Is it time to buy QBE? Not at current prices, in our view, but below $10 the stock would be interesting. The serial disappointer last week downgraded its earnings guidance for the fourth time in the last two years but our valuation was conservative; we don’t need to downgrade and we see enough underlying progress that a valuation upgrade is probable at some stage.
The big picture is that this formerly acquisition-driven insurer is transitioning through a painful period of restoring appropriate provisioning in disparate insurance books worldwide, and is shedding unprofitable acquired business by ceasing to underwrite while seeking non-core asset sales. The result will be a smaller, more profitable and more stable insurer that we expect to eventually capitalise at a higher equity multiple.
The 1H14 result to be reported on August 19 will include:
- Claims reserve strengthening of $170 million in South America, mostly for an unexpected increase in claims in the Argentinian workers’ compensation business.
- Higher than expected large individual risk claims.
- An adverse discount rate effect of about $120 million outside Argentina.
There was also a downgrade to gross written premium (GWP) guidance to $8.5 billion (1H13 $9.4 billion), below management forecasts for $8.9 billion.
As a result management now expects the 1H combined operating ratio to be 96-97% compared with consensus expectations of 93%, and the 1H insurance margin is now likely to be 7-8% compared with consensus of around 10%. 1H14 net profit after tax (NPAT) should be around $390 million (1H13: $477 million).
Full details are available in the ASX announcement. In response we do not intend to change our adopted value metrics, presented in the chart below, which we think balance the following considerations:
- The steeper decline in GWP, which is due to increasingly competitive market conditions and QBE’s matching commitment to disciplined underwriting and a willingness to walk away from unprofitable pricing. The latter is a source of upside to profitability. We would rather see a smaller, more profitable business less prone to negative surprises, and we think this is where QBE is heading. The profitability of the ‘front’ book (the latest long-tail policies written) is very likely improving. A positive perspective is that CEO John Neal and the board are instilling a more cautious attitude to risk at QBE.
- We would also not be surprised to see more management commentary about what is core and non-core in QBE’s global portfolio. Divestments of problematic books of business would be welcome if they are accretive to normalised return on equity (NROE). QBE probably should exit a number of insurance markets around the world.
- Declining gearing, which should be around 38% for June 30, down from 44% on December 31 and on its way to the company’s 35% target. QBE has $500 million of convertible debt with a December 2014 call date, which could take gearing below the target.
- Obviously inadequate risk pricing in parts of the back book, and our concern management is possibly yet to understand where further claims reserve strengthening could be required. It is discouraging the Argentinian actuarial changes were not picked up in the global review outlined in the last full-year result. The latest downgrade signals management still needs more time to review all QBE’s policies and risks.
- QBE’s apparent preference to top up reserves in single large amounts when deficiencies are identified, rather than expense the amounts gradually. This is painful now but increases transparency and moves the company closer to being adequately provided sooner.
- Management described the Argentinian reserving top-up as “a very strong one-off” but we are less confident. The Argentinian workers’ compensation scheme is clearly structurally troubled, with the coincidence of very high claims inflation and a wider range of workplace illnesses for which courts are allowed to award compensation. This is the kind of scheme which generates ongoing claims inflation and poor profitability for participants. Ultimately sensible insurers withdraw from such schemes to stem their red ink. Any Argentinian sovereign debt default and increase in economic stress would make matters worse by increasing the tendency of workers to claim. QBE says it is 2.5 times better reserved than peers but who knows how well-reserved the peers are?
- Late 2013 claims notifications in the North American crop business means risk margins were not wide enough after all. Though North America is now generating underwriting profits.
- Satisfactory performance in Australia, New Zealand, Europe, the Asia-Pacific and Equator Reinsurance.
- Another half of internationally synchronised catastrophe claims. The company was lucky catastrophe claims experience in Australia was benign. The relative contributions of climate change (increased incidence of extreme weather) and QBE’s multiple acquisitions globally until 2011 are difficult to discern.
- Progress on operating costs ahead of budget.
- The guided 1H14 net investment yield of 2.7% is in line with our expectations.
FY15 (31/12/15) value at the time of writing is $11 and is sensitive to the currency. $A depreciation, which we forecast, would be bullish for QBE. Rising US bond yields, should US inflation accelerate, would boost earnings by increasing investment income. We would need to see the share price below $10 to get interested, as the 16-month forward return at $10 is only 13.6% ($11 / $10 4.6% dividend yield) plus franking credits.
This is not high enough for an investment in a complex general insurer. And as a point of general advice we always recommend investors keep their weightings to insurance stocks small. The companies are black boxes with below-average earnings visibility and returns on equity are only high enough, for the risks assumed by investors, at the top of the cycle.