Stockwatch: Takeover target poised for long-term growth

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In May I posed the question, "Can RSA (RSA) beat the consensus?" and drew attention to chief executive Stephen Hester buying 100,000 shares at 479.85p after first quarter results were released. During his two years in the driving seat, RSA has seen extensive restructuring and the 2015 results showed initial signs of turnaround with the dividend resumed.

I noted analysts raising targets: Barclays Capital reckons if RSA achieves only half of its underwriting performance targets then a share price up to 545p is justified, rising to 660p if it achieves them fully, for example. This assumes earnings per share of 57p and a modest price/earnings (PE) multiple of 11.6 times. The analysts were also entertaining a medium-term pay-out ratio of 40-50% with additional special dividends when justified.

Latest interims affirm this improving scenario with "results ahead of our plans" were seemingly well anticipated by analysts and the market - the stock initially rose about 15p to 512p before easing to 507p.

The release coincided however with expectations that the Bank of England would opt for aggressive monetary easing by way of lower interest rates and stepping up quantitative easing (QE) once again, lower rates not being seen as helpful for underwriters. So it wasn't the best day to proclaim an otherwise good story.

Underlying operating profit rose 20% to £312 million, despite nearly halving to £148 million at the pre-tax level due to one-off gains from disposals enhancing last year's period. Underlying earnings per share jumped 29% to 17.8p and the interim dividend rose 43% to 5.0p, supporting the consensus 2016 forecasts (see table). Moreover this is often RSA's seasonally weaker half.

Returns ahead of target

On a medium-term view the most interesting performance measure is a 12.8% return on tangible equity, achieving a 12-15% target range a year ahead of management expectations. This despite RSA absorbing losses £59 million worse than anticipated, e.g. weather-related claims such as £35 million for UK/European flooding in June and £39 million after the Alberta wildfire.

'We are doing this the "right" way, focusing on high quality sustainable improvements'The group's combined ratio (operating expenses and losses as a percentage of insurance premiums earned) continued to reduce, from 96.4% to 94.3% like-for-like. So despite Hester cautioning that setbacks will continue - as they do in the insurance industry - it appears shareholders can still come out well here.

"Less than six months after raising market expectations materially, we are in the fortunate position of beating consensus again. We are doing this the 'right' way, focusing on high quality sustainable improvements - to customer capabilities and service, to underwriting loss ratios and to cost."

Strategic focus

Disposals of Latin American and Russian businesses have completed, raising £1.2 billion over 2014-16. While the geographic proportions of net premium written vary between personal and commercial, the chief operating areas left are the UK followed by Scandinavia then Canada, with a relatively small business in Ireland.

The UK has recently seen initiatives to simplify customers' experience, exiting unprofitable household areas and prioritising growth - e.g. 13% higher motor business achieved among small to mid-size company clients. Further underwriting improvements and cost reductions are targeted.

The balance sheet has nearly £1.3 billion cash against similar loan capitalScandinavia evolves similarly, improving customer trust scores and maintaining retention rates around 80%, with ongoing growth expected in line with local GDP. Canada has benefited from online business up nearly ten-fold and customer retention up three points to 84%, however first-half net written premiums slipped 3%. Alberta's wildfires took their toll but Canada's transformation programme has overall progressed similarly to the other main regions, and it's a similar story in Ireland.

The group balance sheet is left with nearly £1.3 billion cash against similar loan capital, the pension fund in £188 million surplus. Hester asserts: "Our balance sheet work has also gone very well. Solvency II capital ratio has built to 158%, towards the top-end of our target range and complements our stable 'A' credit rating."

Insulated from Brexit

Initially dropping to about 450p after the EU referendum, the stock see-sawed post-Brexit with this level twice proving support. Overall the Brexit implications appear mixed: management says the group is "insulated" because it benefits from a majority of earnings in foreign currencies and having separate regulated European subsidiaries.

Management expects about £350 million investment income for 2016However, lower interest rates as just declared by the Bank of England are seen as unhelpful for insurers due to lower returns from investment portfolios - where insurers need to more specifically match liabilities than entertain volatile equities.

Based on forward bond yields and foreign exchange, management expects about £350 million investment income for 2016.

Barclays Capital has reaffirmed its 'overweight' stance on the stock while Panmure Gordon is more cautious in advising 'hold' but has raised its target from 428p to 470p, as if its reasoning has quite been overtaken by events.

Takeover target

Given challenges for big insurance groups to deliver organic growth, also with interest rates remaining ultra-low, long-term takeover potential persists. Last year RSA came very close to being swallowed by a 550p a share offer from its larger rival Zurich Insurance (ZURN).

It fell through due to £175 million losses resulting from a Chinese industrial accident and problems in Zurich's US car insurance arm, rather than any irregularities found inside RSA. With the turnaround running ahead of plan, the market value premium for control is likely growing also.

So despite challenges in the insurance industry, RSA's turnaround looks to favour upside. Remember Direct Line (DLG) didn't look very exciting when I drew attention soon after flotation at 175p in late 2012, but its stock has more-than-doubled, with returns boosted by attractive ordinary dividends also special pay-outs. This was achieved significantly by cost reductions plus an extent of repositioning.

Not to draw too close a parallel, but RSA has just strengthened its case for long-term returns.

For more information see the website.

RSA Insurance Group - financial summary Consensus estimates
year ended 31 Dec 2011 2012 2013 2014 2015 2016 2017
IFRS3 pre-tax profit (£million) 613 448 -203 53.0 106    
Normalised pre-tax profit (£m) 696 504 149 34.0 297 184 612
IFRS3 earnings/share (p) 52.4 38.6 -171 -12.9 6.9    
Normalised earnings/share (p) 62.8 45.6 -128 -14.9 25.6 31.6 46.8
Earnings per share growth (%) 43.3 27.4       23.2 48.1
Price/earnings multiple (x)         19.4 15.7 10.6
Dividends per share (p) 40.1 41.0 27.4   5.5 14.2 21.0
Dividend growth (%) 7.0 2.1 -33.0     158 47.9
Yield (%)         1.1 2.9 4.2
Covered by earnings (x) 1.6 1.1 0.2   4.2 2.2 2.2
Net tangible assets per share (p) 307 279 216 286 285    
Source: Company REFS

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.

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