IAG downgraded to Sell
Recommendation
Insurance Australia Group’s (IAG) share price has increased 116% since it was upgraded to outright Buy on 9 Aug 11 (Buy – $2.82) amidst a succession of natural disasters across Australia and New Zealand. Insurance companies are highly cyclical businesses by nature and premiums have been increasing, but Mike Wilkins has also added plenty of value, cutting costs, increasing margins and largely offloading the problematic UK businesses purchased by his predecessor.
Wilkins recently reiterated expectations for 2014. Gross written premium is expected to increase 5-7%, with the insurance margin falling back to a more sustainable 12.5-14.5%, from 17.2% last year. This assumes net losses from natural perils are in line with the budgeted allowance of $640m, no material movement in foreign exchange rates or investment markets and prior period reserve releases equivalent to 1-2% of net earned premium. IAG has also received around 660 claims related to the New South Wales bushfires that should produce net claims of $65-85m. Although there are a lot of variables, we expect underlying earnings of around 45 cents per share for a price-to-earnings ratio (PER) of 13.6.
Paradoxically, the time to buy cyclical businesses is when their PERs are high because earnings are depressed. Right now IAG is firing on all cylinders, and we wonder just how much more juice Wilkins can squeeze out of the business. Though we don’t want to underestimate him, having bought low we’re now selling high in anticipation of better buying opportunities when disaster strikes again. If you decide to hang on, we’d recommend a lower portfolio limit than the 6% maximum, say 3-4%, as there’s no margin of safety to protect you if/when claims spike again. The stock price has increased 4% since IAG: Result 2013 (Hold – $5.85) and we’re downgrading to SELL.