iSelect set to become market darling

Financial journalist
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So there was method in the madness.

The carpet-bombing of TV advertisements – initially featuring the bumbling “Mr. iSelect,” but now featuring a far more confident dude smoothly driving the virtual “iSelectron” – were not just meant to drive brand recognition. They were also the precursor to an initial public offering (IPO) of iSelect on the stock exchange.

The health insurance – and car insurance, home loan, broadband, electricity and gas provider – comparison website is gearing up to float on the Australian Securities Exchange (ASX), although there is no prospectus filed with the Australian Securities and Investments Commission (ASIC).

The float is expected to raise $215 million, $100 million in fresh equity and the remainder will be sold down by existing holders. For example, 29% investor Mi9 (the former ninemsn) is selling its stake into the IPO.

iSelect will be welcomed on to the stock market, for the simple reason that there is a dearth of decent small-cap stocks – so much of the sector is involved in mining services, which have been hammered. The company’s marketing presentations so far to brokers and fund managers have generated huge interest, which – given the size of the float, at $215 million – virtually guarantees unsatisfied demand.

And that augurs well for the after-market.

The home of comparison

Established in 2000 as a comparison shopping site for the health insurance market, iSelect has expanded into life insurance (2007), car insurance (2009) home loans (2011), broadband (2011), electricity and gas utilities (2012) and money (2012). iSelect partners with providers of these products, and takes a commission on sales through its website. It calls itself “the home of comparison” for Australian households.

In FY12, 81% of revenue came from health insurance, with life insurance bringing in 7% and car insurance 6.3%. The other business lines are minor contributors at present, but can be expected to grow – that is where “Mr iSelect” will earn his keep.

The share market has been a big fan of the internet sales model of the likes of REA Group (REA), which operates realestate.com.au, employment website Seek (SEK), auto sales website operator Carsales.com (CRZ), and travel sites Webjet (WEB) and Wotif (WTF), but iSelect is not quite the same as this group. As those companies have grown, they have generated large amounts of cash, but iSelect has a cash ‘lag’, because many of its product providers pay it trail commissions over three or four years, rather than upfront revenue – however, the company accounts for this revenue at the time of the sale.

For example, in FY12, iSelect booked a $91.4 million “net present value of future trail commission” as an asset, with actual cash receipts making up 45% of reported revenue. This receivable sits on the balance sheet until it can be converted: in the meantime, the actuarial value of the receivable fluctuates.

In the pro forma documentation circulating among brokers and fund managers, there is $100 million sitting in cash on iSelect’s balance sheet, accompanied by a future trail commission receivable of $85 million.

The actual conversion can be affected by things like lapse rates, mortality rates, inflation, premium increases and government policy. With REA, SEK and CRZ, this cashflow conversion lag is not a factor. Their EBITDA to operating cash flow conversion is virtually 100% at every reporting.

Closing the cash lag

iSelect recognises this, and is working to restructure its payment ratio between upfront and trailing, looking to sell more product lines that are upfront payment only. In FY12, trailing revenue accounted for 49% of the total: one of the brokers involved in the issue has research in the market projecting that FY13 will see the trailing proportion fall to 39%, and to 38% in FY14.

Even better, revenue is projected to rise from $111.9 million in FY12 to $150.1 million in FY14.

Professional investors will not be unduly fazed by the large trailing revenue component – but they would pay more for a more predictable cash flow. The cash conversion lag makes iSelect relatively difficult to value, and ensures that it will not be given full ‘credit’ in the price/earnings multiple it is given by the market.

To illustrate, the broker research mentioned earlier values iSelect – at an issue price of $1.85 – at 30 times FY13 earnings and 21 times FY14 earnings (projected net profit of $14.5 million).

In comparison, REA trades on 39 times expected FY13 earnings, and 32 times FY14 earnings. For CRZ, those multiples are 27.2 times and 23.3 times.

The internet stock group are all strong cash-generating businesses, typically converting about 60% to 70% of EBITDA into operating cash flow, enabling them to pay dividends. In contrast, despite reporting strong earnings growth, iSelect has not been able to generate positive operating cash flow over the past three years, let alone pay a dividend.

Strong business model

What brokers and fund managers do like about iSelect is the strong brand recognition that it has established, the proven business model and its “scaleability” into newer business areas. The brand recognition makes iSelect the logical place for consumers to research their options in virtually any service market. Comparison sites are the big winners as branded companies fight in competitive markets.

The only thing spoiling the picture in iSelect’s bread-and-butter, the health insurance market, is that it does not have on its site the products of the number one and two players, Bupa and Medibank Private, although the latter sells its cheaper AHM brand through iSelect.

Earlier this year, Bupa Australia settled a misleading and deceptive advertising claim against iSelect: neither it nor Medibank Private likes the commission structure of the comparison sites, arguing that it leads to higher premiums. For its part, iSelect counters that it has increased the size of the health insurance market.

Initial strength expected

In the final analysis, iSelect lives or dies on its ability to attract traffic to its website and call centre, and generate sales across all its product lines. iSelect has become a very well-known brand, with high customer loyalty, and a major path to market for the product lines it sells.

The market is going to love iSelect, because of the scaling-back of broker and fund manager applications, but once listed, the stock has to be valued appropriately. The discounted multiple gives it a bit of room for improvement, but it has to improve its cashflow conversion. As an SMSF investor, if you manage to get hold of some, given that there is no dividend on offer, it’s probably best to sell into the initial strength and then let the professional investors sift through the working capital cycle and assess what it is really worth.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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