Description

 Admiral has been written in VIC in the past, first in September 2014 by north481 and more recently in July 2015 by rickey824 (https://www.valueinvestorsclub.com/search/admiral). I recommend members not familiar with the story to read their posts as they provide an excellent summary of Admiral’s history, their capital-light business model and profitability, competitive advantages, reserving policies and management integrity. Since 2015, Admiral have paid out £925 million in dividends to shareholders, and the stock has returned 61% since rickey824’s write-up, or 18.27% annualized. I believe this is a compounder that goes ignored by the market from time to time. It is time again to buy the shares at the current price of  £19.4

Summary:

Admiral is a consensus sell today, with 10/21 analysts (as per Bloomberg) recommending a sale and 6/21 a neutral. Sell-side has historically been proved wrong on Admiral, so I don’t consider my buy recommendation a strong contrarian call. However, I believe the market is too focused on Admiral’s apparent expensiveness vs. UK listed peers and is assigning too much weight to what seems a softening UK market, given the company’s >15% market share in UK motor insurance. Also, sell-side tends to penalize Admiral for not being able to show much in the form of profits in their international businesses, some of which have been in investing mode for more than a decade. Lastly, the new Loans product in the UK has left insurance analysts puzzled.

I believe that on their own, the UK motor business and its combination with a fast growing and now profitable household insurance business present upside to the current share price; also, I believe the group of international businesses are building up significant value despite not being able to contribute to the bottom line just yet. Some of these businesses are already making money or breaking even, and the reality is they don’t take a lot of capital investment to continue growing, so I believe management is right to persevere in their efforts. They continue to show the same discipline and conservativeness that has made them a well know name within the value investing community. Insiders continue to have significant skin-in-the-game with more than 20% owned by both cofounders and employees and the culture is still one of the best I’ve come across in recent years. Shareholders can rest assured that their interests are being looked after here.

There are 288 million shares outstanding. At the current price of £19.4, the market cap is £5.6bn, roughly 12x 2017 UK insurance pre-tax profits of £465 million. The business delivered 55% ROCE in 2017 and has historically delivered returns on capital above 50% consistently. It also has an excellent track record of returning excess capital to shareholders.  

I recommend buying Admiral Group shares today at £19.5/share with a view of realizing double digit returns over the coming five years with no spectacular assumptions. Regular dividend payments, special dividends and price appreciation once the underlying value of the different businesses is recognized by the market will do the job easily.

Management is keen in showing investors the value of what they have built so far: in his first letter to shareholders in 2016, David Stevens, CEO, listed as his priorities: to “ensure Admiral remains one of, if not, the best car insurers in the UK”, to “Demonstrate Admiral can be a great car insurer beyond the UK”, to “Develop sources of growth and profits beyond car insurance” and, to “Ensure Admiral stays a great place to work”. A coming European Investor Day in Rome in September should be a catalyst for priority number two.

Recent developments in Admiral’s business:

• Henry Engelhard retired as CEO. Following the departure of Kevin Chidwick from the US Elephant business in early 2017, he stepped in as interim CEO to revamp operations and find a permanent replacement. In late 2017, Alberto Schiavon was promoted from within Admiral. He first joined Admiral as International Pricing Manager in 2012 after his MBA and according to his Linkedin profile, he has been Head of Renewals, Head of Sales and Head of Marketing and Pricing for the Elephant Auto Insurance business prior to becoming CEO.

• David Stevens, co-founder and formerly COO, has taken over the role of CEO for the group.

• They have officially launched their Loans product in the UK offering unsecured personal loans and Car finance. As of the end of 2017, they had £66 million of loans on the balance sheet, compared to £2.3 million in 2016. The business had a loss of £4.4 million for 2017. They expect to secure a first round of external funding for this business during 2018 and expect losses of around £5-10 million for the year. This is a business that could generate 20%+ ROE, according to management. They are looking at external sources of finding, with the aim of mitigating the capital intensity of growing this business. Personal unsecured loans and car finance is a £60bn+ market in the UK and in the event that autonomous vehicles, car sharing or other events significantly disrupt the motor insurance business, this could provide a growing business at decent returns. I believe management sees this as a long term hedge against future changes in their traditional core business.

• They have also launched several Price Comparison Website (PCW) initiatives through Preminem, their joint venture with Mapfre, including: China, where they launched “Duobi” in April 2017; Mexico, where they launched “Rastreator.com.mx” in early 2018; Turkey, where they are scouting the market for PCW opportunities. Gladiator, the van insurance broker, has now moved in-house, and they fully underwrite van insurance in the UK. They have also launched Travel insurance in the UK.

• They have made applications to the Spanish insurance regulator for permission to underwrite all the EU insurance business from there in anticipation of Brexit.

• They have completed their Guidewire implementation in 2017. One important benefit of this is they now have capability to offer multi-cover to their UK customers. They have underwritten multi-car policies since 2005 and according to Hastings, a competitor, are still the best at it. Since 2017 they can now add Home insurance to their multi-car offering. In conversations with management, they’ve mentioned that an increasing amount of customers are buying multicover. Amongst the benefits of multicover are: you can’t really offer it via PCWs, so your acquisition costs are lower, as customers have to go through the direct channel; comparability is limited, so there’s less shopping around once you have it. as a result, average customer life increases with limited, if any, increase in associated costs; you increase the amount of data you process, so your ability to price correctly grows, while competitors struggle to get it right.

• From 0% market share in UK Household insurance in December 2012 when they launched the product, Admiral now has ca. 3% of the market, with more than 650k risks insured.

• In the UK, the Ogden rate was set at -0.75% in February 2017, down from 2.5%. as a result, Admiral increased its excess of loss cover in anticipation of potential impact on large claims. They moved from XoL above £8 million to £5 million. For 2018, they are back to average long term levels of XoL above £8 million, at a higher cost than before. Management has mentioned that XoL was a mispriced option for all competitors until Ogden rate changes last February 2017 and that this mispricing has been corrected, such that the market is now back to a level playing field. They estimate the cost of £1 million retention level doubled from 2017 to 2018, going from around 3% of premium to 6%, while the cost of a £10 million retention level increased 2.5x, but only to 2.5% of premium, from 1% previously.

Businesses

UK Insurance:

Admiral insures over 4 million motor risks and 666 thousand home risks today. While the listed players today represent approximately 40-50% of the market, they continue to gain market share in motor and are rapidly increasing market share in household. Can they keep growing? Maybe, but for investors, I think what matters is that “the group is focused on bottom-line profitability in the short, medium and long term. Indicators such as total premium, turnover, growth and market share are by-products, not drivers, of decisions and strategy” (2014 subordinated notes prospectus) and, to reassure investors, David Stevens said in its recent annual letter: “Over most of the last 20 years our costs have been lower than our competitors – by at least ten percentage points of premium. That’s the equivalent of £50 less expense for a typical policy, and over £200 less for a higher premium policy. And that’s one of the main reasons Admiral’s brands come top on the UK’s price comparison sites more often than any of our competitors”.

The UK Insurance business generated pre-tax profits of £465 million in 2017. While the profitability of the business can be lumpy given the way the business operates, I would feel comfortable knowing there’s still a large portion of the market that remains unprofitable where they can win business from. It is true that having a larger market share makes them less immune to industry cycles than before and pricing should have a higher impact on underwriting margins, however, as they showed in late 2016 and early 2017 when they raised rates ahead of the Ogden decision announcement, which was ahead of what competitors did, and later reduced rates following the Ogden announcement, there are ways in which they can soften the impact of industry cycles. For 2017, Admiral’s projected ultimate loss ratio is 76% and ther expense ratio was 16%, almost half of the market’s 31%.

As a result of lower frequency, declining whiplash claims and premium inflation, Admiral have said that they expect 2017 to be one of their best years ever and expect significant reserve releases if claims develop as expected. In 2017, releases were 21% of Admiral’s original net share of earned premiums. Other revenue per vehicle has been around £64 per vehicle since 2013.

In addition to Motor, they are now operating profitably in Household insurance. As explained by David Stevens in 2014, when he was still COO:  “Two years on and we insure more households than we did cars two years from our launch as a motor insurer, and we’re growing fast as more and more people embrace price comparison shopping for household cover. Our strategic bet is that we can materially undercut the 40%+ expense ratios of many of the established players, while also delivering a decent loss ratio outcome” PCW represent ca. 55% of household insurance new business toda and continues growing. In its full year 2017 results announcement, Direct Line pointed out that their home insurance business had been less profitable than in the past few years and that 2017 would be the rebased level of profitability for the business. Both Direct Line and eSure have seen negative growth in home as of 1Q18 and EY, in their 2018 General Insurance outlook, mentioned: “Fundamentally, this is an industry in transition where the challenges may last for several years. While there is evidence of the green shoots of new business, traditional players are being challenged by new technology and are having to invest in digital capability in order to keep up. These changes have combined to push down premiums while at the same time rising claims and expensive inflation have created a double whammy. Taken together these issues have had a negative impact on profits with more deterioration expected to come. Home insurers are expected to achieve a barely profitable 99% NCR in 2017, assuming the year ends with no major weather events, with a further deterioration forecast for 2018 of 101.7% NCR”

Home Insurance in the UK is a £6bn market by premium value going the way of Motor Insurance. With the ability to operate at a lower cost, I believe Admiral stands to win big here, even if absolute profits will be lower than in Motor.

International Businesses:

US:

From Deloitte’s 2018 insurance outlook:

Source: Deloitte 2018 Insurance outlook

Frequency and severity have increased rather than decreased due to a number of issues, including distracted driving and higher repair costs, both human and mechanical/cosmetic, due to increasing use of high-end electronics and technology put in place precisely to prevent accidents from happening.

Some of the largest insurers in the US were caught off-guard, and their results have shown underwriting losses in recent years, with AM Best expecting a net underwriting loss of $29.3bn for the US P&C insurance industry as a whole in 2017, up from an estimated loss of $6.5bn in 2016. Combined ratios have deteriorated to 105.1 for 2017, from 100.9 in 2016 for the industry as well, even though US personal auto lines showed some improvements over 2016, with combined ratios at the end of 3Q17 estimated to have declined to 101.6 from 105.9 in the same period the year before.  In the same report, AM Best expected auto insurance rates (premiums) to go up in 2017 by mid-single digits driven by adverse development of prior years’ loses (https://www.insurancejournal.com/news/national/2018/02/07/479835.htm)

It appears that auto liability reserves have been eroded since 2012 driven by the above mentioned increases in severity and frequency.

Consequently, insurance companies have aggressively increased rates during 2017 (https://www.insurancejournal.com/news/national/2018/02/01/477580.htm). Given catastrophe losses also contributed negatively to underwriting results in 2017, mostly due to Harvey and Irma storms, it seems reasonable to expect additional price increases for auto insurance in 2018.

According to The Zebra’s State of Auto Insurance report 2018 (https://www.thezebra.com/state-of-insurance/auto/2018/)  national average annual premiums have been on the rise since 2013 by about 5.5% on average.

Despite the hit on profits, insurance companies have continued spending heavily in advertising, With the top 10 insurance companies spending ca. $5.5bn in aggregate (2015 data), almost 80% of the total.

All this means the market remains as competitive as ever. Interestingly, for compare.com (Admiral’s price comparison website) this is proving to be quite helpful, as they now work with 3 of the top-10 Auto Insurers (Travelers, AllState and Liberty Mutual)

The correlation between higher rates and more shopping around is likely increasing, as shown by compare.com’s organic search results improvement over the last 2 years and the same happening to organic search results for elephant.com, Admiral’s insurance brand in the US:

Compare.com organic search growth:

Elephant.com organic search growth:

Source: semrush.com

At the same time, as shown by Admiral in their FY17 results presentation, the underlying profitability of the business continues improving (with lower acquisition costs, better combined ratio and an improved customer mix) while growing (8% policy count growth)

Source: Admiral FY17 results presentation

Full year results 2017 comments around the US business were good and bad. On the good side, customer numbers continue growing (8% in 2017), the absolute loss continues declining (£16m vs. 21m and £23m in 2016 and 2015 respectively) and strategic changes implemented earlier in 2017 are showing positive results, as the mix of customers has improved significantly towards customers with higher propensity to renew, without an equivalent spike in acquisition costs. There is also progress in COR, which has come down from 143% in 2014 to 119% in 2017. Admiral’s share of loss has also been in decline at Elephant.

On the negative side, the US insurance business still lacks scale. As of December 2017, Admiral had unused tax losses of £166.1 million relating to the US businesses, both Elephant Auto and compare.com, but no deferred tax assets were recognized against these. During the FY17 presentation, David Stevens explained that, after running stress tests on the US business, they had decided to partially impair the carrying value of it on their books, taking a £25 million hit. The fact that no DTA was created against the tax losses may imply their belief that there won’t be enough profits in the future to offset accumulated losses.

Europe:

Italy has now made a profit for four years in a row and turnover in Europe has increased 61% vs. 2015 at £309m. Admiral now insures 854k customers in France, Spain and Italy, with 500k in Italy alone. I would highlight that, in quite challenging markets such as Spain, where premiums have not yet increased despite the regulatory changes around Baremo of 3 years ago, and Italy, where premiums have fallen 22% over the past five years despite a deteriorating market COR, the losses in European insurance have declined from €10m in 2015 to €2m in 2017. Recent comments pointed at how Admiral Seguros in Spain is operating around breakeven and close to sustainable profitability. They also pointed out at the improving expense ratio for the European operations, at 40% now vs. 45% in 2015. Guidance around loss ratios is 70-80%. The Italian business expense ratio has come down from 37% to 31%. This business in particular appears to have reached the necessary scale and considering the deterioration in the Market COR, a shift in the recent premiums trend would help Admiral grow at an even faster rate. Italy customer numbers have grown at a 34% CAGR over the last 9 years from 35k. Italy is a £19bn premium market with 44 million vehicles, so there’s still a lot to go after. It’s also, according to the company and analysts’ views, the most similar market to the UK.

Another market flying under the radar in Europe is France. This is a market where COR have been above 100% for the past 5 years, where regulatory changes are happening that are pushing people to shop around more often and with estimated premium value of £16bn and 37 million vehicles. Penetration of PCW is still limited, but already L’olivier has increased customer numbers 9.6x in 7 years and there are two other players growing in the market, helping adoption. Turnover is now €66m, vs. €29.2m in 2015.

The problem child in Europe is still Spain, Admiral’s first international market expansion. However, there’s hope given the sharp deterioration in underwriting experienced by the market, where CORs have moved from ca. 86% in 2012 to above 100% in 2016, which should eventually put some pressure on prices and hopefully help direct insurers such as Admiral and their PCW Rastreator.com.

Price Comparison:

Results for 2017 were encouraging, saving from the fact that the UK competitive environment had a significant impact on confused.com profits, which fell from £16m to £10m in 2017, a 38% decline. The positive trends at Compare.com should continue helping Americans’ adoption of direct insurers with low advertising spend and a smaller print. I say this because during the year, Compare.com signed up Travelers and Encompass (a subsidiary of Allstate) to their panel of insurers. These are two of the top 10 P&C insurers in the US, and them signing up to a PCW such as Compare.com could be an indication of the viability of Price Comparison Websites in the US as they are known in the UK.

Rastreator in Spain is consolidating their 70% market share and leadership and opening for business in Mexico. France’s LeLynx continues reducing losses as well. Price comparison’s share of new insurance business in Europe is now above 20%, from  less than 5% a decade earlier.

Valuation:

Admiral’s current dividend yield is 5.5%, which is in line with its historical average. As a reminder, Admiral has distributed £2.6bn in dividends since their IPO in 2003, ca. 47% of the current market cap. Over the last 3 years, the dividend distribution has been £924.7 million, or 16% of the current market cap. Special dividends have been limited in the last couple of years as Admiral has chosen prudence in preparation for their application to the PRA for use of their internal Solvency Capital model. They have mentioned repeatedly that their expected upper end of their Solvency Capital Ratio should be 150% and are currently operating at 205% as of end 2017. Previous experience by peers after approval of their Solvency models has been an immediate increase of their Solvency Capital Ratios (Hastings, Direct Line), and I would a similar case for Admiral. However, investors won’t know how much surplus capital Admiral will hold until at least early 2020, once their model has been submitted, reviewed and approved. In the meantime, Admiral has £295 million of capital above its guided upper end of solvency ratio. This is 5.4% of the current market cap.

The economics of the UK motor insurance business remain as attractive as ever. Assuming policy count growth of 3% over the next 5 years, Admiral would have ca. 4.6 million customers. At no growth in average premium, this would leave them with £2.6bn of turnover and about £543 million of premium revenues. At an 85% combined ratio and assuming retention of 87% of the profits, this leaves them with £402 million of pre-tax profits, plus £275 million of other profits (assuming £60 of ancillary income per vehicle insured). Pre-tax profits of £677 million at 12x delivers £8.1bn of EV. Subtract £200 million of debt outstanding, £685 million of capitalized overhead (at 10x assuming 5% annualized growth) and you have £7.2bn of equity value for the UK motor insurance business alone, which is 29% above the current market cap of £5.6bn.

The US business value is hard to calculate. However, looking at AllState’s acquisition of eSurance, the average price paid per policyholder was $1,180. You can read about the transaction in White Mountains annual report of 2011 (http://www.whitemountains.com/PDF/WTM_2011_Management_Report.pdf). The combined businesses (eSurance and Answer Financial) controlled 845,000 policies and had premiums of ca. $1.2bn combined. They had been lossmaking for over a decade and were still at the time of AllState’s purchase. A similar price per policy for Elephant would give me $215 million, or £159 million. However, there are more than £166 million in NOLs that would be valuable to a private buyer with offsetting profits. This is less than 5% of the current market cap today, but I would argue that this value will only increase over the next five years, judging from recent trends as seen in the organic search results for both elephant insurance and compare.com from Semrush.

The other international insurance businesses will probably be priced in more accurately post the September 2017 European Investor Day. A way to think of the combined 854,000 customers in France, Spain and Italy is to think of Admiral itself at the time of the IPO and a few years before. Admiral’s combined ratio in 1993 was ca. 132%, with a 70% expense ratio. They managed to bring their expense ratio under control over seven years, reaching below 20% levels in 2000. Underwriting results improved as they increased they gained scale and the quality of their data improved, but it wasn’t until 2001 that the combined ratio fell below 100% consistently. This represents almost a decade of improvement. Only three years later they were doing an IPO. They came to market when the policy count was less than 1 million at a valuation close to £800 million. At a similar value per policy, the international business would be worth ca. £850 million, or 15% of the current market cap. But again, this is a business that continues growing in policy count and profitability, so in 5 years, the value could be significantly higher.

The price comparison businesses present another valuation challenge. Confused.com is under significant competitive pressure given moneysupermarket.com, gocompare.com and comparethemarket.com are all trying to gain market share and are spending significant amounts in advertising, which Admiral is not matching. Hence profits here have declined in 2017. The international operations, however, have all improved operations. The combined price comparison operations have moved from a £7.2 operating loss to a £7.1 operating profit. Compare.com has reduced its own losses from $33 million in 2015 to $9.1 million in 2017. This is a business that does not require a lot of capital, so applying a 15x multiple to the £14 million improvement would imply a £210 million increase in valuation. That’s another 3.7% of the current market cap if you were to assume no additional growth and profits over the coming five years.

On top of this, any positive developments in the ogden rate would unlock additional reserve releases and also, I’m not making any projections to the household insurance business or the loans business. Household should increase its contribution to the overall UK result and loans could become more relevant if it continues an initially positive experience.

Overall, I believe Admiral should deliver attractive double digit returns under fairly conservative assumptions. I would recommend buying the shares at £19.4.  

Catalyst

European investor day in september 2017

Ogden rate positive review in the UK during 2018