Discounted growth and a healthy yield
This week, I am initiating coverage on Steadfast Group Limited (SDF), the largest general insurance broker network and the largest underwriting agency group in Australia and New Zealand. The company was founded in 1996 with an aim of pooling resources between 43 insurance brokers, and listed on the ASX in August 2013 with 279 brokers. The listing raised $334 million and enabled the group to take ownership in 58 broker businesses, four underwriting agencies and two complementary businesses via a combination of cash and shares.
Since listing the company has met or exceeded guidance, and made material acquisitions that are expected to result in near term earnings-per-share accretion. Despite the solid performance, the share price has not performed to expectations, creating an opportunity. The business is a growth story in a market that should emerge from a cyclical low in coming years. Having acquired scale, SDF is well placed to benefit from any upturn. At the current share price level, under $1.45, the forecast dividend yield for the business is above 4 per cent, plus franking value (near 6 per cent on a fully franked gross yield basis). In addition, I believe that there is further upside to dividends in FY17 and beyond if premium prices stabilise. My valuation for SDF is $1.68, implying good upside to the currently depressed share price. The income first model portfolio will take a 6 per cent weight in SDF as of the open price on the morning of December 8.
Dividends outlook and cash flow
SDF’s dividend policy is to pay between 65 per cent and 85 per cent of net profit after tax (NPAT). In FY15 the company paid 5 cents leading to a payout ratio of 77 per cent of underlying cash NPAT, near the midpoint of this range. With growth in cash earnings per share expected to be delivered in FY16, there is an expectation that the dividend will grow towards 6c per share for the full year payout. Here are SDF’s dividends on a half by half basis since listing, along with my half yearly forecasts for FY16 and FY17 – note the expectation of a 3c dividend for the next three half years.
Supporting the dividend is the fact that SDF has delivered strong operating cash flow before movements in trust money. This trust money is the cash that is held by the brokers on behalf of their clients that will be used to pay the insurance premiums to the insurance companies, net of the brokers’ fees and commissions and interest income.
Steadfast is divided into two major divisions – Network Broking and underwriting agencies. Historically the business has focused on the insurance broking side, and was founded as a means to strengthen a network of brokers. As the business has grown, there has been an increasing level of diversification through acquisitive expansion into the underwriting agencies division. Most recently, SDF purchased two large underwriting agencies from QBE: CHU and UAA, for $290m. These acquisitions are expected to add materially to the company’s earnings in FY16 and beyond.
The Network Brokers division is a service provider and equity holder across a network of 304 insurance broking businesses. These broking businesses source insurance products on behalf of clients and assist customers in submitting and negotiating claims. SDF receives marketing and administration fees from partners within this network. Additionally, SDF holds some ownership in 56 insurance broking businesses. SDF has been an aggregator in this space, and will likely continue to purchase equity stakes in broking businesses through its network relationships. My view is that this is an attractive option for SDF to continue to expand its involvement in the broking business. In FY15 on a run rate basis (so assuming a full year contribution from the likes of the Calliden agencies, CHU and UAA), the Network Brokers division accounted for 45 per cent of earnings before interest, tax and amortisation (EBITA). It will remain the core of the SDF business going forward.
The Underwriting agencies division consists of 22 Underwriting agencies under SDF ownership. Underwriting agencies act on behalf of insurers to design, develop and provide specialised insurance products and services. For example SDF owns Argis Insurance, which specialises in packaging farm insurance products. It is essential to point out that these agencies are not taking on the insurance risk, or underwriting the business. They are merely packaging insurance products from the underwriters for specific industries, taking a revenue for that service. In FY15 on a run rate basis, the Underwriting Agencies division contributed 44 per cent of EBITA, which is significantly more than its weighting in 1H FY15 – which was only 18 per cent.
In addition to these two main divisions, SDF has interests in a range of complementary and related businesses. This includes a specialist life insurance broker (50 per cent ownership), a premium funding business called Macquarie Pacific Funding (50 per cent joint venture), a reinsurance broker called Steadfast RE (50 per cent ownership) and a few other niche operations. Overall, the combined contribution of these non-core ventures, along with profits from the Steadfast Network, which mostly related to net M&A fees, is 11 per cent of EBITA. My view is that this is both a potential positive and a potential negative to the overall business. At 11 per cent of EBITA in FY15, the "other interests" division is not immaterial. However, little insight into these businesses is easily ascertainable.
Additionally, these could be considered as distractions from the main game. My view is that these are complementary businesses that will afford SDF the opportunity to expand its breadth of operations in the right circumstances. Additionally, these businesses could be used to service the core divisions, enhancing earnings margins.
Management and strategy
I spoke with SDF’s CFO and chief executive early in my analysis, and their strategy is very clear. Both Robert Kelly, the company’s MD & chief executive and Stephen Humphrys, the company’s CFO, were perplexed by the company’s relative share price discount. My view here from talking with SDF was that the company has thus far been a strong success story, and the team is very focused on ensuring that recent large acquisitions are integrated smoothly. With the key focus of SDF being the integration of the acquisition of the Calliden agencies, and of the QBE underwriting agencies mentioned above, additional acquisitions may not be the key focus in the short term. That said, SDF was keen to point out that the balance sheet has capacity and the leadership of the business continues to address opportunities on a daily basis. Pleasing to me was the operating focus. Management were quick to point out that the size of the acquisitions made in 2015 was such that full synergistic benefits of integration would likely not be felt until FY17, as operations are more effectively combined to share costs, and cross sell benefits. Thus, the future for SDF appears to be well set by a focus on extracting value from the company’s current position.
Outlook and risks
SDF’s guidance in FY16 is for underlying net profit after tax and before amortisation (NPATA) growth of between 41 per cent and 46 per cent to a range of $80m to $83m. This guidance is based upon expectations for a flat market for general insurance premiums, contributions from the aforementioned acquisitions and no future material acquisitions. My forecasts are for the company to achieve at least the bottom end of this guidance range, though I note that some risks do exist.
Firstly, general insurance premium markets have been soft in recent years, and there is a chance that the assumption of a flattening market in FY16 is a little premature. Rival insurance broking business Austbrokers (AUB) described the market outlook at its AGM as seeing lower levels of premium rate reduction in FY16. This suggests that the decline in premiums is starting to stabilise, but with benign inflation, and continuing levels of competition, there is risk that this trend may take a little longer to turn than anticipated. Slower decline is the first step towards stabilisation, but investors should be aware that the market is weak in general insurance premiums.
Secondly, SDF faces the task of successfully operating and integrating large acquisitions. My view is that SDF management have a very strong history as aggregators within the insurance broking market, and it is a relatively safe assumption that the management team’s forecasts are achievable for these acquired businesses.
SDF is priced at a discount – unfairly
I have mentioned that SDF is attractive when compared to its closest peer on the ASX – Austbrokers (AUB). Here is a table based upon Bloomberg consensus numbers showing the relative value metrics to which I am referring:
Source: Bloomberg, Eureka Report
This table shows that SDF’s forecast growth prospects are slightly better than AUB (using the Bloomberg estimates). Additionally, the company’s PE is lower indicating that the market is not pricing in this relatively better growth outlook. My view is that this growth aspect of SDF is what makes the company more attractive. SDF, is now also more diversified than AUB where insurance broking accounts for 77 per cent of profits.
Despite this, AUB is also a good prospect. The problem is that growth is not really apparent with a forecast EPS growth of 1.69 per cent in FY16, and dividends forecast to remain unchanged. SDF’s ability to grow its earnings in FY16 gives me confidence that the dividend will grow to 6 cents in FY16 (5 cents in FY15), a lift of 20 per cent.
With the FY16 guidance including a full year contribution of the recent acquisitions, this growth is reasonable. Additionally, management believes that the synergies to be extracted from acquisitions will take time and the scale of the recent purchases from QBE and Calliden will continue to deliver bottom line improvements through synergies into FY17 and beyond.
My valuation for SDF is based upon a blend of a 3-stage dividend discount model and a discounted cash flow model. The resulting valuation of $1.68 implies a healthy amount of upside to the current SDF share price. My view is that should SDF deliver on guidance, and market conditions stabilise so as to provide investors with more confidence in the cycle, SDF may provide some capital upside as well as a solid yield.
Income First inclusion at a 6 per cent weight
Given the SDF outlook, and the potential for the sector to start to emerge from a challenging part of the market cycle, my view is that there is a good long term entry point for SDF at current share price levels. The business has made some large acquisitions and now has a better scale should the market for general insurance premium rates improve. Key to this investment is the knowledge that SDF is not an insurance business like IAG, SUN or even QBE. It is a network of insurance brokers and a co-owner of general insurance intermediaries, so the risks are very different. It is not a company that may have a hole blown in profits by a super-storm or unusual claims event – it is not a bet on the weather. The business makes money through distribution of insurance products, and is therefore not exposed to traditional and volatile underwriting risks.
Given this, the Income First model portfolio is taking a 6 per cent stake in SDF as of the open price on Tuesday December 8. Exposure to the insurance sector via a broker is seen as an ideal method to diversify, but restrict the type of risk involved in the investment. While the dividend yield is not necessarily world beating, it is a solid 6 per cent including franking credits, based on our forecasts. The portfolio’s running yield on invested capital is quite high, with companies such as GEM and DWS offering a lift to the overall yield. The exposure to SDF from a portfolio perspective, will help with balance and diversification, but maintain a strong income from the capital deployed.
To see Steadfast Group's forecasts and financial summary, click here.