Stockwatch: Dividend and re-rating potential here

Can RSA beat the consensus? The FTSE 100 shares for this £4.9 billion international insurer have traded in a volatile downwards trend from 700p over the last five years, recently recovering off a 373p low in February to twice test 480p in mid-April, and again now. Certainly the insurance sector is in question, with yields of about 6% not unusual - as compensation for the risks of high competition in the UK especially.

RSA has undergone an extensive restructuring, cutting costs and trimming international exposure from the Far East, Russia and Latin America, leaving a group exposed mainly to Scandinavia, the UK and Canada. The five-year financial table shows a turnaround taking shape, initially by way of the 2015 results with projections advancing it.

Dividends have resumed and are forecast to recover strongly for a prospective yield around 3.5%, although admittedly there are better yields right now. Direct Line Insurance Group, for example, is priced for a 6.8% yield on a forward price/earnings (PE) multiple of about 13 times, its stock doubling in value since listing at end-2012, but where its financial record and prospects indicate low growth. At first sight, therefore, in a sector generally favoured by income investors, RSA looks quite fairly priced.

Why did boss buy half a million pounds of stock?

It's been reported how chief executive Stephen Hester wasted no time snapping up 100,000 shares at 479.85p after release of the first quarter 2016 results and it was not the only purchase recently. In February a non-executive director bought 5,650 shares at 435.4p once RSA came out its closed period surrounding 2015 prelims.

Now analysts at Barclays have gone out on a limb claiming RSA's ambitious targets offer capital growth in the mid-teen percentages if only half-achieved by 2018 - and nearer 40% if they are.

The case rests on further transformation of RSA from a mid-tier insurer to close its gap on leaders such as £17.3 billion Aviva, which trades on a forward PE of 8.5 (assuming a near-70% bounce in 2016 earnings) and yields 6.0%. Again, at first sight, Aviva looks better value, although its sheer size makes it hard ever to be priced for growth.

Meanwhile, RSA's first-quarter results showed good underwriting progress, hence operating profit ahead of internal expectations: "a streamlined and focused business model is already proving its worth, channelling our self-improvement measures more effectively to drive performance gains." The chief executive asserts they are on-track, albeit still with much to do as regards ambitious plans to transform performance, e.g. customer service and underwriting with the help of technology.

Profitability ratio targeted for material improvement

The chief underlying measure of an insurer is its combined ratio, i.e. operating expenses and losses as a percentage of insurance premiums earned. RSA's recent and expected trend is positive - i.e it is down, from 98.8% in 2014 to 96.0% in 2015, with strong results across Scandinavia, Canada and the UK, the combined ratio as low as 91.7% in Canada.

This, despite a £76 million hit from last December's flooding in Northern Britain. A ratio of 94% or lower is targeted for the UK and Canada and 85% or lower in Scandinavia. By comparison Aviva achieved 94.6% in its general insurance business, the best in nine years and despite the December floods.

With 2016 being RSA's last year of restructuring, total proceeds from disposals have raised £1.2 billion after operations in the Far East, Russia and Latin America were exited; at a rough estimate this leaves about 50% of profit derived from Scandinavia, 29% from the UK and 21% from Canada.

The end-2015 balance sheet showed cash down from £1.0 billion to £816 million, but which should support both dividends (e.g. about 15p per share, costing about £68 million) and investment.

Also, the cost reduction programme is ahead of targets, hence an upgrade to over £350 million annualised savings by 2018. It all means RSA is confident of raising its underlying return on equity expectation to the upper half of its 12-15% target range by 2017, with further improvement thereafter.

Revised share price targets up to 660p

Altogether this has prompted analyst upgrades - yet to be reflected in the table - with a "base case" earnings per share (EPS) target of 48p. Barclays has raised its share price target from 457p to 545p, assuming RSA only gets half-way with its objectives for a combined ratio of 94% or lower in the UK and Canada, and 85% or below in Scandinavia.

If it does achieve this scenario, then 660p based on EPS of 57p and a modest PE of 11.6 times is possible. It's therefore interesting to follow RSA's improvement story, given this first significant upgrade coming after the chief executive's share-buying.

News flow has scope to create a recovery-to-growth story in the medium term, as RSA also looks to optimise its capital structure and refinance debts which accounted for a £106 million interest charge versus circa £500 million operating profit last year.

While the table shows recently static net tangible assets per share of 285p, management cites an improvement to 303p at end-March, i.e. an extent of asset-backing and in a positive trend.

Special dividends to resume in 2018

Final restructuring costs and pension contributions are expected to check dividend growth in the near-term. However, some analysts target special dividends by 2018, implying an overall 6.6% yield rising to 8.1% in 2019.

Management has already held out a carrot in its "strategic update" introduction to the 2015 results: "medium-term ordinary dividend payout of 40-50% with additional special payouts where justified". This bolsters yield credentials ahead of Aviva and Direct Line if the improvement programme keeps delivering.

Stephen Hester is just over two years into his chief executive role, so to achieve performance bonuses it does not look as if he will move on - as some turnaround managers do - which is a potential risk given his high profile.

So, while more evidence is needed to justify higher equity value, you can appreciate why he reckons the stock rates 'buy'.

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This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.