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Brokers Question IAG’s Change In Tack

Australia | Dec 13 2016

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

Insurance Australia Group's is shift to a more customer-centric model has brokers highlighting the risks.

-Targets suggest 10% growth in earnings per share
-Investors cautioned about using cost savings as basis of profit growth
-Customer loyalty may be tested by changes to the system


By Eva Brocklehurst

Insurance Australia Group ((IAG)) has signalled a shift away from a strategy of acquiring growth, one that has been in place since listing in 2000.

The company has implied around 10% growth in earnings per share per annum for the next four years and provided 3-5 year growth and earnings targets. The commitments are largely based on achieving gross written premium (GWP) growth targets and delivering $250m in operational savings in FY20.

Market-related organic GWP growth and reductions in expenses are expected to provide the operating base for future earnings growth, UBS observes. On both measures, the broker asserts the company has fallen short in recent years. Hence, this is uncharted territory for IAG.

The broker is encouraged by the progress being made so far in terms of innovation and customer initiatives but remains conservative in its forecasts. Customer-led initiatives and innovation, while not insignificant, are less tangible and, therefore, in its assessment UBS focuses on efficiencies.

Cost savings are expected to flow across claims handling, underwriting expenses and fee businesses, and appear credible. The broker gives the company the benefit of the doubt and reduces the forecast expense growth trajectory beyond FY19. UBS also notes there is minimal headroom for another buy-back in 2017.

Credit Suisse does not believe the targets will be achieved. Moreover, they will be, realistically, difficult to measure in five years time. While the broker is encouraged by a focus on costs, investors are cautioned around using cost savings as a basis of profit growth. The broker asserts cost saving programs are more an acknowledgement that the environment is tough.

That said, Credit Suisse is not suggesting the company's new focus on customers is heading for failure and highlights the fact such a strategy has been in place for over five years and, arguably, the company should understand the potential much better now. Hence, the opportunity may be greater.

The concern the broker has is with new products and the potential to upset the existing customer base. In essence, innovation and embracing change are worthwhile but do not come without risk, especially if you are the largest player in a stale industry.

While the company's growth has been 1-2% below system in recent years, its retention rate for personal lines remains one of the highest in the world and the broker asserts that disturbing a loyal and profitable back book is a key risk.

In a challenging insurance market, Credit Suisse does not believe the peak multiple to be justified either. The stock is currently trading at the highest absolute price/earnings ratio it has traded at since listing, at 16.4x. This is well above the company's historical 10-20% discount. The broker retains an Underperform rating.

The cost optimisation program is larger than Morgans expected. The scale has exceeded the combined $230m in benefits derived from the synergies from the Wesfarmers ((WES)) insurance business acquisition and the implementation of a new operating model.

The target of 10% compound growth in earnings per share implies further capital management, in the broker's view, and evidence supports the prospect of some being implemented in FY18.

While Morgans retains some scepticism regarding the sustainability of margin improvements, as underlying insurance margins actually fell to 14% from 14.2% over FY14-16, downside risks are still considered to be reduced.

Trading conditions are actually more positive than Macquarie had suspected. To deliver on its medium-term targets the company needs additional quota share reinsurance, as the targets imply an underlying insurance margin of more than 16%.

Macquarie shares the concern, given the current strength in the company's leading brands, that profitability, market share and customer loyalty may be tested by changes to the system. Long-term targets are ahead of expectations and will require additional capital and earnings optimisation, the broker contends.

Ord Minnett believes the commercial cycle is turning and the company will benefit from entry into the South Australian CTP (green slip) market. This broker is also cautious about the long-term viability of the targeted growth in earnings per share, because of the low-growth nature of general insurance and the company's dominance of that market.

Nevertheless, IAG has the strongest brands and offers the most conservative guidance across the broker's coverage in the general insurance sector. Ord Minnett suspects the market will like the latest cost reduction plans and upgrades earnings estimates by around 4%. The stock price remains a little high for an upgrade and a Hold rating is retained.

It remains unclear as to how much of the targeted savings will find their way to the bottom line and most of the benefits will accrue in FY19 and beyond, Citi observes. The broker expects the transformation to a customer-centric model from a channel and product-centric organisation will mean a significant reduction in local staffing and this carries a reasonable level of execution risk.

FNArena's database shows seven Hold ratings and one Sell (Credit Suisse). The consensus target is $5.78, signalling 1.4% downside to the last share price. The dividend yield on FY17 and FY18 forecasts is 4.6% and 4.7% respectively.

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