Corporate Australia has delivered a few impressive turnarounds this decade: Qantas Airways, Bluescope Steel, Perpetual and Wesfarmers’ Coles division, for example. Is the improving QBE Insurance Group about to join them?
QBE, once a market darling, rallied from almost $6 in September 2001 to $35 in August 2007, becoming one of Australia’s great companies in the process. Investors loved QBE’s expanding global footprint, management and execution.
Then the rot set in. QBE tumbled to $9 in September 2016, giving back more than a decade of share-price gains. Savage earnings downgrades in 2013 and 2014 followed a string of costly natural disasters earlier this decade. QBE lost its market halo.
Long-term investors suffered. QBE’s 10-year annualised total return (assuming dividend reinvestment) is -4.2%. The five-year annualised gain is 1.4%. The figures would be much worse if not for a 22% return over the past 12 months.
Chart 1: QBE Insurance Group over the long term
Source: Yahoo Finance
Contrarians who bet too early on a QBE turnaround learned a painful lesson: big insurers are hard to turn. Insurance cycles play out over many years as insurance premium demand, rates and margins rise and fall. Climate change and its link to extreme weather events exacerbates the threat of natural disasters and insurance pay-outs. QBE’s fall from grace troughed with media speculation in January that German insurance giant Allianz had the Australian insurer in its sights. QBE rejected the rumours, saying it was not in discussion with Allianz or any other suitor. But takeover rumours reinforced the value in QBE and created a perception it was ‘in play’.
Then there was last month’s revelation that QBE CEO John Neal was docked $550,000 off his bonus for failing to notify the Board of his relationship with his personal assistant. Although a strong call by the Board (and hopefully a precedent for others to follow), the decision overshadowed QBE’s best full-year result in years. The market’s reaction to the result was surprisingly subdued. Perhaps much of the rally came in the lead-up to QBE’s February announcement. Either way, QBE, at $12,88, is only marginally up on where it started in 2017, although well up on November prices because of the rise in US bond yields (more on that later). That’s an opportunity for investors.
Chart 2: QBE Insurance Group over one year
Source: Yahoo Finance
QBE’s cash net profit of $898 million for FY16 was up 12% on a year earlier (on a constant-currency basis) and ahead of market consensus forecasts. Return on equity rose to 8.1%, from 7.5%. QBE, arguably, delivered one of the best results of the recent earnings seasons, relative to market expectation.
The outlook for insurance margins stood out. QBE said the rate of decline in global insurance pricing was easing and expected modest improvement in margins. I made a similar point in a recent article for The Switzer Super Report.
The recovery in QBE’s premium rates in the second half of FY16, after flat premiums in the first half, is promising.
The insurance margin of 9.7% in FY16, from 9% a year earlier, reflected a solid underwriting performance and surprised the market. It was at the top end of the 8.5-10% guidance range.
Heightened global competition, particularly from digitally based insurance disrupters, drove premium margins from the high teens to a decade-low of around 7%. QBE’s result suggests margins are finally improving, albeit off a low base.
QBE’s Gross Written Premium (the total premium written by an insurer before deductions for reinsurance and ceding commissions) was slightly lower in FY16. Management expects relatively stable GWP in Australia and is encouraged by the United States’ improving economic outlook and its effect on insurance premium demand.
US, Europe divisions to drive re-rating
A better performance from its North American division and, to a lesser extent, Europe is the key to QBE’s fortunes over the next few years. The insurer makes almost a third of its revenue in North America and about 28% in Europe, Morningstar data shows. The company has good leverage to a US recovery, rising US dollar and higher US bond yields.
Elsewhere, Australia and New Zealand make up 28% of revenue and emerging markets account for the rest. The Australian operation showed some encouraging premium rate gains in the third and fourth quarters.
QBE is driving efficiency gains under its turnaround strategy. Management expected reinsurance savings of more than $350 million from January 2017, and said it would execute on another $150 million in cost savings and $200 million in claims savings by 2018.
Taken together, these factors add to confidence in QBE’s management, strategy and execution. QBE is starting to get its mojo back. Years of hard work are pay off, principally through higher insurance margins and cost-efficiency gains.
A 33-cent final dividend in FY16, up 8% on a year earlier, and the announcement of $1-billion share buyback over three years are good signs. The buyback implies QBE believes its shares are undervalued – a reasonable view given its improving performance.
Nevertheless, QBE has many challenges and its recovery is embryonic. Senior management turnover has been unusually high by its standards.
It is not unusual for corporates undergoing transformation to have management casualties along the way. Often, it is healthy when fresh blood joins the team. Changes in executive management and the search for a permanent Chief Financial Officer suggest intense pressure to perform, but they come with broader management risks.
Right or wrong, revelations about the CEO’s non-disclosure of the relationship with his personal assistant are an issue for shareholders.
Understandably, Neal seemed taken aback by the Board’s tough stance on his private relationship and the scale of the fine, based on his reported comments. The Board’s decision brought huge public attention to a deeply personal, sensitive matter.
Perhaps that casts doubts about Neal’s long-term tenure at QBE. As the architect of the company’s unfolding turnaround, he must remain at the helm, particularly considering other management changes. An unexpected CEO succession event would damage the market’s renewed confidence in QBE. The Board must tread warily.
Eight of 13 broking firms that cover QBE rate it a strong buy or a buy. Four rate it a hold and one a sell. Macquarie’s 12-month price target is $13.45. Morningstar’s fair value of $14 a share suggests QBE is marginally undervalued at the current $12.88.
Some short- and medium-term tailwinds are turning for QBE. Rising US bond yields help large insurers that invest premium income in long-duration assets, such as bonds.
QBE’s share price is correlated to the yield on US 10-year Treasuries. The US Federal Reserve has signalled a March rate rise, probably the first of three hikes in 2017. CLSA last year estimated a 50-basis point increase in rates is worth $272 million to QBE’s earnings.
About 85% of QBE’s $25.2 billion investment portfolio is in corporate and government bonds, and short-term money instruments. QBE’s heavier investments in the US, to match its liabilities, means it should, in theory, have more to gain from higher US bond yields than its Australian insurance counterparts.
Over three years, QBE should benefit from an improving recovery in global insurance margins, particularly in the US. Although likely to be modest, the gains are welcome relief after years of contraction and the threat of digital disruption in insurance.
Rising gross written premium, margins and investment income should underpin QBE’s performance expectations for FY17. Do not expect the company to return to its glory days (and sharply higher share price) anytime soon. But there’s enough in the latest result to suggest its turnaround has substance and that QBE warrants a place in portfolios at the current price.
A forecast yield of 4.3%, partially franked, should placate investors as they wait for the turnaround to gain momentum.
If the market undervalues QBE’s transformation, watch for an offshore predator to pounce. It’s too strong a business to trade on a forecast Price Earnings (PE) multiple of about 14 times FY18, based on consensus forecasts.
Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at March 6, 2017.
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