Description

  COFACE (EPA: COFA) – Buy ($5.46)

Executive Summary

We are long shares of COFACE. The current pricing provides a low valuation floor, ~35-45% upside in the base case, and ~90% return if the company is able to act on its three-year plan and successfully return excess capital to shareholders. The trade credit insurance (TCI) industry possesses significant structural barriers due to an inability of players to take risk on their float and an indispensable global infrastructure to correctly price the riskiness of specific company trade credits. Recent underperformance related to the company’s emerging markets portfolio and the loss of a government contract has led the stock to fall by over half over the last 18 months, and the Company now trades at .59x tangible book, significantly below peers. We believe these issues will subside through management’s plan to have a more bottoms-up approach and a focus on granular, country-by-country risk management through the new CEO’s initiatives (which will materialize in the company’s operating costs by 2018), as well as the general short-tail nature of trade credit insurance lending to rather quick fixes in premium pricing. Furthermore, regulation related to Solvency II could free up excess capital as the company reverts to historical profitability, introducing the potential for capital return to shareholders.

Investment Thesis

1. The trade credit insurance industry demonstrates strong barriers to entry with a necessary global infrastructure to support successful risk management in pricing insurance premiums.

2. Recent COFA underperformance related to emerging markets, a loss of a government contract, as well overhang related to majority stakeholder Natixis has mispriced the company’s run-rate profitability in a misunderstood and underappreciated industry.

3. The company’s announced initiatives in September and the general short-tail nature of TCI will result a swift reversion to historical profitability, not a gradual pace. We also believe the new CEO likely had high incentives to “take a bath” in 2016 in terms of operating costs and start the company anew moving forward.

4. As the company’s operations return to normalcy and management attempts to achieve its targeted RoATE, there could be significant return of excess capital to shareholders by 2018/2019 as the company normalizes its overcapitalized balance sheet.

I – TCI Industry Backdrop

TCI is an insurance policy to entities trying to protect their accounts receivable from losses stemming from credit risks (protracted default, insolvency, bankruptcy). The value-add to the insured is fairly clear:

1.      Access to liquidity – many revolvers / LCs require TCI

2.      Increase sales and trade – facilitate transactions that may otherwise be deemed too risky by insured entities

3.      Profitability – enhances company economic stability by sharing trade loss risks with diversified TCI companies who are better equipped to absorb losses

Essentially, the transfer of a portion of non-payment risk to a diversified receivables manager facilitates international trade and improves a company’s access to liquidity. Companies pay a premium which is charged monthly as a percentage of sales (10-40bps). Usually, contracts are structured as a “whole turnover” policy, insuring the entire basket of receivables, as opposed to specific customers to the insured supplier. In the event a customer defaults and doesn’t pay the receivables account, COFA and its competitors have “rights of subrogation”, whereby the insurer steps in as the creditor and has a claim against the creditor.

Penetration of TCI in global receivables stands at 5%, so it’s definitely not a saturated market; post-recession growth stands at 3.2% y/y. Overall, the industry has interesting profitability dynamics compared to the rest of the insurance industry. Because receivables default trends tend to correlate heavily with capital market swings, TCI players can’t take significant risk on their float – two-thirds of the investment portfolio is in investment grade bonds, half of which are in sovereign fixed income securities. In general, the inability to take on duration risk stymies the returns TCI players can generate on their investment portfolio. COFA has earned 2-4% on its investment portfolio since 2013, and it is unlikely that investment return would increase over time. As a result, whereas most insurance companies breakeven on the insurance business and generate returns through their float, players in the space are required to have a profitable insurance business – the three primary players have exhibited combined ratios (i.e. underwriting profit ratio, which is loss ratio (claims expense) + cost ratio (opex)) of 75-80%. On the other hand, the average combined ratio in 2015/6 for P&C insurance was 97.8%. RoATE over the last 3-4 years has been ~8.5-9.0% for COFA; while the company is targeting run rate RoATE in excess of 9% over the next three years, we’re less bullish given emerging market exposure and believe 8% is a more likely outcome.

The three largest players are Euler-Hermes (36%), Atradius (25%), and Coface (20%), representing 81% of the total market. Driven by industry consolidation, the market share of these players expanded from 40% in 1990 to what it is today. Unlike most scale driven barriers, which tend to be regional, the advantage in TCI stems from international scale advantages. Since whole turnover policies are a majority of premiums, insurers need to understand the underlying riskiness of not the companies they insure, but the creditors of the receivable accounts. Consequently, a global infrastructure is essential when assessing the riskiness of receivables of numerous international companies. The TCI space also necessitates players to be well-diversified by geography, industry, and companies in order to insulate them from pockets of economic downturn (see below). The informational advantage larger players have enables them to price and understand risk much better than a company that doesn’t have the same amount of information. Coface currently has 50,000 clients across 100 countries and a database of over 80 million companies – smaller players simply can’t understand company-level risks as well as the three largest players, which is why the advantage for these players is so clear. Furthermore, the demand for TCI primarily exists in foreign, not domestic transactions. Domestic TCI tends to have lower premiums and simple structures since the amount of companies covered is less.

2015 underwriting revenue splits by geography, country, and industry –

Although a more nuanced point, it is worth mentioning that Coface has been in business since 1946 – for 70 years, the company has operated successfully through numerous economic downturns, grown with the TCI market, and expanded its presence beyond Western Europe across six continents. While not extremely relevant to the thesis in the short-term, the long-term success of the business speaks to longevity and defensibility.

In terms of growth, mature markets are exhibiting a slowdown in growth, and TCI players are looking towards the single digit emerging market growth as a source of value creation over the next three to five years.

II & III – Recent Business and Market Underperformance & Rapid Return to Profitability

Emerging Markets & Return to Normalized Loss Ratios

After consistently generating net income of ~$125mm form FY2013-2015, COFA’s earnings in 2016 are expected to be in the low double-digits for 2016. The largest driver of this underperformance was emerging markets exposure, where the company underestimated volatility with an untested team and undeveloped infrastructure. The heavy correlation of emerging market growth to oil prices led to significant losses for COFA, especially in the higher risk Asia Pacific and LatAm segments.

Per the company, the existing infrastructure being used in mature markets was applied to their emerging markets. This strategy, in periods of little to no significant economic downturns, appeared to be working. Once commodity prices fell, it was evident that the current strategy was not working given the high experienced loss ratios. In emerging markets, information tends to be less reliable, payment terms are longer than the traditional 90-180 days, and more importantly, the industry only recently entered emerging markets and up until the commodity crisis, had not experienced a cyclical downturn. With loss ratios in excess of 100% in some instances, it’s clear that what COFA was doing in emerging markets was not working. COFA’s exposure to LatAm is the highest of the three Global players, with 37% market share in LatAm; consequently, COFA has been particularly hit hard over the last year relative to competitors, as it was the “first mover” to really entrench itself in the TCI market. Loss ratios for 2016 are consequently expected to be 63%-66%.

In September of 2016, the new CEO announced a 2-3 year initiative to adjust the company’s existing operations in emerging markets, related to information, the underwriting process, and incentive structures. Probably the most important initiative is increasing the amount of data the company purchases and headcount in emerging economies (25 full-time personnel), the cost of which will be funded from the State Guarantee proceeds (discussed below). This process involves increasing the monitoring segments from 10 segments to 150, segmented by country and industry sectors. This investment in information should improve risk underwriting in these higher risk countries. Some of these results have begun to manifest themselves in LatAm, where loss ratios have fallen from a peak of 170% to 80% (prior to commodity crisis, loss ratios in this geography were roughly 60-70%). Initiatives vary country-by-country, and the Company’s presentation on its “Fit to Win” plan actually outlines pretty well how each country has different issues that it did not properly focus on before.

The important thing to highlight is that a return to profitability (from a loss ratio perspective) can occur rather quickly. Given that trade receivables have average terms of 90-180 days, turning over the entire “loan book” takes around 3-4 quarters. Hence, once the company began to experience significant losses in Q1’16, it has to allow for its entire existing, mispriced loan book ride off, which takes about 3-4 quarters. This short-tail nature of the industry works to the benefit to industry players, as even large mistakes in pricing don’t necessarily bear long-term consequences if the company quickly adjusts its premium pricing. Therefore, we believe a large portion of the return to profitability can occur by YE2017, with potential delays stemming from cost-cutting initiatives taking time (which is on the cost ratio side, but affects the total combined ratio).

Loss of State Guarantee Business

The company also lost its State Guarantee business in France, reducing annual contributions by $30mm (historically 4% of the company’s business). The decision itself had nothing to do with Coface itself, as the government didn’t switch to one of the other two global players. Instead, they were looking to now provide a direct state guarantee, not a TCI guarantee which is indirect and on behalf on the sovereign. Regardless, the stock price fell 21% in response to this news.  However, in the terms of the cancellation was a one-time payment to COFA of $70mm, half of which is being used for infrastructure technologies in emerging markets, and the other half on cost savings. Cost savings primarily relate to reducing internal staff by approximately 250 people over the next 2 years (net of the new hires necessary in the emerging markets). Management expects that the cost saving initiatives should lead to ~$30mm in savings by 2018/9.

New Management with Focus on Operational Improvement

Lastly, the Company announced that it will replace Jean-Marc Pillu in January 2015 with Xavier Durand as the new CEO of Coface. Pillu led the company for five years before “stepping down” at the beginning of year. Durant is a 20 year veteran GE Capital, where he was most recently the CEO of Asia Pacific and Director of Strategy and Growth. While Pillu was successful in IPO’ing the company in 2014 and had a strong focus on growth, it’s likely that the heavy losses in Asia Pacific and LatAm came from this aforementioned growth, and along with bloated cost ratios, caused majority holder Natixis to act and implement someone who would focus on streamlining and improving the operations of the company. Durand has repeatedly stated that the focus on growth is secondary to stabilizing operating expenses and existing operations, which we believe is the best approach.

IV – Potential Excess Capital Return to Shareholders

The Company is targeting RoATE’s greater than or equal to 9% after the successful implementation of its Fit-to-Win plan. Due to the low organic growth in mature markets, and the company’s likely hesitation for aggressive emerging market expansion, we believe it is likely that hitting the target RoATE will have to involve some sort of capital return through either dividends or share buybacks. Excess assets on the company’s balance sheet will deflate profitability metrics, and a capital return could provide a strong catalyst for the market to appreciate COFA’s entrenched position in TCI.

Solvency II became effective in January 2016, which imposed new regulation on EU insurers with respect to solvency requirements (100% minimum solvency requirement with 99.5% confidence interval – implies that the insurer can meet its obligations “in the event of a severe shock that is expected to occur once in every 200 years”). The Company has stated that it’s targeting a Solvency II ratio of 140-160%, and it was 155% at H1’16. A big driver of solvency ratio growth will stem from reinsurance initiatives, which lower capital requirements (as the Company is less liable for total gross premiums). Management has explicitly stated that once the solvency ratio exceeds 160%, it will payout cash to shareholders through dividends/buybacks to get back down to a 160% ratio.

The calculation of Solvency II ratios is pretty difficult and companies don’t really release a lot of granularity on it, but some rough numbers get the point across that if the company is able to generate RoATE of ~9.0%, capital returns to shareholders can be quite significant. If the company is able to generate $880-$920mm of premiums by 2018, the amount excess capital will be roughly ~$170mm. We don’t project what that implies on share price if the company does buybacks (that would require an assumption of 2018 trading price), but the point is that the excess capital is 20% of today’s market capitalization and represents an opportunity for significant capital return to shareholders and further expansion of RoATE.

Valuation

Similar to other P&C insurance companies, TCI companies are also valued on a P/E and P/TBV basis. P/TBV can be a good measure of judging how “cheap” an insurance company is generally, but this assumes proper mark-to-market on the company’s assets, which include receivables related to banking and insurance activities (companies do reserve against these accounts, but still not technically “market”). As previously mentioned, COFA currently is at .59x TBV; the P/E multiple on an LTM basis is north of 20x and is inflated given the recent poor performance. For the reasons mentioned above, specifically how short-tail the riskiness of TCI loan portfolios is, a return to profitability can occur within a 1-2 year span. Coupled with management’s cost structure and infrastructure initiatives, cost ratios should also normalize in conjunction with loss ratios.

For valuing COFA, we looked at how the industry has traded historically (see below) on a P/E basis (and P/TBV to a lesser extent, since the focus of this pitch is more on operating performance).

Keeping valuation simple, we sensitize the four primary drivers of returns – net premiums, combined ratio, ROIC (on investment portfolio), and P/E. As you can see below, getting to 35%-45% upside doesn’t require aggressive assumptions. The company and industry has historically operated at 75%-80% combined ratios post-recession, but we run with 83% targeted by management through the cycle; the higher ratio is likely to conservatively account for the higher emerging market exposure the company has relative to years past. In terms of net premiums, the company generated $920mm in 2015 and is expected to generate ~$880mm in 2016, which should grow at 3% y/y per industry and market research reports (it could also grow in excess through higher growth in emerging markets, but we believe management has a focus on normalizing profitability first). By 2018, we think run-rate profitability will return to the business.

For the company’s investment portfolio, we keep returns flat at 2.0% (what it has earned since 2014). Increases in real rates should strengthen the return profile of the portfolio, but let’s ignore that for now (rate increases would also negatively affect existing portfolio value, but that’s mitigated by the short duration of the portfolio). Lastly, for valuation, COFA and competitors have traded between 12x and 14x P/E post financial crisis, but had recently traded down given the emerging market exposure and general macroeconomic concerns. We use 11x, COFA’s median trading multiple (excluding the last 2 months for obvious reasons per the charts above) in our base and sensitize it +/- 1x for bear/bull scenarios.

At net premiums near what the company has generated recently, we’re getting to 35%-45% of undervaluation. While this obviously seems attractive, the point of emphasis we’d like to make is that the amount of downside protection is pretty high. That may sound aggressive given we’re showing an increase of net income from low double digits up to north of $100mm over 2 years. However, as the 3-4 quarter lag in the receivables book materializes by Q4’16/Q1’17, the sharp increase in profitability should be expected easily by 2018, if not even 2017. The bear case in this investment presents a pretty high valuation floor, making the risk/return profile quite attractive.

Basically, a strong portion of this pitch relies on the fact that COFA can take advantage of the short-tail nature of its business and quickly adjust pricing. A 10 percentage point fall in loss ratios from 63-%-66% in 2016 to ~53% seems ambitious, but beyond the trade credit they insure, increasing the premiums charged to emerging markets, something COFA and its competitors will have to and are doing, should enable the company to achieve this ratio (which is still above historical averages for the three players).

A lot of insurance investment plays rely on these short-term issues related to mispriced risks, but I think this opportunity is a little more interesting since there’s no reliance on increasing investment returns to drive alpha, no substantial growth necessary, and the timeline can be rather short, providing a pretty strong catalyst through earnings recovery.

Summary valuation

Risks

Investment portfolio: inadequate returns and duration risk: 2.0% is certainly not something worth writing home about, but investment returns are still going to be ~25% of total “revenues” (underwriting profits + portfolio income). The Company earned 3.8% in 2013, but that was in a higher return environment. We don’t think there’s a lot of “portfolio management” risk here – the company knows it can’t take any real risk with its investment portfolio (as exhibited by the 2/3 concentration in bonds, of which almost all is either investment grade corporate or sovereign). However, the duration on the bonds in the company’s investment portfolio is 3.2 years, about 2.5 years above the trade credit book, so the matching on duration is not exactly 1:1. Concerns over low returns on the float could be mitigated through potential increases in interest rates (probably less likely in Europe than the US however, especially in the near-term).

Pricing competition in emerging markets: While COFA took the risk to take a plunge into emerging markets, eventually the other two players will also follow suit. This could introduce pricing competition in geographies with higher standard deviation in growth, lower quality standards in financial reporting, and generally more uncertainty. While we believe all three global players are incentivized to increase premiums, as the market becomes more developed, downward pressure on pricing could affect combined ratios. A potential short-term mitigant to this is being the “first mover” should provide it with better data on companies, how to price its premiums, and the appropriate reserves needed. It is also highly unlikely new players enter the segment – emerging markets should in long-run still be dominated by the current three players; the global infrastructure requirement still applies, and no player with exclusive operations in emerging markets could generate returns needed on the float side to offset the potential volatility in combined ratios.

Europe concentration (48.5% of gross premiums): Although not a nascent industry, all TCI players are European corporations and grew their business from their out. Europe by far has the most mature TCI market, and portions of the developed world, especially North America, has only begun to utilize the benefits of TCI. The concentration in Europe is not something idiosyncratic to COFA, as all three players are largely exposed to the continent. Investors are pretty wary about the future of Europe, related to Brexit, Italy, Spain, Greece, the general lack of organic GDP growth, as well as certain investors who are heavily short the large commercial banks of some countries under the premise that NPLs have not been written down to their true value. Along with its competitors, the company would likely exhibit some pretty heavy losses if Europe were to experience serious issues in the near term.

Pair Trade

Obviously, the industry is pretty exposed to general macroeconomic trends, especially when all correlations go to one. A potential pair-trade with Euler-Hermes can neutralize this exposure such that the investor captures purely the relative value appreciation of Coface. Atradius is part of a larger Spanish firm, so it makes more sense to use Euler-Hermes for a more “pure” hedge.

Catalyst

The dramatic recovery in earnings should happen rather quickly over the next 1-2 years.