iSelect: Result 2016

After a horror first half of 2016, iSelect guided to 2016 earnings before interest and tax (or EBIT) of between $15m and $18m. We thought that was aggressive – so count us pleased at its result (the benefits of low expectations! – Ed).

The damage done in the first half – particularly in iSelect's Health segment – meant 2016 was far worse than 2015 (see Table 1). Yet it's the future that matters and iSelect's 2016 second-half performance suggests the business has stabilised.

Healthy recovery

As we noted in iSelect: Interim result 2016, the company's Health segment tends to be much stronger in the second half of the financial year as customers rush to purchase health insurance to beat the annual premium rises on 1 April and, if they lack cover, increases in the Lifetime Health Cover loading on 30 June. 

And so it proved. Whilst revenue and earnings before interest, tax, depreciation and amortisation (or EBITDA) both declined in 2016 – the latter by a substantial 34% – this was primarily due to the company's abysmal first half. Inadequate staff training and below-average conversions of leads into sales were rectified in the second half and both revenue and EBITDA rose compared to the same period in 2015, by 4% and 6% respectively.

There are now apparently 40,000 different health insurance policies to choose from. As such, iSelect's staff provide more value helping customers choose the most appropriate higher-end policy with more complete coverage than the low-cost policies with more exclusions sold by the likes of Medibank Private's ahm.

The strong second half meant that average revenue per sale increased, by 18%, from $759 to $894 for 2016, helping compensate for the 20,000 fewer health insurance sales in 2016.

Commissions trailing

Depending on the policy, iSelect either receives commissions from insurers upfront or over a number of years. 82% of total segment sales are now upfront, an increase from 80% in 2015.

The company – aggressively in our view – recognises the full value of trailing commissions immediately, albeit discounted to present value and after adjusting for assumed attrition rates. This is one reason why cash flow from operations trailed net profit in 2016.

New trailing commission receivables booked in 2016 slightly exceeded cash collected from prior period receivables and so the balance of iSelect's trail commission receivable also slightly increased to $104m at 30 Jun 16. As actual cash received from trailing commissions moves closer – and perhaps even exceeds – new trailing commission receivables booked, cash flow from operations should more closely match NPAT in coming years, thereby also improving free cash flow. 

Health insurance policies represent by far the biggest portion of this balance although rising life insurance sales are also contributing. As we noted in Medibank & NIB: Results 2016, the 6% average increase in the price of private health insurance policies over the past ten years has encouraged customers to let their policies lapse or downgrade to cheaper options. iSelect is seeing this in the mix of its customers, with management seeing more customers who were ‘switchers' rather than new purchasers of private health insurance.

Increased ‘switching' is good for iSelect's current business, of course, but it also imperils the balance of trail commissions receivable. Attrition rates continue to increase, ‘with higher increases experienced for policies that have been in force for shorter periods of time'. If this continues, then we'd expect the trail commission receivable to be written down at some stage and so we discounted it by 20% when upgrading iSelect in January.

Other segments

In any case, 48% of revenue is now generated from products other than health insurance, up from 41% in 2015.

Helped by conversion rates rising from 4.2% to 6.2% as a result of additional staff and more insurers agreeing to sell their products via iSelect, Life and General Insurance revenue rose by 33% to $33m.

Car insurance was the highlight here due to the additions of QBE and Progressive. Moreover, the lower average revenue per sale iSelect receives on car insurance compared to life insurance was more than offset by the 39% increase in policies sold in this segment. As a result, segment EBITDA rose 53% to $12m.

Management has already adopted the changes to life insurance commissions arising from the Trowbridge review and believes they'll have minimal effect on its business. The high costs of acquiring customers for traditional advisers may even benefit iSelect as its model relies on customers using its website before speaking to one of its staff members.

Despite a 34% increase in revenue, to $40m, for the Energy and Telecommunications segment, additional staff and investment in marketing to grow this segment meant EBITDA was essentially flat at $1.7m. Management claims that 5% of Australia's residential broadband sales were via iSelect in late 2016 and it believes it can further increase this figure as the NBN ramps up in coming years.

Receivables in the Energy and Telecommunications segment remain outstanding for longer due to suppliers having longer payment periods than in other parts of iSelect's business. Growth in this segment in the last quarter of 2016 is another reason why cash flow from operations lagged net profit in 2016. Management said that receivables had reversed in July and August and we'll take their word for it for now.

iSelect continues to expand into new products, recently adding a credit card section to its website. It will also begin selling travel insurance and mobile phone plans shortly.

Increasing price guide

While iSelect operates in a fiercely competitive industry against the likes of well-resourced comparethemarket.com.au, it appears to be on the right track after recent turmoil. Moreover, despite our concerns over the trail commissions receivable, its strong balance sheet – it had nearly $90m of net cash at 30 Jun 2016 – puts it in a good position to continue to invest in its business while spending enough on marketing to fight off competitors. Depending on its share price, iSelect will also potentially buy back another 25m shares (or more than 10%) over the next twelve months.

The stock has risen 71% since we upgraded it in Is it time to pick iSelect? on 29 Jan 16 (Speculative Buy — $0.90). Based on 2017 guidance – and after subtracting the cash and 80% of its trail commissions receivable – iSelect is selling on a forward PER of 11. Bear in mind, though, that if we're stripping out the trail commission receivables, the remaining business may generate little free cash over the next few years despite the anticipated cash flow improvements. As a result, we'd need a larger margin of safety before buying, but we're increasing our price guide and continue to recommend you HOLD.