Description

Qualitas Controladora (BMV: Q*)

Thesis – off-the-radar compelling, mispriced compounder

Long Qualitas Controladora (“Qualitas”), the largest auto insurer in Mexico trading at a compelling 7x P/E with tailwinds to grow at a 10-15% CAGR for the next decade at a 20%+ ROE with an unlevered balance sheet. Qualitas has a confluence of factors that lead to its significant undervaluation - it is a domestic Mexican business with no ADR, has a relatively small float (approx. 400m USD), operates in an industry shunned by many investors (financial services/insurance), and has limited sell-side research coverage. That said, Qualitas has very low risk of permanent capital impairment and an investment at today's price we expect to return between 110% and 295% over the next 5 years.

Qualitas is a much safer investment than it might appear at first glance. Auto insurance is by nature short-tail and recurring, with Qualitas' contracts realized and repriced nearly annually and thus there is a de minimus chance of surprises hiding on the balance sheet. The company's leading ~30% market share has allowed it to underwrite at a ~95% combined ratio and earn an average 23% ROE over the past decade, despite a conservatively positioned investment portfolio. And perhaps most importantly, Qualitas is run by minority-shareholder-friendly founder Joaquin Brockman Lozano, who together with his family and close associates owns 58% of the company and cares deeply about the company's long-term health.

There are three layers of tailwinds to the Mexican auto insurance industry that Qualitas can catch. First, auto insurance penetration is growing off of a low base of 30%, driven both by natural adoption and recent federal/state regulation.  Global and Latin American peers stand around 85%. Second, automobile ownership in Mexico is significantly lower than global averages and growing at 4-5% per annum. Finally, economic growth drives higher value per vehicle over time. Qualitas has also been a share-gainer over time, though we do not model in much more gain given that they are already ~30% of the market.

Alternatively viewed, Qualitas’ MXN 42.55/sh price is a 34% discount to its MXN 64/sh investment float, which serves as a conservative and growing measure of intrinsic value. We expect the float to continue growing to 77 by YE19 and to 128 by 2023, reflecting continuing growth in intrinsic value per share.

Business Description

Qualitas is the largest auto insurer in Mexico. It was founded by Joaquin Brockman Lozano in 1993 after working for his father’s insurance firm for 17 years, and has grown largely through organic growth.  Through the years, Brockman has uniquely focused the company entirely on auto insurance and as a result has steadily expanded its distribution reach and cost/underwriting excellence while larger competitors have relied upon cross-sell through their existing channels.

Today, Qualitas distributes through three channels – OEM new car sales whenever financing is used for purchase (“Automotive financing”, 41% of written premiums), to owners of fleets of semis/trailers and other vehicles (“Fleet”, 32%), and directly to individuals through its network of agents and brokers (“Individual”, 27%).  Automotive financing is both the best and the worst segment – new car sales are the entry point of growth in the industry, though the segment has large macro-driven swings and more cyclical competition. In contrast, Fleet and Individual grow in much less volatile patterns with higher customer stickiness. Qualitas’ market shares are ~40% in Automotive financing, ~50% in Fleet, and ~25% in Individual.

Competition is generally weak in the Mexican Auto Insurance industry.  The #2 and #3 players, GNP Seguros and AXA Seguros, are multi-line insurers that lack Qualitas’ focus and scale in auto insurance with ~10-12% of the market each.  As a result, they are at a disadvantage on multiple fronts: underwriting data on a wide variety of vehicles/geographies, responsiveness to changing market conditions, and relationships with agents/OEMs/repair shops/replacement parts suppliers.  Qualitas’ focus and operating prowess has allowed it to grow from ~19% share in 2009 to ~30% today, even as they enjoyed a ~95% combined ratio vs. the non-bank competitor average of 101%. While the industry continues to evolve and new capable monoline players have emerged, Qualitas is well positioned to continue to prosper within the industry as it grows.

Long-term Tailwinds

Auto insurance penetration is on the rise.  In 2014, the Secretary of Finance published new rules to enforce liability insurance for 3rd parties (injury, death, damage) on roads and bridges within Mexican territory.  This has already begun to drive penetration through the OEM new car financing channel and will come into full effect in 2019.  While the journey from 30% to 85% will take a long time due to cultural and enforcement barriers, these changes will drive meaningful progress on that journey.

Vehicles per capita in Mexico is currently at ~250/1000 vs. ~500/1000 in most developed countries and ~900/1000 in the US, Mexico’s cultural/geographic sibling and economic aspiration.  Recent opening of credit availability in Mexico by major OEMs drove a sharp 45% total increase in new car sales from 2013-2016, and new car sales of 1.5m annually will increase the overall number of vehicles in Mexico by 4-5% per year.

In total, insured vehicles has historically grown at 6.5% and premiums/vehicle has grown at 4% for total premium growth of 10.5%.  We believe that this accelerates to ~13% due to the above-mentioned regulatory changes and that Qualitas will catch these tailwinds at high ROE.  Even if the industry grows slower or not at all, investing at 7x P/E is very appealing for a well-managed and consistently profitable market leader that cares about its shareholders.

Ownership and Capital Allocation

Qualitas management is well-aligned with shareholders. Insiders collectively own 58%, with the Brockman family owning 40%.  The company reports regularly with good detail, is open and transparent on earnings conference calls, and has been more than willing to engage with us directly and engage with our suggestions.

Qualitas is also actively returning capital to shareholders.  Their dividend policy is to pay out 50-90% of excess capital above 150% of regulatory requirements; we expect this to be close to MXN 0.90/sh next year (2% yield).  The company also net repurchased 6% of shares over the past year. Capital returns are, of course, limited by prudent opportunities to redeploy the capital within the business at higher ROEs.

Recent events

New car sales in Mexico have been weak over the past year, following cyclical highs in 2014-2016 and further hurt by macro-economic uncertainty from NAFTA renegotiations and the presidential election.  Qualitas has exhibited discipline in this pullback, yielding a bit of the Automotive financing market share they accumulated in the last cyclical upturn rather than create a pricing war; because of their scale advantages, market share loss has been limited.  We agree with this approach and expect them to regain the lost share in the next upturn. In the meantime, they have continued to grow in the less-volatile Fleet and Individual segments.

In 2016, the Mexican insurance regulator implemented Solvency II, changing capital requirements for the industry.  One nuance of the new regulatory environment is that capital requirements are now based on underwriting performance, rather than a blind uniform standard across the industry.  Not only did this lower capital requirements for Qualitas (and raise it for peers), but we believe it should have a dampening effect on industry competition, further increasing the benefits of solid underwriting and deterring attempts to grab market share via loose underwriting.

Valuation and Financials

Qualitas has both strong underwriting results and strong investment results contributing to TTM ROE of 34% and currently trading at 7x TTM earnings.  While these investment returns and underwriting profits might be somewhat volatile over time, we estimate the company’s market leadership will allow it to earn at least a 20% ROE through the cycle.  Additionally, the company operates with an unlevered balance sheet, allowing for future optionality to drive higher returns on equity. We believe that once discovered the stock will trade at 15-20x earnings given the company’s strong competitive position, tailwinds and resiliency.

Investment float per share is currently MXN 64.  Why is this a good proxy for intrinsic value, despite the insurance liabilities unpaid on the balance sheet?  Our logic is this: if someone gives you $1 and you never have to give it back or pay interest on it, how much is that worth?  (answer: $1). This is precisely the case here – not only will we not ever have to (net) repay this liability due to the inevitable march upward of written premiums, but in fact we are being paid to hold the $1 through positive underwriting results.  Plus, we are nearly assured to take in additional dollars on the same basis in the future.

In 5 years, we believe Qualitas will earn approx. MXN 7.59/sh and have an investment float of MXN 128/sh, in addition to cumulative capital return of MXN 14/sh.  Using either valuation method, it is easy to come to a price target of MXN 76-152/sh and a total return of 114-295%.

Risks

Higher interest rates have a mixed effect on Qualitas.  Whereas new car sales are discouraged by weaker financing availability and a generally weaker economy, Qualitas’ investment book consists largely of short-term and floating-rate securities.  Thus, volume growth and underwriting results tend to suffer, while investment returns excel. The Mexican 28-day Treasury has recently spiked to a high point of 7.75%, and may increase further to match the rise of rates in the United States (though this is debatable).

A weak Mexican peso would reduce the return for American or other non-Mexican investors.  We believe that using reasonable estimates for the future peso exchange rate will still result in excellent returns with this stock, especially given the correlation between a weak peso and a high Mexican interest rate (and thus high investment returns for Qualitas).  In addition, purchasing power parity suggests that the peso is potentially undervalued relative to other currencies.

Andres Manuel Lopez Obrador (AMLO), the new president of Mexico, continues to be a question mark.  We remain relatively constructive on AMLO due to his success as Mayor of Mexico City and his clear desire that Mexico thrives.  Further, we believe that the auto insurance business can thrive even if he makes less market-friendly policy decisions.

Rising theft, rising cost of replacement parts, floods, and other underwriting losses cause pain to insurers in the short-term, but over the long term demonstrate the value of insurance to customers.  Pricing will adjust, and insurance penetration will grow. These hardships are also opportunities for Qualitas to excel vs. less focused/scaled competitors, i.e. through the selective deployment of GPS tracking to combat carjacking.

Competition from new players could theoretically reduce industry margins, if it arises aggressively.  However, with Qualitas already dominating the market with a 30% share, we see the worst-case scenario that another player (perhaps ABA) grows to Qualitas’ size while weaker players lose share and the industry becomes a semi-cozy oligopoly.  We note that such growth requires ample capital (which is more difficult in Mexico) and is operationally and regulatorily difficult at small scale.

Catalyst

- Added to the Mexican S&P/BMV (largest 35 Companies) index in coming years
- Discovered by investors
- Potantial ADR in the future
- Continued buybacks