-Valuations somewhat stretched
-IOOF expected to struggle
-ASX least surprising
 

By Eva Brocklehurst

Brokers have weighed up their recommendations in the diversified financial sector ahead of results season.

BA-Merrill Lynch expects asset managers which can defend their value proposition will outperform those financials simply providing platforms. This favours Perpetual ((PPT)), where the broker considers there's upside risk to the estimated 7-8% earnings accretion that comes from the recent acquisition of Trust Co. On JP Morgan's hot list for surprises is Challenger ((CGF)), where expectations for an upgrade to FY14 guidance may not be met. Citi retains a different view and thinks there's a good chance of an upgrade to Challenger's annuity retail book growth.

JP Morgan sees several stretched valuations across the sector. Risks to the downside lie with IOOF ((IFL)) from margin attrition and regulatory reform costs, while the least risk is with ASX ((ASX)), which doesn't usually surprise at the results season. For Computershare ((CPU)), the focus is on margin income and the quality of results. In the case of Challenger, JP Morgan thinks the market's expectations for an increase in full year guidance may not be met as an unusually high number of annuities will mature in FY14. The broker retains an Underweight rating on Challenger.

Merrills has reinstated coverage of wealth managers Perpetual and IOOF after a four-year break. On the broker's Buy list among the diversified financials is Perpetual, Computershare and Macquarie Group ((MQG)). Challenger is upgraded to Neutral. as the broker does not feel an Underperform rating can be justified with better-than-expected margin outcomes and the recent performance of the funds management division.

The global strategists at Merrills are bullish and expect the great rotation in equities to to continue. Hence, diversified financials are well placed to outperform again. Nonetheless, in line with JP Morgan, the broker finds some valuations are looking a little stretched. The broker is also concerned about IOOF, which attracts an Underperform rating. These concerns centre on the regulatory and competitive pressures which could ultimately erode industry platform margins. IOOF also lacks scale and balance sheet capacity as well as the distribution reach of its larger peers.

On the other side of the scale is Macquarie, upgraded to Buy by Merrills, where the company looks set to benefit from an improving outlook for the advanced economies as well as stronger capital markets activity. Strategic and financial flexibility will enable the company to make accretive acquisitions or distribute capital, as it sees fit. Perpetual derives the bulk of its earnings from asset management and has significant leverage to rising markets. Hence its attraction for the broker. The stock tops Merrills' list among asset managers for now.

Citi's order of preference in the sector is Challenger, IOOF, Henderson ((HGG)), Computershare, Perpetual and ASX. A number of the stocks are considered relatively expensive, such as Perpetual, so the broker has all but Challenger on a Neutral rating. Macquarie is categorised in the banking sector and Citi has a Buy recommendation. Citi's strategists expect the equity market will continue to advance in 2014 and the broker recognises the risk that these stocks could become even more expensive. Perpetual shows some upside risks to Citi's forecasts, especially if the equity market advances. Still, given the flows, the broker is more of the view that it is fully priced.

Challenger is top of the stack in diversified financials as the valuation remains reasonable and Citi thinks there's a good chance for an upgrade to annuity retail book growth and life guidance. Henderson may reveal a turn in institutional flows to the positive side of the ledger in the fourth quarter and Citi suspects the company will beat guidance for second half performance fees. Still, the broker finds the stock expensive despite the strong business momentum.

In terms of IOOF, Citi also expects the company to struggle to achieve organic revenue growth but, if the market is kind in the first half and cost control still evident, then it should still be a solid result. Citi is also seeing upside to the revenue forecasts from Computershare, but thinks the overall outlook remains mixed for the stock. Citi observes Computershare has significant positive leverage to rising short-dated interest rates. The broker thinks ASX is looking more like a high dividend, low growth stock. It doesn't appear to be extracting benefit from rising markets the way it once did. Declining velocity is part of the reason, Citi suspects, but this is being exacerbated by the extension of revenue growth rebates.
 

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- Bank PE expansion significant
- Earnings growth remains subdued
- Dividends remain attractive
- Various headwinds to consider

By Greg Peel

Commonwealth Bank ((CBA)) will report its half-year result mid-February and each of ANZ Bank ((ANZ)), National Bank ((NAB)) and Westpac ((WBC)) will provide December quarter updates during the month. This will provide the first indication as to how the banks are faring as we move into 2014 and the Australian economy attempts to transition from a mining to a non-mining focus.

Of the past three years of major bank share price appreciation, notes BA-Merrill Lynch, 73% can be attributed to “PE multiple expansion”. On FY14 forecasts and current share prices, the Big Four are averaging a price/earnings ratio (PE) of 13.6x, with CBA the stand-out at 15.2x. What Merrills’ calculations imply is that only 27% of the three-year rise in share prices can be attributed to increased earnings – that which, at the end of the day, drives stock value – while 73% can be attributed to the market simply paying higher and higher share prices for that same earnings growth.

Under normal circumstances, a stock’s PE will rise in anticipation of future earnings growth, but for the best part of the last three years, the subdued credit growth environment in Australia has meant equally subdued forecast earnings growth. In recent months we’ve seen a pick-up in housing investment in Australia, leading to improved expectations for housing credit growth, but credit growth in other sectors, particularly business, continues to languish. In the case of the banks, something else has been driving PE multiple expansion.

And of course we know the answer to that is “yield”. As long as the banks can maintain attractive dividend yields, investors all over the world will find Australian bank yields attractive. The lower interest rates fall domestically and offshore, the greater that attraction will be. And the banks have had another trick up their sleeves.

Starved of meaningful credit growth in recent years, the banks have still managed to book significant “earnings” by reducing bad debt provisions. All this means is a lot of the money the banks put aside after the GFC as a buffer against a run of bad loans (back when we all thought the world might end) has been brought back to the P&L as “earnings” (given the world didn’t end). These “earnings” windfalls bolstered balance sheets and allowed the banks to pay back shareholders who suffered when everything was going the other way in 2009-10. The banks increased their dividend payout ratios (of earnings) and offered up special dividends, thus increasing their yields, thus increasing their attractiveness, thus increasing share prices, and thus increasing their PE multiples.

So here we are. Now what?

Let’s first consider the following one-year chart.
 

 

The blue line is the ASX 200 (XJO) and the red line is the ASX Financials ex-REITs (XXJ). We can clearly see the big “sell in May” correction of 2013, which was driven by the first hints of Fed tapering, and the point at which bank yields began to act as a parachute. When sentiment turned in June, the banks led the charge. The rest of the market caught up around September (bear in mind the banks represent a significant chunk of the index and hence there should be correlation) but when tapering appeared to be truly on the cards, the banks again provided a yield parachute in December. Again we bounced, and again the market caught up. But as we entered 2014…

Let’s zoom in now to a three-month chart, and we see that the relationship has reversed.

 

 

The banks have underperformed the index, and we can largely put that down to two factors. Firstly, as global economic growth forecasts improve, investors have been switching into resource sector exposure. Secondly, the banks have reached levels which, on PE multiples, investors feel leave little room for further upside. Hence it is the banks out of which investors have switched.

On Merrills’ numbers (comparing current to long-run average PE multiples), NAB is 10% overvalued, ANZ 12%, Westpac 13% and CBA 19%.

Outside of housing, credit growth is forecast to remain subdued in 2014, and hence bank earnings growth is expected to remain at single-digit percentage levels. Significantly, bad debts are now close to record lows. Not post-GFC lows, but record lows. In other words, the windfall days of redistributing bad debt provisions to shareholders are possibly coming to an end (perhaps with the exception of NAB’s UK exposures).

That said, Macquarie believes there is still the potential for lower impairments in 2014 when comparing to the past twenty years given the next ten years will feature a much lower prevailing interest rate environment. The broker has subsequently lowered its bank impairment forecasts for the period, suggesting the potential for further provision releases.

There is little agreement amongst analysts. Goldman Sachs believes the second half of 2013 will show to have marked the trough in bad debt reductions, with the uncertain domestic economic outlook leading to a potential increase from here.

Nevertheless, forecasts for global economic growth in 2014 have been improving. The IMF, for example, is forecasting 3.6% global GDP growth in 2014 compared to 2.9% in 2013. Over the past ten years, the Big Four have underperformed the index when global growth has accelerated and outperformed when growth has slowed, Merrills has found. This is simply a relative measure – resource sector stocks perform much better in times of global growth. Over 25 years, this relationship remains 80% accurate.

And over the past twenty years, Big Four earnings growth has averaged twice the current forecast growth rate for FY14-16 of 5-6%. Merrills doesn’t see much in the way of earnings downside risk for the banks, but it doesn’t see a lot of upside either against a backdrop of low bad debt levels and stretched PE multiples.

The economy is one thing, but outside of post-GFC economic trends the banks also have to deal with GFC-inspired global regulatory changes. Fundamentally, banks across the world now have to hold a higher ratio on their balance sheets of common equity tier one (CET1) capital, which in Australian terms means ordinary shares. Before the GFC, the Big Four averaged 5.5% of CET1, notes JP Morgan. Today that average is pushing above 8%.

The Big Four are also categorised amongst world banks as “D-SIBs”, or “domestic systemically important banks”. Or in simple GFC parlance, “too big to fail” in a domestic sense. The Bank of International Settlements (BIS) recently decided D-SIBs need an extra 1% of CET1 on their balance sheets as a precaution.

Then there are net stable funding ratio (NSFR) requirements and liquidity coverage ratio (LCR) requirements. The latter refers to the level of liquid assets held on balance sheets that can be readily cashed in in times of crisis to head off another liquidity crunch, and to that end they must also thus be “risk free” assets, basically meaning government bonds. The RBA was forced to step in with regard to LCRs and gain approval from BIS to provide a committed liquidity facility for Australian banks given the Australian government simply does not issue enough paper for the banks to buy, despite political hysteria over government debt.

Australian banks have been building up their capital positions since the GFC, initially by cutting dividends and directly raising fresh capital and then by “back-door” capital raisings through dividend reinvestment plans (DRP), as well as reducing liabilities. Assuming the Australian Prudential Regulation Authority (APRA) applies the new BIS rules as they are, and not strengthen them, then the Big Four are looking pretty comfortable as far as JP Morgan is concerned. The banks themselves have clearly been feeling more comfortable, as they have recently both increased dividends and “neutralised” DRPs (meaning no fresh capital issued). The rules will come into force in 2016 and by that stage the banks will have increased their CET1 ratios further.

This means ratios of around 9% will be required, suggests CIMB, if the banks are to maintain current dividend payouts (which reduce CET1 by 1%). There should be no trouble in reaching 9% while loan growth remains subdued. However, the additional D-SIB requirement will act as a drag on banks’ return on equity, and hence even a modest rebound in business lending growth is likely to mean an end to the neutralisation of DRPs, CIMB suggests, implying shareholder dilution.

In other words, while Australian banks are in a more comfortable capital position than most banks around the world, a recovery in credit growth which, of course, is what we’d all like to see, will actually be encumbered in bank valuation terms by the new post-GFC regulations.

Another consideration for the Big Four as the GFC fades further and further into the distance is that of competition. After a long hiatus, non-bank lenders are now returning to the game.

Mortgage broker AFG has for the first time published data outlining bank and non-bank loan originations by product and brand. The November data, suggests JP Morgan, confirm non-bank lenders are now back to capturing a greater share of new home loans, at 23% of all AFG originations. Banks have recently started to increase broker commission rates once more, supporting broker-led originations. They now stand at an all-time high of around 45%.

Fixed rate mortgages have become very popular in the new low interest rate environment, and the share of new fixed rate mortgages for non-banks has increased to 40% from 20% only one year ago. On the other side, banks’ share of new fixed rate mortgages has decreased to 60% from 80%. Nonetheless, banks still control around 80% of all existing mortgages.

But they are not satisfied. Competition amongst the majors for new mortgages is heating up once more, with discounted floating rates being offered on the one hand and increased loan-to-value ratios (LVR) on the other. Banks profit more from larger sized loans, so the greatest discount and LVR concessions are being granted on the larger loans.

It looks like, at least from the banks’ perspective, the GFC is dead and buried. How far back can we go into lax lending practices?

On the other side of the balance sheet, however, competition for deposits amongst the majors is easing. Term deposit spreads hit their lows one year ago and are now an average 60 basis points higher, Goldman Sachs notes. This eases the margin pressure associated with mortgage loan competition.

None of the above paints a particularly clear picture of whether the Big Four can carry 2013 share price momentum into 2014. Merrills cites overblown PE expansion on the one hand, while CIMB’s view is not as bearish. Sure, says CIMB, the banks are overvalued on both price to earnings and price to book value bases, but only marginally, relative to the wider market. Assuming no near term threat to earnings and dividends, the banks remain attractive compared to other industrials and resource stocks, the broker suggests.

In assessing the Big Four, let’s look at where they stood back in November, shortly after the full-year reporting season.
 

 

Despite overvaluation calls, the table above shows only CBA was at the time trading at a share price above its consensus target price. Following solid earnings reports, driven largely by bad debt provision returns, analysts collectively raised their targets. In so doing, they satisfied the long-run FNArena observation that when bank share prices exceed target prices those share prices are set to fall, unless analysts find reason to raise their target prices.

We also note ANZ was the most preferred bank on consensus, attracting four Buy ratings, while the perennially “overvalued” CBA sat in last place with only two Buy ratings.

Moving ahead to today, based on yesterday’s closing prices, we find that if this consensus table is any guide, only CBA is strictly overvalued, as it was in November, and the upside to target prices in general has increased. There have only been slight changes to target prices in the interim. Clearly these numbers are impacted by recent falls in bank share prices, as noted in the chart above.
 

 

We also see ANZ has lost top place to NAB, albeit both attract only three Buy ratings, while CBA has slipped further at last place with only one Buy rating.

The pullback in share prices has also naturally affected an increase in dividend yields, which are, on a fully franked basis, still attractive. On that basis, it is hard to see bank share prices falling significantly over 2014, barring any left field disaster. But parachutes aside, it will be tough for the banks to provide further PE expansion until earnings growth can improve beyond the “subdued”.

If the global economy performs well in 2014, and forecasts have the “world” performing better than Australia, then resource sector stocks will draw more attention and the switch will continue, undermining bank share prices. Furthermore, if the Fed keeps tapering on US economic health, the next step is for higher US interest rates. Once this occurs, incremental increases will chip away at the offshore attractiveness of Australian bank shares, and a falling Australian dollar will also act as a deterrent to Australian investment in general.

Perhaps 2014 will be the year the banks return to simply being “defensive” stocks, as they once used to be.
 

Technical limitations

If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.

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-Strength in incumbency, cash flow
-Growth underpinned by access to PPSR
-New comprehensive reporting opportunity
 

By Eva Brocklehurst

Veda Group ((VED)) returned to familiar ASX surroundings with an IPO in December after a period of absence and brokers have taken a look at its current prospects. Veda conducts credit checks on consumer and commercial enquiries for the insurance, automotive and property sectors and provides customer data analysis for many other sectors from its long-dated, proprietary databases.

Both Citi and UBS have initiated coverage on the stock, ascribing Neutral ratings, with $1.94 and $1.95 price targets respectively. Veda's current intention is to declare an unfranked FY14 dividend of 2c per share. Citi notes the implied dividend yield may trail domestic peers in absolute terms but would be in line with, or even above, offshore peers. Citi's valuation places the stock at similar multiples to professional and business services peers with some attention to offshore comparisons, as there's a lack of directly comparable domestic operators.

The strength of the business is in incumbency but UBS hails the fact the company has not become complacent, with several significant product developments and bolt-on acquisitions implemented in recent times. The broker believes the stock offers investors good exposure to a dominant market position in consumer and commercial credit checks as well as business-to-consumer credit scoring. Cash flow conversion is strong and while capex is elevated in the short term, UBS expects this should ease back, enabling cash generation to provide scope for either bolt-on acquisitions or an increased pay-out. The pay-out ratio is currently targeting 40-60%.

There are four primary drivers of growth for Veda, in Citi's view. These are deeper products, volume growth, new comprehensive credit reporting in Australia, and acquisitions. The company is focused on expanding product offerings and also bringing new products to new sectors in Australia and New Zealand as well as offshore emerging market investments. Veda operates in the Middle East and Asia. In 2013 Cambodia improved access to credit information by establishing its first private credit bureau with Veda. 

Of some concern to brokers is that Veda is heavily leveraged to the financial services sector, with at least 78% of its customers in FY13 being in a finance or finance-related industry. This creates some risk in Citi's opinion as while no single customer contributes more than 10% of revenue, the big four Australian banks collectively represent 30% of revenue. The broker also notes some potential ambiguities in reporting profitability which, as a result, can lower overall understanding of the company. Veda only discloses revenue by segment and not contributing EBITDA. Citi is concerned about a lack of insight into the margin contribution from each division, which can lead to an over-generalisation of forecasts.

The brokers note risks mainly come from adverse changes in regulations or access to data being removed, limited or compromised, as well as the usual competition from new entrants. Some of the former risks can be serious. An example UBS provides is of US credit reporting agency Equifax, which recently lost a judgment related to falsely identifying information in a consumer credit report. The consumer was awarded $18.6m as a result of the mistakes, which had prevented credit being provided from financial institutions across a number of years.

The cyclical upswing may be helpful, with mortgage credit applications experiencing a strong recovery, but non-mortgage consumer credit and commercial credit continue to be relatively weak. Hence, UBS believes Veda's growth prospects in the near term will be underpinned by identification services and access to the Personal Property Securities Register (PPSR). PPSR is the single national source of registered security interests in personal property and has new rules to help protect consumers and business manage credit risk and check interests. Veda flags an advantage in that its established search function for the register, called VedaCheck, saves customers time and money.

Another changing feature of the credit landscape has positive aspects, but also more potential competition for Veda. Australia is introducing more comprehensive credit reporting in March, as the current system only allows the collection of negative data. A number of industry participants have lobbied for changes that would facilitate a shift towards full or comprehensive credit reporting. Having insights into a customer's credit worthiness would enable business to evaluate a risk profile and provide more valuable information, according to those that are pushing for reforms. Underpinning the case is that customer payment or repayment history is a strong predictor of future behaviour. Making this data available to credit providers therefore appears compelling. Comprehensive credit reporting should provide a new avenue of growth for Veda but won't be a material opportunity until FY16, in Citi's view, as it will take time to achieve critical mass.

UBS considers the upside for the stock is predicated on the introduction of comprehensive reporting because, not only will the level of enquiries increase, but World Bank data suggests that enquiries are 90% higher in such markets, relative to negative-only reporting markets. UBS suggests one caveat that needs to be applied to that statistic is the extent of concentration in a particular market's banking sector. Nevertheless, in a local scenario where comprehensive reporting drives enquiries up by even 50% this could add $40m to the broker's revenue forecasts for Veda, at what is a high incremental margin.

On the downside a competitor like Experian, which obtains a larger contribution from business-to-consumer enquiries and reports in the UK and the US, could make hay while the sun shines in Australia. UBS notes comprehensive reporting success could be greater with new business enquiries under the expanded system rather than for existing business with established credit checks. Further comparing Veda to Experian, UBS finds Veda has substantially less direct consumer contribution to revenue. While comprehensive reporting increases awareness amongst consumers for the need to manage credit scoring and credit attributes, UBS considers it's only part of the explanation for the gap in the contribution to earnings, which is 21% for Experian versus 8% for Veda.

Veda started back in 1967 as the Credit Reference Association of Australia, listed in 1998 as Data Advantage and then merged with Baycorp in 2001. It was taken private in 2007 by Pacific Equity Partners and Merrill Lynch Global. Merrill Lynch sold its stake to Pacific Equity in 2011. Pacific Equity retains a majority shareholding. The company's main competitor in Australia is Dun & Bradstreet.
 

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-Benefit to IAG outweighs price
-Some regulatory concerns probable
-What will Wesfarmers do with funds?
-Wesfarmers shares remain expensive
 

By Eva Brocklehurst

Diverse conglomerate Wesfarmers ((WES)) plans to sell its insurance underwriting business in Australian and New Zealand to Insurance Australia Group ((IAG)). Brokers consider the price is full - $1.85 billion - and at the top of the insurance earnings cycle. If the sale goes ahead, and it's subject to a number of regulatory approvals, both locally and across the Tasman, it will simplify Wesfarmers' offering, a little. The company will still retain its insurance broking side and has done a deal with IAG for Coles supermarkets to retain the insurance distribution channel for 10 years.

CIMB considers the strategic benefits to IAG outweigh the high price, as this acquisition secures a major business that can assist the company's domestic growth strategy until the Asian business lends more support. The Coles agreement also opens up a new distribution channel, while removing a threat in motor insurance, although the broker does wonder whether that channel could cannibalise existing business. The deal raises IAG's gross written premium by 18% and gives it a leading position in the intermediated insurance market in Australasia.

That's if it secures all the regulatory approvals required. Credit Suisse notes IAG's attempt to frame the market share debate around an "intermediated" distribution view suggests there's some concerns regarding regulatory approval. Citi thinks the deal may drag out as it's not an easy case for the Australian Competition and Consumer Commission (ACCC). Also, the acquisition will increase IAG's NZ exposure in the intermediated business to 40% of market share. Macquarie observes that competition approval is likely to focus on certain lines of business, potentially rural, but the market is difficult to define.

Credit Suisse thinks the timing makes sense for IAG. While premium rate increases have slowed and will continue to slow, the benefits from the acquisition lie in the significant reinsurance savings and improving the efficiency of the underperforming operations. The deal also gives IAG access to what the broker considered was its biggest threat to personal lines, Coles. The acquisition is not without risk, as a large part of the savings lie with increasing the retention of the acquired business and realising reinsurance synergies. There are a number of commercial players in the market looking to grow market share in coming years and Credit Suisse anticipates they will not make integrating the Wesfarmers' business easy for IAG.

Morgan Stanley's view is along the same lines. The strategic rationale is sound as IAG becomes number one in Australian commercial lines, with 24% of the market as the structure improves. Also, it protects the company's personal motor franchise, where the broker thinks Coles was a real threat. Deutsche Bank is a little cooler about the deal. While it may help plug an earnings growth gap after FY14 as the insurance cycle turns, the broker questions the sustainable benefit relative to a cheaper, albeit slower, organic approach to growing commercial lines. Macquarie finds the strategic rationale sensible, consolidating a market with a high degree of product and geographic overlap.

The profit on the sale is around $700-750m so the natural question is, what will Wesfarmers do with the money? UBS considers capital management the most likely scenario, or an acquisition, given that, after this divestment, Wesfarmers will have in excess of $4.6bn in unused facilities. Alternatively, buying back $1.5bn in shares would be around 0.8% accretive. CIMB thinks, at the current share price, the accretive value of a buy-back is not worthwhile but the lack of franking credits means a dividend increase is also unlikely. CIMB wonders whether Wesfarmers will buy a metallurgical coal asset at the bottom of the resources cycle. The company has signalled it likes the opportunity for counter cyclical investment, having previously discussed a desire to evaluate acquisitions that offer economies of scale or downstream benefits.

Wesfarmers has just sold its 40% interest in Air Liquide for approximately $100 million. Is it sizing up another deal? Credit Suisse doesn't think so, given the company's discipline regarding fundamental valuations for acquisitions. The rise in markets over the past year and low debt costs are more likely to lead to acquirers paying a high price. Moreover, with Wesfarmers having acquisition capacity of $2-3 billion, it makes an acquisition only moderately material for the group, in the broker's opinion. BA-Merrill Lynch believes both businesses - insurance underwriting and Air Liquide - were generating earnings that looked unsustainable into the future, without sizeable amounts of capital being invested.

CIMB has decided the deal looks good on both sides and upgraded recommendations for both stocks to Hold. Macquarie likes the sale price Wesfarmers stands to receive and thinks it should provide the opportunity for another capital return. The broker upgraded the stock to Neutral from Underperform. JP Morgan considers Wesfarmers is well managed and active in returning capital but lacks valuation support so Underweight is the way to go. Citi thinks Wesfarmers is expensive and retains a Sell rating. The sale of insurance underwriting removes a business that was highly volatile, in Merrills' view, and one where shareholder interest and understanding was low. The broker is upbeat about the growth for the stock and remains the FNArena database's only holder of a Buy rating on Wesfarmers.

Brokers have tweaked price targets for Wesfarmers in both directions following the news, as they grapple with whether the stock is still expensive. Most seem to concede it is. The new consensus target on the FNArena database is $42.17 and is level pegging the last share price. This compares with $41.38 ahead of the announcement. The targets range from $34.60 (Citi) to $53.00 (Merrills). Wesfarmers' dividend yield on FY14 forecasts is 4.6% and for FY15 it's 5.1%. The stock now has two Buy ratings, three Hold (with two of these being upgrades) and three Sell.

IAG's consensus price target has also risen, to $5.75 from $5.64 beforehand. The new target suggests 5.8% upside to the last share price. IAG has one Buy rating (Macquarie), five Hold and two Sell. The dividend yield is 5.0% on FY14 forecasts and 5.3% for FY15.

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- QBE issues warning, share price tanks
- Earnings opaqueness keeps brokers concerned
- Management possibly conservative, but caution rules

By Greg Peel

“Today’s QBE profit warning is a painful reminder that micro can quickly overwhelm macro in opaque turnarounds,” says UBS.

For a long while QBE Insurance ((QBE)) struggled against near-zero interest rates in the US, a strong Aussie dollar and a burst of higher than average catastrophe claims. This year, however, light was seen at the end of the tunnel by long suffering investors as the Fed flagged stimulus tapering (leading to a bounce in US rates), the Aussie dropped around 14% and catastrophes appeared to be well contained. Indeed, long-term insurance watchers were keen to point out that “cats” tend to cycle, such that a period of extensive claims is usually followed by a quiet period.

This is where insurance companies can outperform, given prior high cats justify premium increases into a period of low cats. But then QBE is not just about said “cats”. It’s about workers comp and crops and a lender-placed business, among other things.

When the macro story began to turn around, investors were quick to jump on QBE. Never mind that it’s very difficult to predict claims activity across the range of insurance activities the company engages in in North America. As UBS notes above, this difficulty renders QBE’s supposed turnaround “opaque”. Investors were prepared to back the “macro” (rates, AUD) and pay scant attention to the “micro” (claims et al).

And so it was the company issued a profit warning before the market open yesterday, and the share price plunged 22%.

QBE downgraded its profit guidance, last updated post the August interim result release, to a US$250m loss due to claim provisions and write-downs in North America. Behind this number was a $300m provision increase for prior accident year claims development relating to workers comp, general liability and construction defects risks. US crop insurance claims rose by 11% last quarter due to materially lower crop prices. Some $150m has been apportioned to restructure the lenders-placed business along with $330m in intangibles write-downs.

And $600m of US goodwill has been written down. Bit light, suggests Macquarie, given the $2.354bn ascribed to North America goodwill at the 2012 result.

Investors may be angry about the downgrade but red-faced stock analysts are far from amused. Ahead of the warning, four of eight FNArena database brokers rated QBE Buy (or equivalent) and only one rated Sell. JP Morgan (Underweight) rates stocks on a sector-relative basis. What has changed so materially since the interim result? analysts ask. This rapid deterioration in profitability since August is a concern, UBS suggests. Says Credit Suisse:

“With reserves less than US$1bn a year ago, we remain confused at how the provisions have increased to excess of US$1.5bn today. We assume management has this time taken an extremely conservative approach to reserving; however, we have no supporting data to back up this view.”

QBE’s guidance for FY14 implies that the issues have not yet been resolved, CS adds.

Not surprisingly, analysts have slashed their earnings forecasts and their target prices. The FNArena consensus target price has fallen to $14.79 from $16.36 prior. However, both JP Morgan and Deutsche Bank (Buy) are yet to update their views and targets. If we drop those two out, the consensus target becomes $12.98.

But with the stock down 22% yesterday, where is QBE sitting in value terms now?

The focal point of QBE’s earnings is its net margin, expectation for which management yesterday downgraded to 6% from 11% in FY13. The preliminary target for 2014 is 10%. UBS believes that 10% is achievable but “remains cautious”. BA-Merrill Lynch believes 10% is too conservative and has pencilled in 11.5%. Credit Suisse suggests that on the assumption North America recovers next year, and expenses are successfully pulled out of the group, an insurance margin recovery of some 300 basis points can be achieved from the current 2014 base.

CS has thus retained its Outperform rating, given yesterday’s share price rout. UBS and Merrills have both stuck with Neutral.

CIMB cites a lack of confidence and ongoing issues across the North American portfolio that are more widespread than previously envisaged in downgrading to Hold. Macquarie cites “insufficient visibility on the earnings outlook” as its reason to downgrade to Underperform. Despite improving macro conditions, this visibility issue offers up a “high potential of material variation from current forecasts,” the broker warns.

That leaves us with only two Buy ratings, although one is still up for reconsideration. There are also two Sells, ditto. Four Holds make up the balance.

At the time of writing, QBE is down another 6.6% in today’s trade.

When backing the macro, do not neglect the micro.

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