Description

Summary of the investment thesis:

Unipol Gruppo (“Gruppo”, ticker UNI IM) is a mid-sized (€3.5bn market cap.) and quite straightforward Italian financial holding company that owns a controlling stake in Unipol Sai (“Sai”, ticker US IM), a leading listed Italian property and casualty insurer. Sai comprises c. 80% of Gruppo’s operating asset value (i.e. the value of the operating businesses, excl. debt/cash at Gruppo, etc.). In addition to being the majority owner of Sai, Gruppo controls a number of small insurance businesses and a small banking business, Unipol Banca (“Banca”) that collectively comprise c. 20% of Gruppo’s operating asset value

Gruppo is currently trading at c. 5.6% consensus 2015e dividend yield whilst Sai is trading at c. 7.0% consensus 2015e dividend yield, both of which are substantially in excess of European P&C peers. On a PE basis, we estimate Sai trades at a c. 20 to 25% discount to European insurance peers

Additionally, Gruppo trades at a c. 30% discount to NAV (using market based valuations for Sai, which is publicly listed and conservative valuations for the other businesses), which is at the high end of the historic discount to NAV (typically in the teens to low 20s)

Furthermore, the Italian P&C insurance sector has consolidated substantially in recent years (led by Unipol), which should drive improved pricing rationality and better combined ratios for all market players. As such, we believe that Sai’s earnings power should increase over time and is undervalued at current market prices (c. €2.7 per share). At a fair value for Sai over the next 12 to 18 months of c. €3.5 per share, we believe that Gruppo’s discount to fair value is in the region of c. 50% (in addition to dividends received), which is too extreme

The company is taking significant steps to both (a) improve the operational performance at Sai, and (b) streamline the corporate structure at Gruppo. We believe that management’s continued actions in these areas and a number of clear catalysts should enable the company to unlock significant shareholder value in the next 12 to 24 months, conservatively delivering an annualized potential TSR of > c. 20 to 30% over the next 12 to 18 months

We’ll keep the write-up brief but are very happy to discuss parts in more detail in the Q&A section

Summary of the company:

Gruppo’s sum-of-the-parts valuation is below. Its main assets include three unlisted insurance subsidiaries (Unisalute, Arca and Linear) and an unlisted bank (Banca).

Sai is the largest P&C insurer in Italy. The company has c. 25% share; Generali has c. 18% and Alliance has c. 12%. It was formed by a four-way combination of Unipol Assicuarzioni, Milan Assicuarzioni, Prefamin and Fondiaria-Sai in January 2014

Source: Berenberg

The Italian P&C market has many attractive attributes. The Italian non-life market is very profitable and, whilst volumes have been declining, we expect a recovery in 2015/16e. We see a significant longer-term opportunity from the current level of low penetration. The market composition and regulatory backdrop helps to maintain profitability. It is not as attractive as the Nordic regions (ridiculous levels of rationality in pricing, stability in market share, and low combined ratios) but it is better than many markets in Europe. We believe consolidation could lead it to continue to improve over the next few years

Italian valuations are low; some investors think deservedly so. Some investors argue that Italian earnings should be rated on a low multiple, leading to domestic competitors (such as Unipol) trading at c. 20% discount on PE multiples to the European sector. We disagree with this view. Motor premiums, which dominate non-life, are v. near trough levels but road use is picking up. Any increase in claims volumes should be more than offset by increase in pricing. Longer term, there is an opportunity from the very low penetration.

Consolidation and asset optimisation remains an ongoing trend in the sector and should help maintain discipline, as should improving payout ratios. Sai’s combined ratio for 2014A was 94%. Whilst this is decent, the company is still in the middle of a very positive cost improvement programme that should help drive combined ratios down. As can be seen from the below chart, Allianz earns a combined ratio in Italy in the 70%s. This is anomalously low (especially for a composite insurer, who tend to be run worse combined ratios than pure play P&C insurers), but it indicates the scope that Unipol has to continue to improve its own combined ratio and the capacity for Italy to be an attractive P&C market

Source: Berenberg

Weak disclosure and shareholder pacts have put investors off in the past. Unipol is no exception here. However, this is changing across Italy (witness the Popolari banking reforms in action) and we believe a desire to engage more with shareholders should help the share price of both Unipol and other competitors. We have found the Unipol management team very accessible and frankin their analysis of the competitive challenges that Sai and Gruppo face, the changing sector dynamics, the growth opportunities ahead, etc. 

Banca is a very poor bank. Let’s not mince words here. In the run-up to the financial crisis, Banca made too many loans to sub-standard real estate borrowers, actions that have led to significant amounts of non-performing loans. Whereas other banks with these problems were “rescued” by the Bank of Italy, Gruppo has itself spent significant amounts of effort and capital in improving the NPL coverage ratios at Banca to get it back on its feet. But, as mentioned, it is an very small component of Gruppo's overall value. In the interests of brevity, we will not spend much time on Banca’s financials. To get a better understanding of Banca’s economics, we suggest you review the recent 2014 FY results presentation and releases

Things are changing for the better at Unipol, governance wise. Whilst the mis-management at Banca is a clear red-flag to an investment in Gruppo, we believe that – all things considered – current management are (a) very open about the mistakes that have been made historically, (b) conservative in their approach to Banca’s (and Gruppo’s) future prospects, and (c) executing a clear plan to clean up and dispose of Banca

Management quality / shareholder composition:

Strong management. From our background checks, it is clear that the CEO, Carlo Cimbri, is well-regarded in Italian financial circles. From our interactions with him, he comes across as a very conservative, down-to-earth and competent manager. As shareholders, we are comfortable with him leading the company. Furthermore, interviews with other members of the management team also impressed us, cementing the view that the management team at Unipol is surprisingly solid. Management incentives are decent and fairly well-aligned with shareholders’ interests (vs. other Italian companies, they are fairly strong)

Risks to the investment thesis:

Trading conditions in the Italian motor market worsens. This feels unlikely from all the channel checks (including major competitors) that we have performed, but it is possible

Missing 2015e net income guidance. Management has been firm in their belief they will deliver €815m of net income at Sai in 2015e. Missing this target would raise doubts as to management's conservatism, managerial abilities and general trustworthiness

Delays to being able to offload Banca. Any delays in cleaning up / off-loading Banca will potentially delay the "ultimate end goal" of collapsing Gruppo and Sai into one entity (see catalyst section, below). As the popolari banking reforms lead to banking sector consolidation in Italy, there is a chance that Banca is "bridesmaid, never bride". Management are fairly well connected and their intentions to offload Banca are clear; we believe that even accepting an offer below fair value would still be value-accretive to Gruppo shareholders, such is the drag on Gruppo investor sentiment created by Banca

Any horizontal or vertical expansion. Given the discount that Gruppo is trading at vs. reported NAV (or fair value), any further expansion would likely increase the holding company discount. Furthermore, it would run against management's strategy of cleaning up / simplifying the business. We do not believe this is a major risk, given management's firm commentary on the topic, but we cannot rule it out

Why is Unipol mispriced?

Gruppo’s (and Sai)’s complex holding structure is off-putting to many investors. Both Unipol and Sai each have three share classes (one ordinary class and two preference classes). To streamline the corporate structure, shareholders of both Gruppo and Sai have very recently approved the collapse of the preference share classes into the ordinary share classes, meaning Gruppo and Sai will, from Q3 2015, have one share class each

Banca is a dog. But only a very small dog (terrier, chihuahua, etc.). Banca is not a good bank. We value it at 0.4x tangible book value, which is conservative even when compared to other problem banks in Italy. We estimate Banca is only worth c. 5% of the total value of Gruppo’s operating assets. Yet we believe it is having a far larger drag on investor sentiment than the bank’s economic drag actually creates on Gruppo cash flows from here onwards. We strongly believe that the impact that Banca has on Gruppo’s valuation is far greater than any negative economic impact it creates for shareholders. But investors are, understandably, disenfranchised by Gruppo owning Banca. It seems clear that when Gruppo is able to off-load the bank – which we believe will happen within the next 12 to 24 months (see “catalysts” section, below) – Gruppo’s discount to NAV will narrow substantially, driving returns to Gruppo’s shareholders

Very limited sell-side coverage from non-domestic investment banks. Only GS and Kepler publish research and even their reports are extremely “thin”. As Unipol’s float improves we expect (as does the company) that coverage will improve, which will drive greater awareness of the investment opportunity with institutional investors

It’s an insurance business. Let’s not pretend that most investors do not steer very clear of financials if they can at all help it. But Unipol Gruppo and Sai are both fairly simple to understand businesses, so we don’t think this should put you off looking at Gruppo and Sai

Unipol has a chequered past. Sai was formed by the merger of Unipol Assicuarzioni, Milan Assicuarzioni, Prefamin and Fondiaria-Sai in January 2014. Fondiaria has historically been mired in a number of corporate governance scandals (again, let’s not mince words) that mean that, if you speak with any Italian investor over the age of 25, he or she is likely to look perplexed or even worried if you pitch Unipol or even mention Fondiaria. We have conducted extensive due diligence into the Unipol’s history and believe that these issues are firmly in the past. The previous, questionable, management teams were removed after the merger completed and the current management team is significantly more respectable and trustworthy as stewards of investors’ capital. That said, we must also be realistic and

Valuation and potential returns / IRRs:

We think the best way to express an investment is through Gruppo, though Sai also offers attractive upside. Gruppo is currently trading at c. 5.6% consensus 2015e dividend yield whilst Sai is trading at c. 7.0% consensus 2015e dividend yield, both of which are substantially in excess of European P&C peers

Sai is trading at a material discount to peers. With a market value of c. €7.5bn, Sai is currently trading at c. 11.5x Bloomberg consensus 2015e net income forecast of c. €635m. Management has been extremely clear that Sai should generate > €815m of net income in 2015e, which implies a 2015e P/E of c. 9.2x

Clear plan for ongoing cost improvements at Sai. Management has outlined, very clearly, how it intends to continue to drive significant cost improvements at Sai (of which most of the related one-off costs have been incurred, but most of the improvements are still to be seen). Having spoken with most sell-side analysts that comprise consensus, it is clear that most have low estimates not due to major concerns with Sai’s earnings power but because they are either (a) playing a “wait and see” game with Sai to execute, or (b) due to Sai being a low priority for them to cover (if you were a sell-side insurance analyst cover 20+ stocks in Europe, Unipol would likely be no. 15 to 20 on your order of priorities). The sell-side analysts acknowledged to us that the company is continuing to improve the expense ratio and improve Sai but want to see evidence of execution. Our analysis suggests that consensus is being too conservative and that Unipol is likely to deliver on the €815m of targeted net income

Gruppo is trading at a c. 50% discount to fair value. If we assume that Sai delivers €725m of net income in 2015e (i.e. roughly halfway between consensus estimates and management’s very firm guidance) and maintains the same 2015e P/E multiple of c. 11.5x, Gruppo is trading at a c. 50% discount to fair value. This is our base case estimate for triangulating fair value. This is patently too large a discount for a company that is (a) improving operations, (c) operating in an increasingly attractive sector, and (c) reducing the complexity of the holding company structure

The fair discount at CY 2015e is c. 10 to 15%. Given the current format (Gruppo and Sai both having three share classes), we estimate a fair discount to NAV for Gruppo is perhaps c. 15 to 20%. Once the share classes are collapsed (Q2 2015), we estimate the fair discount should also decrease to perhaps c. 10 to 15%. In the future (next 12 to 24 months), we believe the two companies (Gruppo and Sai) could combine entirely, which would eliminate Gruppo’s holdco discount entirely

For illustrative purposes, if we assume that Sai delivers €815m of net income in 2015e (i.e. in line with management’s guidance) and maintains the same 2015e P/E multiple of c. 11.5x, Gruppo is trading at a c. 70% discount to fair value. We believe this is probably too optimistic a view to take as a base case for Gruppo’s fair value (we estimate the normalised net income that Sai could earn is between €750 and 800m on a normalised basis over the next few years) but it is very much possible that we, like many investors, are being too conservative: management certainly think so (and they have, to be fair to them, come across as very conservative in our interactions with them).

Catalysts / why will it re-rate to fair value?

Share class consolidation in Q2 2015. The collapsing of the three share classes in each of Gruppo and Sai will improve liquidity and enable larger instructional investors to consider investing where they previous could not due to liquidity concerns

Index inclusion in Q3 2015. The collapsing of the three Gruppo share classes into one, in Q2 2015, will lead to Gruppo being included in the Italian FTSE index, which should prompt index buying (and broader awareness of the company)

Further cost savings at Sai (and Gruppo). The company will issue an update on the current cost saving plan at the end of this financial year. Sai expects to be able to continue to drive costs lower / improve expense ratios over the mid-term, which should help improve consensus estimates even further

Selling or off-loading Banca. Management is doing everything they can to off-load Banca, thereby removing a major cause of negative investor sentiment towards Gruppo. Management has been aggressively cleaning up Banca’s NPL portfolio, reserving very conservatively, improving the management team and more generally improving Banca’s operations. We urge you to read Unipol’s published figures on Banca. Whilst it is clear that it is not the highest quality bank, it is clear that management has committed substantial efforts (and capital) to shore up the bank so that it is divestible.

Popolari banking reforms should help Gruppo sell Banca. With the upcoming Popolari banking reforms in Italy, we have spoken to a number of Italian FIG investment bankers, industry consultants, research analysts and competitors about the possibility for Unipol to be able to divest Banca. We believe that Gruppo may be able to off-load Banca to another banking company – either to a domestic bank or a 2^nd tier international bank with a sub-standard Italian footprint (e.g. SocGen, Credit Agricole). Realistically, this is un likely to happen in 2015e (Unipol Banca is unlikely to be one of the first banks to take part in the sector’s expected consolidation), but 2016e presents a distinct possibility

Collapsing the Gruppo / Sai structure. After Gruppo sell Banca (i.e. 2016e), there is very limited reason for the Gruppo / Sai structure to exist. It is clear from conservations with management (and external analysts) that the Gruppo / Sai is likely to be collapsed in short order thereafter, completely eliminating the Gruppo discount to NAV

Gruppo as an M&A target. We have heard this theory from some investment bankers covering the sector (e.g. a European multi-line insurer wishing to increase exposure to Italy over the coming years). We don't give it much credence but it may be increasingly feasible in 2016-18e

In summary…

The operating environment in Italian P&C insurance is improving significantly. Sai is taking out significant amounts of excess overhead (as a result of its four-way merger in 2014). Collectively, this should lead to improved profitability for Sai (and for Gruppo)

The company is taking significant steps to both (a) improve the operational performance at Sai, and (b) streamline the corporate structure at Gruppo. We believe that management’s continued actions in these areas will enable the company to unlock significant shareholder value in the next 12 to 24 months

There are clear reasons why Unipol (Gruppo and Sai) is mispriced: questionable history; distaste from investors for Italian financial companies; limited sell-side coverage; complicated holding company structure with share classes for both entities, etc., etc.

There are clear catalysts that suggest these reasons for mispricings will be addressed over the next 12 months: collapsing of the multiple share classes; improving profitability at Sai; improving profitability at Banca; greater sell-side coverage by international investment banks; and the eventual sale of Banca and the collapsing of the Gruppo / Sai structure

Gruppo is currently trading at c. 5.6% consensus 2015e dividend yield whilst Sai is trading at c. 7.0% consensus 2015e dividend yield, both of which are substantially in excess of European P&C peers

Additionally, Gruppo trades at a c. 30% discount to NAV (assuming market based valuations for Sai, which is publicly listed) and conservative valuations for the other businesses, which is at the high end of the historic discount to NAV (typically in the low 20s)

Furthermore, we believe that Sai is undervalued at current market prices (c. €2.7 per share). At a fair value for Sai over the next 12 to 18 months of c. €3.5 per share, we believe that Gruppo’s discount to fair value is in the region of c. 50% (in addition to dividends received)

Ultimately, the combination of improving fundamentals and very undemanding valuations mean that both Gruppo and Sai offer a compelling margin of safety for investors at today’s levels. A number of clear catalysts should enable the company to unlock significant shareholder value in the next 12 to 24 months, conservatively delivering an annualized potential TSR of > c. 20 to 30% over the next 12 to 18 months

Misc. / appendices:

Catalyst

See main write up:

·         Share class consolidation in Q2 2015. The collapsing of the three share classes in each of Gruppo and Sai will improve liquidity and enable larger instructional investors to consider investing where they previous could not due to liquidity concerns

·         Index inclusion in Q3 2015. The collapsing of the three Gruppo share classes into one, in Q2 2015, will lead to Gruppo being included in the Italian FTSE index, which should prompt index buying (and broader awareness of the company)

·         Further cost savings at Sai (and Gruppo). The company will issue an update on the current cost saving plan at the end of this financial year. Sai expects to be able to continue to drive costs lower / improve expense ratios over the mid-term, which should help improve consensus estimates even further

·         Selling or off-loading Banca. Management is doing everything they can to off-load Banca, thereby removing a major cause of negative investor sentiment towards Gruppo. Management has been aggressively cleaning up Banca’s NPL portfolio, reserving very conservatively, improving the management team and more generally improving Banca’s operations. We urge you to read Unipol’s published figures on Banca. Whilst it is clear that it is not the highest quality bank, it is clear that management has committed substantial efforts (and capital) to shore up the bank so that it is divestible.

·         Popolari banking reforms should help Gruppo sell Banca. With the upcoming Popolari banking reforms in Italy, we have spoken to a number of Italian FIG investment bankers, industry consultants, research analysts and competitors about the possibility for Unipol to be able to divest Banca. We believe that Gruppo may be able to off-load Banca to another banking company – either to a domestic bank or a 2^nd tier international bank with a sub-standard Italian footprint (e.g. SocGen, Credit Agricole). Realistically, this is un likely to happen in 2015e (Unipol Banca is unlikely to be one of the first banks to take part in the sector’s expected consolidation), but 2016e presents a distinct possibility

·         Collapsing the Gruppo / Sai structure. After Gruppo sell Banca (i.e. 2016e), there is very limited reason for the Gruppo / Sai structure to exist. It is clear from conservations with management (and external analysts) that the Gruppo / Sai is likely to be collapsed in short order thereafter, completely eliminating the Gruppo discount to NAV