Treasure Chest | Jul 08 2016
By Eva Brocklehurst
The protracted underwriting issues experienced by travel insurance provider Cover-More ((CVO)) over recent months have diverted attention from the stock's key investment thesis, the outlook for outbound travel. Now there is some clarity in this regard, Bell Potter believes it is time to look at the company's margin trajectory and exposure to the travel theme.
The company has finalised an underwriting arrangement with Great Lakes Australia in the interim while a new underwriter is obtained. The term will run until September 30, 2017. The company is able to terminate the deal on reaching an agreement with new underwriters, with notice of intent to be provided 3-6 months ahead of termination. The target loss ratio is unchanged. A new underwriter agreement is expected to commence no later than January 2017.
Bell Potter is now increasingly confident earnings margins for Australian travel insurance will gradually move towards the company's stated guidance of 7.5-8.0% of gross written premium over time. The company provided this guidance prior to the resolution of the underwriting arrangement and the market has attached little credence to the likely delivery.
Now some clarity has been provided, the broker expects the improving margin outlook over the next two years will increasingly be heeded. Bell Potter assumes the process will be gradual, as the impact of premium re-pricing takes time. Still, the main point is that the trajectory in margins is likely to be up.
The outbound holiday theme is also an appealing aspect of the stock, a theme which has been set aside while the machinations of underwriting play out. Bell Potter finds this is one of the main attractions in Cover-More, given its domestic travel insurance business is leveraged to volume growth in this variable. The broker expects a structural shift to outbound travel at the expense of domestic will continue, and the finalising of the underwriting agreement is a positive step towards restoring market confidence.
A combination of favourable age demographics and downward pressure on airfares provide powerful tailwinds for the segment in the year to come. The broker believes the recent slowing in outbound travel is indicative of a slowdown in household consumption expenditure, as part of a correction within a long uptrend.
Bell Potter, not one of the eight stockbrokers monitored daily on the FNArena database, retains a Buy rating and $1.86 target. The broker believes Cover-More's tourism exposure is enhanced by the light capital nature of the business and a solid balance sheet with an increasing dividend stream.
This interim arrangement will lift the alignment between Cover-More and Great Lakes and reduce volatility in underwriting premium, UBS concurs. However, the broker notes that Cover-More will share in both the upside and downside of claims cost experience versus the target loss ratio, compared with the prior arrangement when Great Lakes took the downside risk.
The main question relates to the flow through of any new deal to insurance margins. The current share price appears to be factoring in margins of around 5.0% in perpetuity and UBS suspects the market will retain a cautious stance until new underwriting details are signed off.
There are two Buy ratings and one Hold for Cover-More on FNArena's database. The consensus target is $1.79, suggesting 37.7% upside to the last share price. The targets range from $1.50 (Morgan Stanley) to $2.00 (Macquarie). The dividend yield on FY16 and FY17 estimates is 4.8% and 5.7% respectively.
Short traders have increasingly moved in on Cover-More in recent weeks. The latest ASIC data has shorts on Cover-More rising to 9.4% as of last week, leaving the stock exposed to short covering potential. (See The Short Report)
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