We love it when good companies buy back stock at decent prices. When a stock is trading below its intrinsic value, buybacks give remaining shareholders a larger slice of the pie without lifting a finger and increase the value of their holding (see The case for share buybacks).
Insurance Australia Group is doing just that. The company has announced a $300m off-market buyback, which is to be funded by existing cash and investments. Buybacks aren’t always a good thing, but with IAG towards the lower end of our price guide and extra cash freed up by a deal with Berkshire Hathaway, we think this one makes sense.
Growth low; competition high
Lower income from investment portfolio
Berkshire deal was positive
The news adds some sizzle to an otherwise mediocre full-year result. Gross written premium (GWP) – an insurer’s measure of revenue – fell 1% due to what management described as ‘the most competitive conditions in almost four decades’ at the interim result.
The Australian Consumer division – IAG’s largest, accounting for half of revenue – increased GWP by 3.3% and improved its underlying insurance margin from 13.9% to 16.0%, with fewer natural peril claims than expected. Unfortunately, the Business division didn’t fare well, with GWP down 6.7%. The underlying margin, however, increased from 3% to 10%, again due to fewer claims.
IAG’s New Zealand business (19% of total GWP) continued to deliver strong profitability, with an underlying margin of 16.9% (up from 15.9%). Unfortunately, premium growth in direct personal lines was offset by a decline in the commercial segment, so GWP fell 4%.
Lower investment income
IAG’s $13bn investment portfolio was hit hard by lower yields on the company’s fixed-interest investments and poorly performing stock markets. Total investment income fell 29% to $560m. The lower investment income was also the biggest contributor to the 14% fall in net profit to $625m.
|Year to June||2016||2015|| /(–)
|Insurance profit ($m)||1,178||1,103||7|
|Net Profit ($m)||625||728||(14)|
|Final Dividend||13 cents, fully franked, (down 19%)
ex date 5 Sept
On the bright side, IAG’s quota share arrangement with Berkshire Hathaway is working as planned, having now been in effect since July 2015.
To recap, Berkshire now receives 20% of IAG’s gross written premium and pays 20% of claims between now and 2026.
Management said the deal had: (1) reduced IAG’s earnings volatility due to the exchange of insurance risk for a fee paid by Berkshire to use the IAG brand; (2) increased the company’s underlying margin by 2.5%; and (3) reduced IAG’s regulatory capital requirement by $400m, with an extra $300m decrease expected over the next few years.
Until interest rates start to rise, low investment returns are likely to be the norm and, despite growing competition, the company's return on equity still came in at a respectable 13.0%. Unfortunately, management expects GWP to be flat again in 2017 with an insurance margin of 12.5–14.5%. With a price-earnings ratio of 22 and a fully franked dividend yield of 4.4%, we continue to recommend you HOLD.