Stockwatch: Strong income growth on the cheap

Is Aviva set for further gains? At about 480p the FTSE 100-listed shares in this diversified insurer have bounced back after an EU referendum plunge to 346p - although they are still trading below this year's 500p high.

Their valuation is somewhat elusive. Aviva trades on a 12-month forward price/earnings multiple of around 10.5 times, which, combined with a 5.5% yield covered 1.7 times, looks modest against other European insurers. The table shows lumpy profits, however, and the average annual historic PE ranges from the mid-high teens to sub-10 in 2013 and 2015.

So you'd expect market pricing to exact a decent yield to compensate for variability; insurance being a competitive industry and investment management even more challenging. Aviva is also quite diversified internationally which adds complexity to the process of valuation, but is a great sterling hedge.

Bullish brokers

RBC Capital Markets has turned bullish on the shares, confident in its high performing Aviva Investors Multi-Strategy fund and forecasting a rise in bulk annuity sales as the structural growth market opens up - concerns of the death of annuities amid pension freedoms is exaggerated.

While respected funds like Standard Life's Global Absolute Return Strategy struggle, the analysts reckon Aviva is enjoying an industry leading net asset inflow of around £800 million in the fourth quarter so far.

Annuities get a bad name for locking people into fixed returns, but they can work well for long-term assurance. There has been a renewed corporate demand for "bulk" annuity deals and Aviva wrote a third of the industry total in the first half. This, RBC contends, is "one of the best structural growth opportunities in European insurance...by 2018 we expect annuities to account for 76% of Aviva's UK new business profit".

The 2016 interim results showed 58% of revenue derived from the UK, with France, Poland, Italy, Spain and Canada also being significant regions.

Cost-cutting boosts earnings

Current management is IT-savvy and have a new digital focus to streamline the high number of platforms Aviva uses as a result of its acquisitive history. The group has struggled to cut costs because it's been too expensive to migrate IT onto a single system - the new priority for extending digital should help this.

The ebbing of £350 million of Friends Life post-acquisition restructuring costs also bodes well for 2017, when £225 million annual cost synergies from the deal will kick in.

Mind that consensus already expects a normalised pre-tax profit uplift to near £2.2 billion for 2017, although RBC contends improved longer-term prospects due to a higher revenues/cost-cutting mix. If so, then it's possible to visualise a recovery in the earnings rating back to the 16.2 Aviva enjoyed during 2014.

In a scenario of normalised earnings per share advancing towards the 50p also achieved in 2014, each improvement in the rating can significantly affect the price.

Comparing forward PE multiples, Aviva is the cheapest European insurer in a sector that's growing average earnings by 2% each year. Whilst the 5-6% yield is in line with the sector, annual dividend growth is expected to be the third-highest at 8%, outpacing the sector's 4%.

Market pricing has likely exacted an attractive yield to compensate for Aviva's lack of historic growth, which RBC expects to soon gain momentum.

Mixed interims

Aviva doesn't declare updates outside of its first half and full year results, which leaves the mixed 4 August interims the latest to consider.

The release highlighted operating profit up 13% to £1,325 million although operating earnings per share edged up just 1% to 22.4p. A measure of profitability, the group's combined ratio weakened from 93.1% to 96.2% like-for-like - sub-100% indicates Aviva is making profit from underwriting - affected by an increase in weather/flooding claims and commissions to a new distribution partnership.

At least the net premium written in general insurance rose a significant 7% - growth also seen in the life insurance side - which bodes well as the industry moves on from a claims-hungry first-half of 2016.

Fund management profits are small in context, up 48% to just £49 million despite Aviva running a global asset portfolio worth over £315 billion. In regards to limiting downside risk, the IFRS measure of net asset value rose 6% to 412p per share, which is worth noting against the 233p of net tangible assets seen at end-2015. Acquisitions added to nearly £2 billion capitalised goodwill.

Improving balance sheet

Aviva has suffered from a weak balance sheet historically, but the acquisition of Friends Life helped improve solvency which is now strong in a UK insurance sector context: a 174% Solvency II coverage ratio keeps the group well-insulated from external events.

Credit-rating agency Fitch has affirmed Aviva's long-term issuer default rating at A+ and its core insurance subsidiaries' financial strength rating at AA-, asserting a stable outlook. Stable end-June borrowings of £9.7 billion were in the context of £19.3 billion net assets, including £34.9 billion cash. Such a balance sheet should not check equity valuation in an earnings growth scenario.

Santa rally

Aviva has just bounced from 450p to 480p, which may reflect raised prospects but also year-end optimism. A tad frustrating for fresh buyers but at least the chart conveys momentum.

It's hard to cite a dependable value-measure for insurers, but there's scope to assert varied price targets according to earnings and how they are rated. The jump does show the stock in a sensitive area near a 6% yield, where any sense of an upgrade will trigger a rise. Aviva's risk/reward profile therefore comes across as attractive.