IAG Now With Special Dividend Potential

This story features INSURANCE AUSTRALIA GROUP LIMITED. For more info SHARE ANALYSIS: IAG

-Market relief on change of tack
-Other Asian investments continue
-Several special dividends possible?
 

By Eva Brocklehurst

Insurance Australia Group ((IAG)) has had a change of heart on China. Following its $500m equity raising from Berkshire Hathaway in June the company intended to pursue a pan-national insurance offering in that country but, after assessing the opportunities, has determined it will not proceed.

The announcement instigated a sigh of relief from many investors, as to make meaningful inroads into China would require a significant commitment and several stockbrokers had doubts about the idea. Now, the prospect for a capital return is looking more likely.

The market was worried about a large expansion so soon after the company took a $60m write-down on its Bohai acquisition at the FY15 result, given an initial $100m investment. A dilutive equity raising had ensued that IAG chose not to participate in. This resulted in its ownership stake falling to 14% from 24.9%. JP Morgan notes there is no indication whether this remaining stake will be divested.

Nevertheless, the decision to abandon expansion in China is not convincingly the right one, JP Morgan contends, although whether the long-term bears this out will not be known. IAG has been in China for more than 15 years, through its Roadside Assist venture. It also helped the regulator there set up a Compulsory Third Party (CTP) scheme.

As scarce insurance stakes were up for sale, the timing for investment may have been favourable, JP Morgan asserts. China is a high-growth market and the broker suspects there may not be another chance to get in on the ground floor.

That said, JP Morgan acknowledges the decision reveals the company and its new CEO Peter Harmer are willing to listen to investors and not just pursue deals from a top-down perspective. The extent of the share price reaction was a surprise but the broker suspects Peter Harmer may be unravelling what could have been an unpopular move by the former CEO.

One item brokers all agree on is that this decision ratchets up the potential for a capital return. JP Morgan highlights the deal with Berkshire Hathaway meant an improvement to the core capital position of $1.2bn. The company's common equity tier one (CET1) ratio improved modestly in the first half and JP Morgan expects it will continue to do so as the surplus capital is released from the Berkshire Hathaway quota share.

Macquarie estimated the company could have invested $500-750m in China with risk to the upside but accepts this decision will ease uncertainty. The broker forecasts the company will increase its target pay-out ratio to 60-80%. For FY16 Macquarie increases this to 90%, which implies a special dividend of 10c a share.

The broker will review the potential for special dividends annually, recognising future investment in Asia, uncertainty on reserving in New Zealand and ongoing rate softening.

Of note, IAG is maintaining other parts of its Asian strategy, increasing the stake in SBI General Insurance in India to 49%, increasing stakes in Malaysia's AM Assurance and participating in consolidation in Thailand. With the focus on other Asian countries, Macquarie expects the company will invest a further $450-700m over the next 2-3 years.

Deutsche Bank believes it would have been difficult for IAG to achieve targeted returns in China and its concerns were confirmed by the Bohai write-down. This broker also envisages scope for $400-600m in capital returns by the end of FY16.

UBS accepts special dividends should logically follow this decision but points out there are many variables to consider, none the least being the challenging margin outlook in the domestic market. In addition to timing considerations, the company could require $150m for the Indian joint venture and has an open-ended liability for NZ earthquake claims to consider.

While it is unlikely Insurance Australia Group will find the acquisition opportunities to absorb its growing surplus, the broker believes it would be unusual for a CEO in his first year at the helm to part with too much capital. Hence, UBS puts its money on a large special dividend in FY17.

Credit Suisse wholeheartedly welcomes the decision and upgrades its rating on the stock to Outperform from Neutral. The broker remains confident in the delivery of core earnings expectations in FY16 and now includes three years of special dividends in forecasts.

The company was already in a strong capital position, with minimal requirements for capital from organic growth. The broker expects IAG to benefit from 24c per share in excess of CET1 requirements at the end of FY16. Additional capital should be released in the subsequent years as the quota share takes full effect and NZ tax losses are recognised, adding a further 10c per share.

The broker remains concerned about commercial lines but believes this is offset by expected reinsurance benefits. Post the bounce in its share price the stock is seen trading at a 13% discount to the market versus its historical 9.0% discount. With further upside potential Credit Suisse believes it offers a relatively safe holding in the current environment.

FNArena's database contains one Buy (Credit Suisse) rating and seven Hold. The consensus target is $5.55, suggesting 1.9% upside to the last share price. The dividend yield on FY16 and FY17 forecasts is 5.7% and 5.2% respectively.

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