Description

Zbeex wrote a good investment note on Qualitas in November, 2018 (LINK). The stock has done well from then with gains of 125%. While the core of the write-up’s investment thesis continues to be true, I would like to add a few more reasons as to why the stock is still an attractively priced compounder. 

Quick Brief on the business and its long term track record:

Qualitas is the leading Mexican auto insurance with a culture of frugality and customer service orientation imbibed from its founder whose family continues to own 48.5% of the firm. As you can see from the charts below, the firm has done exceedingly well over the long term to achieve market leadership. 

The Mexican motor insurance market continues to be under penetrated with a healthy growth runway. Despite 31 of the total 32 Mexican states enforcing a compulsory motor insurance regulation, only 31% of the vehicles are insured. The overall number of vehicles should itself grow overtime with improving per capita income. Since Qualitas has a large market share already in Mexican auto insurance, a lot of the future upside needs to come from the overall market growing. 

Unlike most insurance firms, Qualitas has a different operating model. They have very decentralised operations in which they appoint service offices across different locations. It is easier to think of these service offices as franchised operations whose work is to build relationships with insurance agents and service them. The service offices are usually run by ex-Qualitas employees and they need to manage the operational expenses of the centre. The pricing is decided at the centralised office but these local franchisees have the marketing flexibility. They don't get any geographical exclusivity as typically the same geography has 2 or 3 service offices which fosters competition. In places with a very marginal population or if it is a new market, the company starts with a company owned centre (usually 2 to 3 employees) and as the business picks up, they make the employee a franchisee. Qualitas has direct connection with the end agents and their customers as well and hence it is easy to change a franchise if he is not performing up to standards. The agents aren't exclusive, but they bring more clients to Qualitas because of the firm’s service levels for the clients. The management was saying that they are still the only insurance firm in Mexico which can underwrite policies even on a Friday evening. 

The core culture of Qualitas seems to be, thinking of these agents (16000+ people) as their customers and not as merely sales people. Everyone in the firm from the CEO to the COO are always available for a call with the agents to resolve any issues, if required. Typically, the agents get 8% to 10% of the premiums as commissions and the service office on a yearly fee model gets something similar (they are responsible for all branch level OPEX). This origination cost and commission is industry standard and there is no big differentiation on this count. The agents also get 1% to 6% of the premiums as bonus if the loss ratios are below a certain threshold. Thus the entire distribution system is well aligned in terms of costs and risks. This is the reason that Qualitas has lower bad debt issues and also high operational flexibility. As of now, the direct business with clients is a very small market and only 2% of Qualitas revenues comes from the same. In the long term, I believe that it would be a risk and the company will find it difficult to differentiate prices between the agents channel and the direct channel, but this risk is several years away.

Strong Moats - Data advantage and Vertical integration:

It is very interesting to understand the firm’s dominance in the heavy commercial vehicle segment (almost 45%+ market share) and amongst the fleet operators who contribute around 35% of the firm’s overall premiums. Unlike other markets, in Mexico, there is no central repository and every company needs to work only with the database that they have on claims, historical trends etc. So one of the biggest advantages for Qualitas is their large underwriting data from being the leader of the market with >28% market share for the last 12 years and this helps them choose and price risks better. 

In the commercial vehicle segment, they work actively with the clients to help them manage risk. Almost all their Commercial vehicles are fitted with GPS or Telematics or Camera kind of products. While they work with 6 different providers of these devices, the entire data from these are owned exclusively by Qualitas. They send their customers weekly updates on driver efficiency, fuel burn, how to reduce accidents etc just like any other fleet management software provider. This unique combination of Telematics + Insurance provides Qualitas with a huge data advantage and creates a very sticky customer relationship which lowers churn. For example, even if a vehicle comes with preloaded GPS, they install their own devices to get better data and the customers get incentives through lower insurance premiums to behave in a certain way. This has enabled the firm to successfully defend its HCV segment dominance without reducing risk adjusted prices even during phases of increased competitive intensity. These devices also help them in servicing customers better during theft, accidents etc. 

Qualitas is also creating a cost advantage over other multi-line insurance firms through vertical integration of its auto insurance business by in-housing certain repair related requirements. They initially bought small stakes in firms that manufacture automobile glasses, wind shields etc that were a large part of Qualitas costs. Over time as they understood these businesses better and they got the right management team for these units. Qualitas has taken 100% control of these firms. It took them several years to perfect operating these subsidiaries, but they have got them to a position where these units are now growing at double digit rates. Qualitas has made these units independent business lines as they tend to supply to their competitors as well and not only used for their in-house requirements. 

Currently, whenever there is any accident or repair, the Qualitas customers directly or through their agent gets in touch with them and the firm gives options of nearby workshops that they can use for repair. Qualitas tend to route traffic to their larger workshop partners with whom they have negotiated volume-based discounts and are rated highly on their internal systems. This allows them to provide superior service to their clients as Qualitas with its huge market share tends to drive the majority of the business for these workshops. At present, Qualitas manufactures Glass & WindShields on 70 to 80% of their claims and distributes it to their workshop partners. Similarly, they currently have units that supply around 15-20% of their total spare part requirements and hopefully this number should increase going forward. They also have set-up their own salvage and liquidation unit that helps them to source cheaper spare parts and get better realisations on accident vehicles. The firm has also innovated on claims servicing in which their express lane customers get money within 24 hours. They are the only integrated insurer in the country and the management hopes that these cost advantages along with their large database built over 27 years will help to continue maintaining their leadership across segments even if new competitors emerge in Mexico.

Conservative Culture:

The organisational culture of conservativeness at Qualitas shows up in the firm’s capital structure, underwriting policies, provisioning and investment portfolio construction. Qualitas has excess capital over the regulatory requirements of almost 650 million USD which is equivalent to 34% of its market cap. 

Qualitas always prioritises profits over market share and hence they are ready to sacrifice market share in particular segments if the pricing is not right. The firm has consistently had reserve releases as they historically have projected and provided for higher loss ratios than needed. Anyways since 75% of the premiums are repriced annually, they can be flexible in adjusting to market trends. Even during COVID when Loss ratios fell dramatically due to less cars on road, they only released a part of their technical reserves. On a rough basis, out of 100 $'s of claims, almost 60% of the claims is for material damages to the car that needs to be repaired from an accident, 20-25% is due to loss from car theft and the remaining 15-20% is due to civil liabilities or hospital charges etc. 

Almost 30% of the total premiums come from the Financial institution channel. Approximately 70% of the vehicles in Mexico are bought on a loan. This channel is the most risky and least profitable as they need to sell policies with the same tenure as the loans (usually 4 to 6 years) while the pricing is decided upfront. It is very difficult to forecast loss ratios or FOREX rates (impacts the repair costs). In the usual business line, the firm changes prices on specific models every 3 to 4 months and the customers get a repriced contract every year. Hence, there is no large balance sheet risk that can't be adjusted away in case of a macro event. A lot of Qualitas peers have been growing faster in this channel and the management believes that this risk could blow up in a bad year. 

Similarly, the firm's portfolio has only 12.9% equity exposure and the debt portfolio is majority in sovereign bonds. The total float is only around 1 year worth of premiums as it is a short tail general insurance operation. As Qualitas grows, their float continues to increase, and they can get healthy interest and dividend income from their investments as Mexico is still a capital deficient country. The firm will also be a beneficiary of increase in interest rates. 

Growth Optionalities - Geographical Expansion + M&A opportunities:

Meanwhile, Qualitas is trying to create additional growth levers by entering into new insurance segments in Mexico such as health insurance and also expanding its motor insurance businesses into other nearby countries where they are getting strong market traction. As of now, 8% of the company's revenues are coming from the non-Mexico market (primarily other Central & LATAM markets with some from South US). The management expects the non-Mexican share to increase to 15% to 20% of revenues in 2-3 years. 

Qualitas usually spends a few years operating in a new market or segment before scaling it up profitably. Their USA and Peru operations have matured, and these businesses are growing at 40%+ YoY from the current low base as they gain market share. Similarly, they intend to do several trial and errors in Health Insurance in Mexico for the next 2 years before scaling up. Over the long term, they expect their health insurance business to become as big as their auto insurance business. They continue to look for attractive M&A opportunities for growth as they are sitting on excess equity on the balance sheet. Please find below an extract from the earnings call in which the management outlines their M&A strategy, 

“Now on potential acquisition and M&A, it's Carlos. I would say that first, the umbrella principle, which is twofold. First, it needs to be something that will create value for the company. And by the company, I mean, for our shareholders but as well for our agents. And therefore, the value creation principle is perhaps the overarching one. And then it needs to be something that we can believe we create value by contributing with what we already have in place to Quálitas. That means because of our specialisation, because of our DNA of service and on cost control. So it needs to be something that we can amplify to further exponentialize whatever we acquire.

With those principles, I would say we're looking into 3 areas. I think it's still very broad, and that is true to what we're hoping for. First would be an acquisition where we already placed, something that will make us grow faster or be more efficient. It could be also a new market and by new markets that could mean a new geography in which today, we are looking into new geographies, and I think I've already mentioned that it will be Latin America, non-Brazil. It could also be a new category, a new sector. And those are likely to follow a strategy on health and medical, something that we have to, and we have also discussed the rationale and the inference behind that sector.

And the third bucket that we're looking into could be an expansion into a vertical integration. And I think in my remarks, it was clear that the fact that we have within our operation, a car glass company, a spare part company and a salvage company creates value by differentiating in terms of service and cost. We're yet to see the potential of those integrations. And I think there's willingness to hear about new opportunities to become vertically integrated, potentially in the technology area”.

Attractive Valuation - Risk Vs Reward:

The Brockman family despite his death earlier this year continue their shareholding through trusts, and they have committed that they would not sell any shares of the firm in the short to medium term. Brockman Jr who is the son of the founder and aged 30 continues to work in Qualitas. He has worked in the firm for over 7 years now and currently heads the Claims division. He has a permanent seat on the board because of the family's shareholding of 48.5%. Insiders put together own around 58% of the firm. 

The repeat business rate for Qualitas is almost 85% and the average vehicle ownership time is 7 years. Hence, their churn rates are extremely low and there is meaningful predictability to the business. The Market Cap/ Investment Float ratio is around 1.2X approximately and hence the investment income linked to market movements doesn’t significantly affect the steady core profitability of the motor insurance business. 

The management believes that they can generate normalised profits of 12.5% (PAT margins) across the cycle (range of 10%-15%). In 2014, 2015 and 2016, their margins were depressed because of 3 factors: 1.) Mexican Peso depreciated by over 30% during that phase and it led to higher combined ratio as over 25% of their costs were dollarized like imported spare parts 2.) Regulations changed on 3rd party civil liabilities and the entire industry took a large hit on their back book due to the new rules 3.) Most importantly, they couldn't reprice these new risks as the firm had a policy mix of 55% towards multi-annual policies and only 45% were repriced annually then. The management has corrected this mix unlike peers and currently over 80% of Qualitas policies are repriced annually and less than 20% are in 3-year contracts. This along with the firm's larger scale and vertical integration makes the management confident of generating margins like 2019 going forward even if there is a soft pricing cycle. 

There are two major long term risks for this business. One is the emergence of a good digital direct to consumer auto insurance firm which can gain market share as we have seen across the world. Even though Qualitas has been investing in technology and is ahead of the curve, I believe that the pivot from an agent led model to a D2C model will be difficult. Hopefully, there is enough transition time and the management is nimble enough to adapt. 

The other long term risk is the motor insurance disruption due to technological advances such as self-driving vehicles. I believe that the long-term risk of car insurance being disrupted in Mexico is still more than a decade away because of their current infrastructure. This is a country which still insures only a small fraction of its vehicles and the biggest loss to insurers come from something as basic as car theft. Even in developed markets where this risk is more pronounced, good automotive insurance franchises in developed markets such as Progressive, Admiral or Linea Directa trade at 2x the earnings multiples despite structurally lower growth and higher terminal risks.

Qualitas is currently trading at 9X trailing earnings and 2X book value which is below historical averages as you see in the image above. For an unlevered recurring business that can grow at 8-10% with ROE's of over 25%, I believe that the valuations are attractive. More importantly, the firm is run by good capital allocators and hence even if the markets don’t re-rate the business, the management will continue to buy back shares and deliver value. Qualitas has bought back 10% of its own shares over the last 3-4 years. Qualitas has indicated that 40-90% of the future profits would be provided as cash dividend to shareholders in addition to the share buybacks. The management wants to buyback shares aggressively below 2X book value, but is aware that such a buyback will diminish the free float even further and create liquidity issues for institutional shareholders. Hence, they are opting for a mix of dividends and share buybacks.

Catalyst

Share buybacks and Dividends