Description

Long Uniqa Insurance (UQA AV) equity, price target of €11.00 (+69%)

Uniqa offers property & casualty, health, and life insurance in Austria and Central Eastern Europe (CEE). The long thesis for Uniqa’s stock is simple: it’s a well-managed, good quality insurance business with high cash generation that is trading at a distressed valuation of 64% of book value and ~6.5x forward earnings. There are several reasons why the stock trades so cheaply: in 2020 the financials suffered from an unusually large number of negative one-off events, the company issued guidance in April 2020 that was conservative to the point of spooking investors, and the company acquired Axa’s insurance subsidiaries in CEE which both attracted significant investor skepticism and increased the company’s overall leverage profile. Furthermore, the stock is a relatively obscure European small cap financial with only €800mm in tradeable float, meaning that institutional investors don’t “need” to own the stock. In a nutshell, investors sold the stock during the COVID selloff and haven’t bothered to revisit since then, creating a good opportunity to buy the equity ahead of dramatically improved earnings in 2021 and the resumption of the dividend in early 2022 (50-60% payout ratio on 2021 earnings).

Summary points:

Uniqa’s financials in 2020 were impacted by a number of 1x events that should not recur; 2021 earnings should rebound strongly and approach €1.00 per share run-rate in 2022 as cost cutting measures manifest themselves.

2020 guidance: €0-50mm of pre-tax profit, which includes the following:

+ €145mm restructuring and merger integration charges to be taken in Q4’20

+ €100mm goodwill impairment to be taken in Q4’20

+ €26mm net equity impairment in Q1’20 (downward only adjustment to equity values in market selloff)

+ €10mm Axa integration charge taken in Q1

= €306mm “normalized pre-tax earnings” in 2020 excluding 1x charges, compared to €295mm in 2019

+ €50mm in cost savings implemented over the course of 2021 and early 2022

+ €40mm in incremental Axa earnings (80mm gross earnings less cost savings in prior bullet point, incremental interest and earnings included in Q4’20 run rate)

= 396mm run-rate in 2022 / ~1.00 per share

11x P/E, 1x book value = €11.00 price target, 5% yield on 55c dividend

 11x forward P/E is the average multiple on which Uniqa has traded for the last several years prior to 2020, e.g. it has been a representative multiple in the current low rate environment. Similarly, Uniqa acquired Axa’s subsidiaries for a 12.5x P/E in a cash transaction in early 2020. European insurers trade at 5-7% yields on estimated 2021/2022 dividends although the broad range of business mix in the industry makes comparisons a bit generalized. We would argue that Uniqa is likely to see faster EPS growth through 2025 via CEE premium increases and cost cutting versus the average large-cap European insurer, hence meriting a slightly lower required yield. If one believes that reflation and higher rates are coming to Europe, then market multiples will likely end up significantly higher (e.g. 14x).

The run-rate earnings target is based on €50mm of cost savings occurring over the course of 2021 and early 2022; which should be apparent in the reported quarterly earnings run-rate by mid-2022. The €1 in EPS compares to 0.76 realized in 2019 and 2025 targets of 9% ROE / 1.20 EPS. The primary drivers between 2019 EPS and 2025 EPS are the inclusion of the acquired Axa business, debt refinancing, and implementation of the cost cutting program, with a small benefit from 2-3% annual premium growth. We would argue that the 2025 plan looks credible, as it is primarily based on cost cutting efforts within management’s control and structural premium growth in P&C insurance in CEE markets.

Background & Recent history:

We assert that Uniqa’s underly business is relatively stable and consistently cash generative, like most diversified primary insurance companies. From 2014 to 2019 Uniqa’s pre-tax profit has averaged around €300mm and ranged between €225mm to €425mm, with the variance in earnings due almost entirely to upfront expensing of a large IT / digitization project in 2016 (e.g. the earnings volatility was due entirely to management’s expensing schedule of a catch-up investment in technology rather than underlying revenue or loss ratio movement) . Natural catastrophe risk is relatively small, with a €30mm annual budget where risk retention is set for reinsurance purposes. The financial model is consequently simply: premiums grow at 2-3% per year (nominal GDP), loss ratios have historically fluctuated within a relatively tight band, and earnings growth is driven by cost cutting and operating leverage.

 Ironically, it was the relative stability of the underlying business that caused investor perception issues for Uniqa last year when management communicated a posture of extreme conservatism in April by reducing not only the 2019 dividend but also pre-emptively canceling the 2020 dividend due to the “possibility of full year losses”. Given Uniqa’s relatively limited exposure to business interruption claims and offsetting benefits in auto insurance (due to lower claim frequency from less driving), investors simply couldn’t figure out where the problem exposures resided that were sufficiently large to wipe out €300mm in annual pre-tax profit. The business had never shown this type of volatility before, was there a cash flow problem somewhere? Did they have a huge loss in some part of their investment portfolio, or perhaps some understated liability hidden somewhere? In the resulting information vacuum, investors simply started selling the stock and kept on selling until well into the Fall as guidance for full year losses was maintained despite an obvious recovery in Uniqa’s business.

 A compounding issue for the stock in 2020 was Uniqa’s acquisition of Axa’s insurance subsidiaries in Poland, Czech Republic, Slovakia and Hungary. Uniqa had carried large amounts of excess capital, and investors had been waiting for the deployment of that capital for several years as a positive catalyst for the stock. From a timing perspective, the situation could not have been unluckier: Uniqa paid around €1000mm in cash for Axa’s subsidiaries in February 2020, a few weeks before the pandemic hit. This meant that not only did Uniqa lose its large excess capital buffer days before a market crisis (feared defaults on IG bonds didn’t actually happen), but it also needed to tap the debt markets to partially fund the transaction in the worst new issuance market in a decade (the issuance was successfully completed in July). Questions also arose concerning the true profitability of the subsidiaries acquired. While Uniqa noted that the acquired businesses would contribute €80mm in net income, sources from Axa indicated to the Street that the profitability of the businesses was never above €50mm, leading to significant suspicion among investors. The discrepancy was apparently around the allocation of corporate-level costs to those subsidiaries while they were owned by Axa, 1x favorable reserve development that flattered 2019 subsidiary figures, and the potential for cost cutting under Uniqa’s ownership (which Uniqa’s management included but Axa’s did not). The reality is that while the acquired businesses did benefit from ~15mm of favorable reserve releases in 2019, Uniqa is merging the acquired subsidiaries into their existing local insurance operations and taking out €20mm of standalone costs - leading us to believe that the €80mm post-synergy number is credible.

In December 2020 Uniqa held a capital markets presentation where they revealed not only the sources of the 2020 earnings issues but also provided very positive long-term guidance around reaching a minimum 9% RoE. The company increased its 2020 guidance from “possibly a loss” to €0 to 50mm headline pre-tax earnings, but in this case due to goodwill impairments and extensive restructuring charges incurred to fund the accretive cost cutting program. The goodwill impairment in particular carries more than a passing resemblance to a classic “kitchen sink exercise” as it was based on higher realized volatility of UQA’s own share price during 2020; choosing to impair goodwill on acquisitions done well over a decade ago on the basis of a falling stock price in 2020 strikes us as a matter of discretion rather than necessity. The confusion amongst investors arose because many companies would have simply excluded these charges from a definition of “operating earnings” in guidance but Uniqa chose not to do so – most likely because Uniqa’s controlling 60% shareholders (an insurance co-op and banking co-op) only care about dividends, and dividends are paid out on statutory earnings which include those charges. However, with the litany of charges about to be complete at the Q4’20 results, the stage is now set for a significant rebound in profitability and eventual dividends paid out on the basis of 2021 statutory profits.

 Business description: Uniqa presents its business in two distinct manners – by business line (health, P&C, life) and by market (Austria and international). At the risk of gross simplification, the Austrian health business is a high quality cash flowing business with profit improvement largely driven by increased efficiency. The P&C segment in Central Eastern Europe is a growth driver while Austrian P&C is stable. Austrian life back books are basically duration and cash-flow matched and in runoff, which frees up capital over time. By business line, the overwhelming majority of the profit increase envisaged between 2019 and 2025 is from higher underwriting profits in health and P&C, while the life insurance blocks shrink. By geography, the increased profits expected in Austria are largely due to cost cutting while the profits in CEE / international are driven mostly by premium growth.

 Health insurance: Uniqa is the dominant provider of private health care insurance in Austria with a 46-48% market share. Austria provides state-sponsored socialized medicine to all citizens, which offers high quality basic care free of charge. The downside is long waiting times for specific procedures (6-12 months for a knee replacement, 2-3 months for chemotherapy) and an inability to choose which doctors provide care. Government insurance also does not cover all potential expenses related to healthcare, like post-op physical therapy/rehabilitation.  Uniqa owns a network of hospitals across Austria and provides comprehensive medical insurance that allows for short waiting times, access to the best medical specialists, and perks like private hospital rooms, higher quality hospital food, and good in-room entertainment options. Uniqa’s health insurance is considered expensive but has an extremely high penetration rate among wealthier Austrians. The premium schedule is tiered over time, with low premiums at €50 per month for an 18 year-old rising to €650 per month later in life, with the schedule indexed to a medical price index to keep pace with medical cost inflation. Consumers accumulate a large “benefits reserve” from their accumulated premiums over the years, which they would forgo in entirety (returned to the insurer as profit) if they switch health insurance later in life when the premium is a lot more expensive. As a result, Uniqa’s policies have low switching and lapse rates even among healthy 50-60 year-olds, which greatly enhances the overall profitability of the business and limits the ability of competitors to cherry pick healthy customers paying high premiums.

 Property & Casualty insurance:  Uniqa is a primary P&C insurer offering traditional business lines – home, auto, fire, marine, business interruption, professional liability, casualty, etc – primarily in Austria, Poland, Czech Republic, Slovakia, and Hungary. Premium growth is 1% in Austria and 4-5% in central Europe. The P&C combined ratio was 96% in 2019 and the company targets 93% in 2025 based on the cost cutting program. Considering that the company was founded as an insurance co-op 200 years ago, Uniqa is remarkably innovative and on the forefront of digital insurance distribution in Austria and Hungary –they too employ chat bot apps and artificial intelligence tools for policy distribution like LMND, etc. Furthermore, the acquisition of Axa’s subsidiaries makes Uniqa the #5 player in central eastern Europe, which is an attractive growth market. Countries like Poland, Czech Republic and Slovakia are not exactly frontier markets, but the penetration of insurance premium per capita there is well below that of Western European countries like Austria and Germany and hence offer long-tailed premium growth opportunities.

 Annual insurance premium spending in € per capita; Uniqa investor presentation Nov 2019

 Life insurance: Uniqa has a back book of traditional Austrian life insurance policies that are largely in runoff, which is distinct from the more problematic German life insurance books with which investors may be more familiar. In German life insurance policies each source of profit (investment results, actuarial risk margins, cost savings) is shared independently with the policy holder while Austrian life insurance has profit sharing on an aggregated policy basis. In practice all life insurers globally have suffered from the reinvestment rate assumption, as risk free rates today on reinvestment are wildly lower than underwriting assumptions made 20+ years ago when the policies were originally sold. However, insurers have been able to partially mitigate this shortfall via cost cutting and actuarial profit sources. German insurers have suffered from full profit sharing on these mitigating actions, while Austrian insurers have been able to combine all profit sources as part of policyholder payout calculations (e.g. resulting in lower aggregate policyholder profit sharing / higher insurer profit). Furthermore, Uniqa started cutting guaranteed rates on new business and closing the asset/liability duration mismatch a long time ago. Today the average guaranteed rate on policies is below the yield on their investment portfolio and the duration gap is only 6 months with assets and liabilities at 11.5 and 12 year durations. Importantly, the book is largely matched on both a cash flow as well as an interest-rate sensitivity basis. In short, the company has sterilized the interest rate risk on their back book and significant capital will be freed up as back book policies expire over time. In the event interest rates ever rose in Europe, they would benefit massively as life insurance policies became a more attractive savings option for consumers and Solvency II capital ratios rose.

 Common questions, topics, and concerns:

 C19 impact on loss ratios: C19 generated significant losses for Uniqa in business interruption and event cancellation policies to the tune of ~€70mm in 2020 out of a maximum exposure of €150mm (which would represent total loss on all policies with exposure). However, Uniqa also benefited by ~€40mm on lower claims frequency in auto insurance due to less driving. We are essentially describing the C19 impact as neutral on normalized profitability as a swing of ~€30mm represent normal volatility in the business, and in fact is equal to the €30mm of annual nat cat risk budget. In 2020 Uniqa clarified the language in their commercial insurance packages (which include a business interruption component) to state that they are not liable for closures due to pandemics or government mandated shutdowns, so the BI situation should not repeat in the future.

 Dividends: Insurance in Europe is still regulated by national authorities rather than a pan-euro supervisory body with binding authority as is the case in European banking. The pan-European agency EIOPA makes “stringent recommendations” which in theory the national regulators take into account, but 2020 has witnessed divergence among the various national regulators on the topic of dividend bans. The Austrian regulator (FMA) permitted Uniqa to pay a dividend in April 2020 on 2019 profits, albeit at a reduced rate. It is unclear what the FMA will do regarding the 2020 financial year albeit “extreme caution” has been recommended regarding payouts. Since it seems unlikely that the regulator would have permitted a large dividend in the next few months in any circumstance, front-loading all potential restructuring, impairment and severance charges into 2020 statutory financials is actually not a bad outcome, as it clears a path for 2021 profits. Hence the company has guided the market to not expect a dividend on the basis of 2020 results but that they will resume a 55-60% payout ratio in 2021 and thereafter.

 Leverage: the annual interest burden at the holding company level from the senior unsecured and LT2 bonds is currently €70mm. Dividend capacity from the international subsidiaries post the Axa acquisition is €80-100mm, dividend capacity from the main Austrian subsidiary is €100-150mm, and dividends from the internal reinsurance subsidiaries are €30-40mm (€210mm to €290mm total dividend upstream or 3x-4x interest coverage at the holding company level). The company plans on calling the 350mm 6.875% bond at par in July 2023, and the company could save ~€15-17mm of annual interest by refinancing at current market rates of 2% on their LT2 bonds issued last year. The Austrian subsidiary is a composite insurer that houses health, P&C and life policies in the same legal entity, and the €100-150mm of anticipated dividends assume no “allocated” contribution from any life insurance books. We use the term allocated as the cash flows and capital generation from all policies are combined in that legal entity which is governed by a single regulatory solvency ratio for all three business divisions in Austria. Although management has guided to not expect dividends from the life business in the near term, as the back book runs off significant capital will be freed up which could be used for dividends or new policy growth. In other words, the solvency ratio should continue to increase at the current payout ratio.  

 Solvency ratios: Pro forma for the acquisition of the Axa subsidiaries and the restructuring/integration charges, Uniqa has a 170% consolidated solvency II ratio, which compares to their target range of 155%-190%. The fact that they are not allocating dividends from the cash flow of their life insurance books will drive capital ratios towards 200% in the next few years, a level which is generally considered very well capitalized by investors. 30% of the legacy life insurance policies will expire by 2030, which will free up substantial additional capital.  

 Book value:  The bond portfolio is carried at market value while the commercial real estate portfolio is carried at historical cost. A number of years ago Uniqa began investing into real assets like commercial real estate (owning the equity in buildings) and has accumulated very large off-balance sheet gains of around €1000-1400mm depending on estimates. These unrealized gains represent substantial “hidden reserves” that bolster claims paying resources in the Austrian statutory accounts. Often investors will state that the insurance liabilities of a given insurer are understated because of above-market discount rates used by the company to value long-dated guarantees, arguing that as a result the stock should trade at a discount to book. UQA’s life insurance liabilities are discounted at a 2.3% interest rate, which compares to the investment yield of the portfolio of 2.5%. Given the close matching on duration and cash flows between the assets and liabilities as noted earlier, the 2.3% discount rate seems reasonable. Hence, we would tend to view the overall book value of the company as being understated rather than overstated simply due to the unrealized gains on the equity CRE portfolio (and which has no shopping center exposure). 

Catalyst

earnings