|Shares Out. (in M):||275||P/E||12.0x||12.0x|
|Market Cap (in $M):||5,500||P/FCF||12.0x||12.0x|
|Net Debt (in $M):||200||EBIT||450||450|
|TEV (in $M):||5,700||TEV/EBIT||10.0x||10.0x|
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With Admiral Group's stock price down over 25% since early July, I think this structurall-advantaged, high-quality UK auto insurer is now priced at a good entry point. It sells for about 12x EPS and pays an 8% dividend yield at today's $20 price (US ticker is AMIGF) and at about 1235 pence (UK symbol is ADM, traded in London.)
After 22 years in business and 10 years as a public company, Admiral is the #2 auto insurance company with about 12% market share, with around 3.5 million customers in the 30+ million UK auto insurance market.
In the UK, they also sell a small amount of home insurance, which is a new product for them in the last two years, as well as some commercial vehicle insurance. But, for all intents and purposes, they are almost all passenger car insurance and the UK is their biggest market that represents about 80% to 85% of their revenues and is responsible for all their profit.
In addition to the important UK market, they have auto insurance units - operated under various local brand names in four international markets; Italy, France, Spain and in four US states (Texas, the largest state, Virginia, Illinois and Maryland.) They have launched in these selected international markets, one by one, from 2006 to 2010. The US is the last market they've entered. By all accounts, they appear to be very careful in how they grow these international businesses.
Overall, these non-UK markets individually and collectively lose money with about 550,000 policyholder. Their go-to executive (their former CFO) has been assigned to head the US endeavor, showing the longer-term importance of this market opportunity with about 200 million cars on the road in the US. In their chosen four-state start there are about 30 million cars on the road, similar in size to the UK market. They fundamentally believe the US is primed for their type of marketing strategy and business model that's been so successful in the UK.
Their unique edge is in their use of their internet niche where they operate various "price comparison" websites for people to shop around for auto insurance. This breeds a certain type of industry dynamic. The UK market shows that about 60% of all consumers use a price comparison website to shop for auto insurance. No other market is even close, but Admiral feels strongly that each of their four international expansion markets will trend in this direction over time. I agree with this strategic belief.
Their Business Strategy:
Admiral's four price comparison websites make money, among other ways, from generating insurance bookings for participating insurers. For example, they recently reported that they have 6 of the top 20 US auto insurers on their comparenow.com US website now (they are in a partnership with White Mountains in the US with this new website.)
The cost of new policy acquisition via this distribution channel for these insurers is lower than other means of gaining new policyholders. Their UK price comparison website - confused.com - is Admiral's most profitable website and it alone has historically made enough money to more than offset the investments they've made in their international expansion insurance operations. Although, explaining part of the stock's recent weakness, the first half of 2014 showed a dip in profitability from confused.com. This is actually a multi-year phenomenon as competition has steadily rampled up since 2007 or so.
Admiral views these price comparison websites as simply part of their long-term strategy in the auto insurance market. At the heart of their strategy is that the low-cost player benefits from price transparency.
The use of the price comparison sites creates a disruptive industry dynamic in the auto insurance market, as evidenced in the UK. Price transparency naturally creates more frequent switching of carriers by consumers and, in turn, creates much more volatility in the industry's profitability cycles. This type of volatility and lower switching costs for consumers creates a structural and strategic advantage to the low-cost insurance provider. Admiral is that insurer in the UK. They are often referred to as the GEICO of the UK, for this reason.
This structural advantage works this way:
In a weakening pricing market, with premium levels in decline, the low-cost player is able to retain their policyholders by lowering their pricing to a lesser degree than the rest of the market players. This allows the low-cost player to avoid the profit destruction that follows a chase to the bottom for business. The low-cost player can float strategically down with the market, invariably experiencing some lowering of margins, yet still remain profitable and, importantly, still retain their customers.
After that margin killing plays out for the rest of the industry, insurance premiums start to rise again and the other insurers eventually eagerly raise rates to gain back profitability. Off the cycle bottom, the low-cost player is better able to raise their premiums to an even greater degree than others. Yet, importantly, their pricing still remain below the pack, of course. They get the pick of the best business and they can get a lot of it during the cycle upswing.
Naturally, in a rising premium environment, policyholders have real, financial reason again aggressively to shop around. When they do, the low cost player picks up market share quite readily. This happened for Admiral in spades in the UK during the last up cycle in '10 and '11 - premiums rose about 40% in a two year period - where market share gains were very, very large for Admiral.
The evolution of an auto insurance marketplace that increasingly embraces online price comparison breeds a major, long-term advantage to the low-cost producer. Admiral's expense ratio is about 13% of premiums versus the 25% industry average due to a few factors (a) lower new policy acquisition cost via the internet channel (for example, about 65% of Admiral's new UK business comes via price comparison sites and their international markets continue to build in this direction) and to a lesser extent through their direct phone sales channel and (b) their underwriting data and selectivity is strong and is used to their advantage in getting consistently good underwriting results and (c) their claim administration process is more efficient and importantly highly satisfactory for their customers as evidenced by their internal measurements.
Overall, Admiral's combined ratio - premiums less claims cost and operating expenses - sits at about 85% to 90%, on average. The rest of the industry operates, on average, at a combined ratio above 100%. It's a tough market and Admiral makes money in it consistently.
A particularly good explanation of this dynamic was written in their 2013 annual report by David Stevens, COO on page 21. I actually encourage interested readers to review the management letters since their IPO in 2004. They give a consistent flavor of the integrity of this management team.
The Use of Co-Insurance and Reinsurance:
A unique aspect of Admiral's business strategy is its use of co-insurance (with Munich Re since 1999, the same year they did a management buyout) and reinsurance (with a consortium of four reinsurers).
The primary outcome of this strategy is that Admiral currently gives up 40% of its underwriting results to Munich Re and also sheds underwriting risks on another 35% under reinsurance deals. Admiral retains 25% of the underwriting results for itself and receives a share of profits from both the 40% co-insurance deal with Munich Re and also from the 35% of volume that is reinsured. This profit sharing is referred to as "profit commissions" on their income statement.
This co-insurance and reinsurance strategy significantly limits their capital requirements in writing the gross volume it writes. Back in their 2004 annual report, their first as a public company, the CEO described their model as to "primarily distribute insurance on behalf of reinsurance partners." As a result, Admiral produces an extraordinarily high ROE if between 55% and 60%. It's kind of like a securitization machine, of sorts.
Their current co-insurance deal gives a UK subsidiary of Munich Re 40% of the underwriting results, on a strait pro-rata basis. The investment of reserves is done by Munich Re. This arrangement has been renewed through 2018.
Their reinsurance deals with four companies (Swiss Re, New Re, Mapfre Re and Hannover Re) are in place through 2016. The reinsurance versus co-insurance deals differ in how much of the insured-book's profitability is retained by Admiral.
Their is a balancing act between (a) retaining underwriting results, (b) co-insurance (a partial long-only on their policies) and (c) reinsurance (a negotiated put option strategy to limit downside risk but keep the underwriting profits.)
Readers will also note their policy of commuting their reinsured business after two or three years of claims experience. This commutation of matured underwriting years is partly a house-cleaning, simplification tactic - I presume it allows for the elimination of ongoing reinsurance accounting work and administrative costs. However, it is only an option for Admiral and will only be done on the right economic terms with their reinsurance partners.
As I considered their outlandish ROE driven by their capital-lite strategy built on these co-and reinsurance deals, it is clear their high profitablity is predicated on the ability to underwrite good, profitable business. Only then will it work over the longer-term. Big underwriting mistakes will quickly cause massive changes in their profit commissions with their reinsurance partners upon contract renegotiation. This fact and the fact that Admiral pays out most of its cash flows to shareholders instills a deep underwriting and cost control discipline. This helps solidify their DNA, as mentioned above.
On the flipside, while Admiral always has the ability to turn the dials up in terms of risk retention and the possibility of garnering a greater portion of their produced profits - which naturally causes the need for more retained capital - they appear committed to growing slower than they otherwise could. I sense no shift in their strategic thinking and I like the consistency of knowing who they are and what their strategy is over the longer-term.
The UK Cycle - the near term key:
The UK industry is in a tough stretch right now with coming regulatory capital changes (Solvency II coming in 2017), the banning of various other fees auto insurers have historically charged in the UK (such as a ban on insurer's ability to earn referral fees from rental car companies after an accident occurs) and, finally and most importantly, the UK is currently in a two-plus year declining premium market environment. The concern is margins are coming under pressure.
Following the massive premium up-cycle in '10 and '11, the down-cycle of '12, '13 and now still into '14 is clearly testing investors' patience. Added up, the industry is in a bad stretch, which happens from time to time. Downgrades by analysts have been the recent trend.
Based on recent history, the UK auto insurance cycle about 7 years in length during the '90s with wilder swings than we've seen since around 2005-06. As one reads the annual reports, Admiral began to muse/identify/discuss a more subdued market reaction as industry consolidation has increased. The previous low-point to low-point cycle following the low-point in '98 and '99 to the next low-point in '08 and '09 was about 10 years. Given this possible new cycle length - if it is a new one - it's possible we may still have some time before the current bottom is reached. However, I don't think these things happen with stopwatch-like precision.
Despite the difficulty this point in the cycle produces, I think Admiral "likes" this stage given their longer-term advantages and the patience to know that upswing in pricing always follows. The catalyst to come is the bottoming of the UK pricing cycle and it appears things are starting to reverse.
Over the past two years, it looks like Admiral is just trying to keep its UK policyholders. Today, in a possible indication of a turn in the cycle, as mentioned by management in their mid-year 2014 update, they appear to have recently increased their premiums, according to recent reports. Admiral may be making this pricing move slightly early because they don't want to sacrifice their margins too much by trying too hard to hold on to their customers on the way down. It's really too early to tell what their recent pricing strategy is driven by and it appears their price hikes were pretty modest.
In summary, I do think it is quite clear that management is rightfully concerned about forward-looking industry margins in this current environment. This is going to require some patience by investors who believe in the strength of their model and their management.
As mentioned at the start, the stock is down about 25% from over $27 to about $20 today. This is the price they traded for back on 2010-2011, before the beginning of this current industry down cycle. Earnings have grown since then. It is priced at about 12x EPS estimates with a nearly 8% dividend. This is not entirely out of line with Direct Line, a large direct insurer competitor in the UK.
I believe this is a very reasonable price given the disciplined and conservative style of management and the future growth potential in both their primary UK market (following the next up cycle) as well as in their international markets (over the next 5 years.)
Of course, it can go lower as it did during late 2011 after they came out with cautious comments on claims experience related to bodily injury claims and the start of the current turn of the cycle. And, of course, late 2011 marked the end of a massive premium inflation period with Admiral picking up huge market share. Everything at that time seemed great and disappointment was hard to take. Still, and this is important, 2012 was a record-profit year, as was 2013 - albeit, slower growth than some investors had grown accustomed to seeing.
A Comment On Their Dividend Policy:
Admiral uniquely pays out about 90% of their profit to shareholders - part is a 45% normal payout policy plus a special dividend that keeps behind just enough cash to fund their growth initiatives and to maintain necessary capital levels. Their view on the dividend policy is refreshing and - ironically for Berkshire shareholders who love Berkshire's zero yield but simulaneously dislike others' insistance on retaining capital for growing their empire - Admiral has fully adopted the value investor's mantra that it's always best to let shareholders ultimately decide on the use of their earnings and retain no more than you need to grow reasonably. They say, and I am paraphrasing here, they don't want to starve their businesses, but don't want managers to feel they have an abundance of capital to do dumb things.
Some are concerned with their recent bond offering, borrowing about $320 million with a 5.5% coupon and a net cost - after interest is earned on the cash - of about 2%, is an indication that profitability alone won't support their dividend and they'll utilize borrowed money to maintain the yield.
Management has stated that the borrowing activity was for possible regulatory capital need related to Solvency II changes. Admiral, a formerly debt-free and debt-averse company, considered it a strategically smart time to borrow.
Regardless of the reason (and they have denied rumors they will make an acquisition of Insure The Box, a telematics-driven, low-cost auto insurer that's about 6% the size of Admiral in the UK), this bond offering has spooked analysts as well. I believe there is no reason to consider management as less-than-forthright today given their history of honesty.
A Comment On Their Reserve Releases:
Now, it's it important to mention that there is a major knock on Admiral's reserving practices and, therefore, some analysts question the quality of their earnings. Historically, about 15% of their annual profit comes from reserve releases as past claims experience comes in better than their reserved-for, expected results. Admiral insists on over-reserving in the name of conservatism. They also expect to release their excess reserves as the better-than-reserved-for claims experience shows through.
Analysts don't like this level of profit contribution from reserve releases. Admiral's opposing view is they think it's more conservative and prudent to release profits as the better than expected experience shows up...rather than booking too much profit to start only to claw it back as the years go by. They think that alternative way of operating is truly "low quality." They think this is the right way to do it. Experience comes first, extra profits show up later, not the other way around. I tend agree with Admiral's management here and their history has shown it has merit.
However, as Admiral recently alluded to on their second quarter earnings conference call, you cannot write low-margin business in a down cycle and expect to have any ability to release enough reserves in the years following. That cohort of business simply won't allow for it. And, that's the current worry if this down cycle continues for too long. Thus, the importance of the turn in the pricing cycle for shareholders today. I like that management seems very cognizant of this fact and has consistently chosen to sacrifice policy count for solid profitability over the cycles.
In summary, I believe Admiral's current price at $20 at 12x EPS and an 8% current yield - importantly with future growth potential due to a unique business model in a generally recession-resistent industry - represents a good longer-term investment.
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