Munich Re, with the contract to be renewed in 2018.

Travel insurance is sold mostly for going abroad. It's correlated to the Australian dollar and the relative attractiveness of domestic tourism, as well as changes in the "wellbeing factor" in CLSA's opinion. The broker thinks Cover-More will be dependent on cost reductions to maintain margins. Cover-More's model is predicated on offsetting lower spread margins with economy-of-scale savings. The broker agrees this is working now but thinks, ultimately, provides for diminishing returns.

While hailing the partnerships the company has forged with Air New Zealand and recently with Insurance Australia (((IAG)), UBS does point out that the longstanding and long-term joint venture with Flight Centre ((FLT)) poses some risks in terms of concentration. UBS estimates Flight Centre writes more than 40% of the company's insurance gross written premium. Flight Centre is expected to contribute 26% of Cover-More's earnings in FY14. As a result, profitability is highly correlated to Flight Centre's sales. From CLSA's perspective, while income may grow and new distribution partners be signed, this will increasingly be on terms which add little to the underlying margin and therefore the growth forecast is not of the quality that requires a higher price/earnings multiple.

UBS expects higher incremental returns over the next three years and has observed the fact that Cover-More lifted insurance earnings/gross written premium margin in the first half to 8.6%, suggesting the company is on track to meet, or exceed, the implied level of 9.1% in FY14 prospectus forecasts. To UBS, this signals that the company can extract benefits of operating leverage without having to pass on all incremental gains to distribution channel partners. CLSA concedes the margins are currently handsome but remains inclined to think insurers will eventually set up their own channels for distribution in the future, and consumers will be less inclined to purchase travel insurance from the arranger.

CLSA attributes little value to the company's Asian initiatives whereas UBS believes growth upside in the medium term in these under-penetrated markets is substantial. On the subject of the company's other business, the medical assistance and DTC segment, CLSA acknowledges it differentiates the company somewhat but adds a low margin business, not something that can be valued as a standalone. Macquarie disagrees. The DTC employee assistance segment could be an area of significant growth prospects, in that broker's opinion.

See also, Cover-More Delivers On Growth Promise on March 3

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms