IAG More Interesting But What About Returns?

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

-Concerns over dilution, profit share
-Capital allocation unclear
-Scope for growth initiatives
 

By Eva Brocklehurst

The market may have responded warmly to the news of Insurance Australia Group's ((IAG)) partnership with Warren Buffet's Berkshire Hathaway, sparking a rise in the share price, but brokers are more circumspect. JP Morgan for one.

The broker was surprised by the positive reaction, considering the dilution that is implied by the $500m placement of IAG shares to Berkshire Hathaway for a 3.7% stake. The deal also includes a 10-year, 20% quota share arrangement and a swap of some portfolios between the two. IAG is guiding to an underlying margin range of 14-16% post the deal, but this includes a boost of 2.0% from the exchange commission. JP Morgan estimates the revised guidance implies around 6.5% dilution to earnings for FY16. Of significance to the outlook is the future use of the funds that have been raised.

Some may see the noted investor's purchase of scrip as a vote of confidence in the insurer, or a desire to eventually increase its ownership stake, but JP Morgan suspects there will be near-term downside for the share price until plans for the capital are made clear. Hence, the broker's rating is downgraded to Underweight from Neutral. Macquarie is of a similar view. In the absence of clarity on capital management and investment initiatives, the broker suspects the stock will underperform, given the current insurance market conditions such as premium rate competition, margin pressure and loss of market share. Not to mention allocation of capital, potentially, to the Asian initiative. Macquarie, too, makes the move to downgrade to Underperform from Neutral.

The deal may be value enhancing and aid free cash flow but Deutsche Bank considers the capital raising unnecessary. Combined with FY16 guidance, it also points to softer underlying earnings trends, primarily in commercial areas. Furthermore, with IAG signalling it will pursue expansion opportunities in Asia ahead of capital management, it suggests to Deutsche Bank a pick up in returns will be some time away. The broker believes value upside will be constrained going forward and retains a preference for QBE Insurance ((QBE)) and Suncorp ((SUN)).

The deal merely delays the issue of underlying earnings, in Credit Suisse's view. The broker assumes IAG is looking to generate savings across its broader reinsurance spending, in order for the deal to be neutral to profit. In the current environment this is not assured, the broker maintains. Still, there is no immediate negative catalyst and there is the potential for a capital return. To this end, Credit Suisse incorporates a special dividend into FY16 forecasts of 15c.

Citi accepts the argument that with a less volatile earnings stream, having swapped 20% of its business for more stable income, the stock should trade at a higher multiple. A number of strategic positives are likely from the deal but the impact on earnings and the implications for underlying margins dampens Citi's enthusiasm.The broker believes assumptions need to be stretched for the quota share to be earnings neutral.

Citi calculates that ahead of this year's weather events, the mid point of guidance for insurance margins in FY15 was 14.5%, assuming reserve releases of 2.0%. The corresponding calculation for FY16, less the benefit of the quota share, suggests the margin is 12.5%, implying a deterioration, even if FY16 will benefit from around 1.0% of incremental synergies. Still, depending how much is spent on acquisitions in the meantime, Citi considers IAG has scope for a reasonable capital return in FY16.

Even with additional background information provided subsequent to the initial announcement, UBS finds it difficult to envisage how the arrangement can be neutral for insurance profits without assuming a generous exchange commission. The deal is appealing from the capital that comes from the best known insurance investor, although the broker emphasises the main game for Berkshire Hathaway is the quota share. The extent to which the capital might be deployed in Asia rather than given back to shareholders remains unclear, nonetheless. UBS, therefore maintains a Neutral recommendation, given further indications of underlying profit deterioration and the medium-term cost to earnings of establishing the relationship.

Morgan Stanley is a little more upbeat. The broker believes the partnership makes sense as it provides scope for growth and capital initiatives, although some of the upside will now be shared. Despite the earnings dilution and challenging outlook, given the insurer's leading position in Australasia the deal de-risks this exposure and allows for benefits from an improved market structure. The stronger capital position, with an option for a further placement of 5.0% to Berkshire Hathaway, offers the capacity to build growth in Asia, the broker contends.

There are no Buy ratings on FNArena's database. There are six Hold and two Sell (Macquarie, JP Morgan). The consensus target is $5.82, suggesting 0.8% upside to the last share price. Targets range from $5.40 to $6.20. The dividend yield on FY15 and FY16 estimates is 5.2% and 5.4% respectively.
 

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