Saturday, 11 October 2014

QBE: Underwriting discipline will ride the ship


***Didn't get time to write this blog earlier but here are my thoughts on QBE after 1H14 earning release

QBE came out with 1H14 with profit headline number marked with following developments:
  • 116M reserve strengthing in Latin America division; majority pertaining to Argentina workers compensation portfolio with increase in litigated workers compensation claim following changes to legislative changes in 2012 and 2013
  •  a non-cash charge of 118M for lowering discount rate used in calculating central reserve estimates
  • Gross Written Premium down 10% to 8.49B with over capacity and competition kept premium rates low and QBE continue to forgo business where adequate premium is not paid for underwriting risk
  • Insurance margin down to 7%. Adjusted margin (adjusting to non-recurring items) inline with expectation of 10%
  • Cash profit down 29% to $416M
  • Increase in investment income - up slightly y-o-y
QBE also taking some positive initiative and have announced capital plan to strength its balance sheet. This will have minimal effect on long term profitability and our valuation. Firstly, it is divesting non-core agency business in North America and Australia as these businesses will drive better revenue growth under external distribution ownership whilst QBE continues to underwrite premiums generated by them. Secondly, it will launch partial IPO for Australian LMI (Lender Mortgage Insurance) business in 2015, this will allow QBE to convert considerable amount intangible capital to tangible capital, whilst retaining considerable exposure to profitable and well positioned mortgage insurer. Thirdly, will raise 750M through equity placement to buyback 500M convertible subordinate debt. This will strength the balance sheet by reducing debt-to-equity ratio down from 38% to 25-30%, whilst having minimal effect on our valuation as I have already used diluted shares in my calculation.

The capital management initiative will give QBE higher APRA regulatory capital up from 1.5x to 1.8x to withstand any downside scenario, balance sheet flexibility by reducing debt-to-equity to 30%.

With all this uncertainty, why I'm still interested in QBE and see it as an opportunity with double digit return over few years? Because amidst uncertainty; I'm also looking at following facts which make QBE intrinsically quite valuable and compelling investment:
  • Core Insurance business/underwriting is still profitable. COR under 100
  • Management continue to be discipline in underwriting. It is forgoing business where adequate premium is not paid for underwriting risk
  • Trading at considerable discount to cost-free float of $16-17$ per share. Comparative insurers with similar underwriting profile, trades above or at par to the value of float
  • Good future earning potential 
    • Investment income will increase in coming years as QBE plan to change its investment style by diversifying assets away from conservative fixed income assets to risk averse assets - upto 15% of total assets. Currently QBE investment assets are mainly in cash, short term fixed income bonds (duration 6 months) and money market funds. Also with increase in interest rate, the investment return could increase from 2.7% to 4-5% in coming years
    • Cost reduction program will be fully accretive to FY 2015 earning - about 250M 
    • Earnings are reported in USD so fall in AUD should be accretive to earning in 2014-2015
  • Compelling valuation:
    • Net earned premium: 13B (incld decrease in premium due  offloading of LMI business)
    • Normalised Combined ratio: 0.92
    • Underwriting profit: 1.04B
    • Investment Assets: 30B
    • Normalised investment yield: 4% (conservative assumption)
    • Investment Income: 1.2B
    • Pretax Earning: 2.24B about 2.5B in AUD (AUD @ 0.9)
    With market cap of 15B; at current price of $11.07 potential earning yield is about 15-17%!!!
  • Most of the bad news is built in the stock price and investor is paying no premium for growth in the business
Uncertainty is a friend of long term investor. This is certainly true in QBE case - profitable insurer with history of profitable underwriting, committed management, trading at decade low valuation with discount to cost-free float. I believe its a right time for long term investor to swing at this pitch.

Disclousre: I own QBE shares