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Students of Bath Investment Club Investment Research Report Admiral Group Research Report 4th March 2012 Tom Shaw Carveth Tommy Dai Andrew Hunt Charles Wong Admiral Group plc Sector: Executive Summary Car Insurance Over the past 10 years Admiral Group has been a top performer in the car insurance market. Admiral’s share price rose consistently since IPO, driven Market Capitalisation: by increasing revenues, profits and dividends. These achievements always £2,860m exceeded analyst expectations. 2011 saw a re-evaluation of expectations as regulations, increasing claims and a possible stagnation of premiums Share Price: 1059p(4/03/12) resulted in Admiral stating they would not meet market expectations for Index: FTSE 100 FY2011 profit. The share price was one of the worst performers of the year and although profits were still expected to be higher than the previous year Admiral’s share price fell around 40% for the days around the Current P/E: 12.95 announcement. SOBIC began investigating whether this provided an appropriate buying opportunity. The CEO and other directors also began Current Div Yield: 5.18% buying shares following the large falls. Admiral has numerous issues to deal with but the company Directors clearly still believe that the low-cost FY10 PBT: £266m competitive advantage will continue to provide strong returns. Meeting Our meeting with Louise O’Shea (Head of Investor Relations) and Rhodri 1H11 PBT: £161m Tilsley (Finance Department) took place on 23rd February 2pm at Admiral’s HQ at Capital Tower in central Cardiff. Company Description Admiral Group is one of the UK’s largest private car insurers based in Cardiff, Wales with four brands: Admiral, Bell, Diamond, and Elephant. In addition, Admiral Group own Confused.com, a leading price-comparison website specialising in insurance and financial services. With average revenue growth of 33% since its inception in 1990 and high dividend yields, the strong, sustainable growth and financial performance that Admiral Group has enjoyed thus far provided a strong platform for investment. Admiral has rapidly gained market share in the car insurance market over the last 20 years. It is now looking to expand in other countries such as France, Italy, Spain and the US. Currently these businesses are small but they could grow to become a significant part of Admiral’s business model. A key part of Admiral Group’s strategy is the customer procurement through price comparison websites. This was pioneered by the Admiral subsidiary Confused.com which controls a significant share (around 30%) of the car insurance price comparison market. Although rival websites have gained market share, Admiral group still receives the majority of customers through this avenue, whether through Confused.com or rivals. Admiral is very competitive on price comparison websites as it is a low-cost provider of insurance. Historic Share Price: Company History The current CEO Henry Engelhardt successfully completed a management buy-out in 1999 where the insurer spun-off from the holding group. In 2004 Admiral floated on the London Stock Exchange with a market capitalisation of £711m. Admiral initially targeted high premium customers such as young drivers, sports car drivers and previously convicted drivers. As Admiral has expanded this target market has widened and Admiral is now a low cost mass market car insurer. Admiral’s share price increased to reflect its successful performance in the industry and the growing expectations of investors. 2011 has been a more difficult year. Although profits remain high, issues such as increasing claims, the threat of competition, increased regulatory involvement in the industry, reducing premiums growth and fears of a reducing impact of the competitive advantage in the UK have seen a re-evaluation of Admiral Group’s share price. Key positive points The first fundamental strength of Admiral is its employee’s belief in the success of the company. This is shown directly from the high employee ownership of the firm; 25% Director owned with a recent £11m share purchase, £7m from the CEO. As seen from 2010’s financial statements, this Admiral Group CEO Henry Englehardt belief is well grounded. With a pre-tax profit margin of 16.75%, return on capital of 59% (up 5% from 2009) and holding zero debt, the financial performance of Admiral is very strong. As such the firm can afford to have a policy of distribution of a minimum of 45% of post-tax earnings as dividends. Further to this, 2010 post-tax distributions totalled 94% which is a strong indication of Admiral’s current financial performance and intention to reward shareholders. Key to this performance is a consistent average revenue growth of 33% since 1990 albeit current projections are lower at 15% revenue growth; however, this still enforces Admiral’s core strength. Driving Admiral’s revenue growth is their sole strategy of vehicle insurance; car insurance provides 90% of revenue. This allows the firm to concentrate all its resources to develop cost advantages and lower prices compared to its competitors, such as RBSi, which have a broader range. Admiral has developed a low cost corporate structure which is less bureaucratic and more efficient in terms of the pricing of risk. Also, Admiral underwrites only 25% and 75% is reinsured; the company has agreed to extend their reinsurance partnerships with various firms such as Hannover Re in addition to an existing agreement with Munich Re at no cost change. This strategy allows Admiral to grow and distribute more funds to shareholders. The news of the extension of reinsurance agreements at no additional cost was positive and resulted in a share price increase. Some investors were fearful that the cost of reinsurance would increase as claims were increasing; the news confirmed this was not the case. Furthermore, Admiral has a significant market share (~30%) in the internet price comparison market (through subsidiary Confused.com) which allows the company to take advantage of the unique characteristic of the UK market where 33% of customers switch insurance each year. Furthermore, the fact that car insurance is a commodity product and a legal requirement allows Admiral to funnel these market characteristics to their comparison site and benefit from the firm being a low cost provider of insurance. Key positive points (cont.) Admiral has also embarked on a conservative expansion into international markets, in particular, France, Spain, Italy, US and Germany. Due to the differences in international dynamics and competition, not all these ventures have been successful, such as Germany. However, it must be noted, to Admiral’s credit, that after only a cost of £10m, the group has pulled out of Germany. Meanwhile, Spain has broken into profit. These factors indicate that Admiral can tap into international markets whilst maintaing very good risk management. Admiral’s International revenue only accounts for 5% of total revenue. However, the interim report showed that international revenue increased by 45% against the previous year’s interim figures. Product/Services Admiral offers one key product: vehicle insurance. Although this has expanded into vans, it is car insurance that provides 90% of revenue. Many other rivals are part of larger groups such as RBSI, Aviva, AXA and RSA. Admiral has car insurance at the centre of its operations, this focus on the core is very important as it allows Admiral to achieve cost advantages over rival firms. Additionally, it means that all of the firm’s resources are concentrated on successfully marketing, pricing and operating Admiral Car Insurance. Admiral’s Subsidiary: Confused.com is a subsidiary of Admiral which provides insurance comparison web services to online users looking to switch insurance policy. It is suitable for the UK market where the consumers regularly switch providers to cheaper options. This industry has expanded and is now more competitive and intensely marketed. Confused.com was once the largest car insurance comparison website, however its market share has been eroded by newer websites such as moneysupermarket.com, gocompare.com and comparethemarket.com. Confused.com has slipped down the rankings to 4th as these rivals have achieved market share gains through intensive advertising. However, this expansion of the market has suited Admiral as a low cost provider. Many customers which switch will ultimately use Admiral regardless of which comparison site is used. However, it remains beneficial for Admiral to link with Confused.com as it means Admiral has free access to the price comparison website, whereas they have to pay fees for the rival comparison sites. Market The car insurance market has begun to attract government and legislature interest as the cost of insurance has increased greatly over the past few years. This is driven by increasing claims and increasing payout for medical costs. Admiral has ridden this wave and has achieved significant profits. The market is expected to flatten driven by reduced car demand and also increased competition – particularly from RBSI. Operating in a market where rates and volume only increase by small amounts makes Admiral less attractive and sales growth will slow. An additional consideration is the government involvement. The government is trying to reduce the cost of insurance and also the claims culture in the UK. To do this they are planning to ban referral fees. These are fees paid to insurers by lawyers to gain information regarding customers or a particular claim. No date has been set for the implementation of the ban, but it is expected to come into force in 2013. The possible effects are: RBSI Brands: • A reduction in referral income for Admiral. This currently makes up 5-6% of income and this will be lost if legislation is passed. • A reduction in the number of claims as lawyers have reduced information to file a claim • A reduction in the rivals’ income as they also lose the income, this could drive premiums up as the market as a whole will increase prices to take into account this lost income. • A reduction in premium prices as fewer claims are made. Other Competitors: Competition Admiral control 11% of the car insurance market. The leading competitor is RBSI (RBS Insurance) who operate through the brands Churchill and Direct Line. Aviva is next largest, with a similar market presence as Admiral. Following this the market is competitive with competition from Esure, RSA (More Than), LV, AXA and Hastings. A threat could come from the proposed IPOs of a lot of these businesses, including RBSI. Although this could indicate that their attention may move away from the marketplace they may also begin to invest in marketing and begin pricing competitively to give the impression to future investors that they are growing. This increased future competition could be an issue for Admiral. Admiral however is the only listed car insurer and the only large company which focuses entirely on insurance for cars. This focus on the core activity is a reason why Admiral can reduce bureaucracy, maintain a flatter structure and be more flexible to changing environment. Admiral has a clear cost advantage. Many of the other competitors are struggling to make profit and are only breaking even by releasing reserves or by relying on referral income. Admiral’s Cost Advantage Admiral has achieved returns on equity and profit margins significantly above the market average. This is due to Admiral having a cost advantage which is emphasised by the company remaining streamlined and focused entirely on car insurance. These two features combined have allowed Admiral to outperform and is their competitive advantage. Admiral maintains a low cost structure compared to rivals. They have achieved this through locating operations in South Wales. From a rental perceptive this is advantageous and also the wage rate is lower. Generally Admiral is able to pay staff less, yet they have a strong culture and good morale. This is maintained by Admiral investing in HR and generally looking after their employees. Admiral was included in “Sunday Times 100 Best Companies to Work For 2011” and “Best Workplaces 2011”, this area is of clear importance to Admiral. Additionally, Admiral is 25% owned by employees, share ownership is emphasised by management and means cash wages can be reduced. Admiral is successfully motivating staff whilst maintaining a low cost structure. From the2010 Annual Report 94% of staff would recommend Admiral as a good place to work and 89% believe morale is high at Admiral. An initial concern was in regards to how successful staff could be maintained and not be tempted by higher paying rivals. However, this is somewhat offset by the positive culture and high morale. Additionally, car insurance is now generally data entry and customer service as opposed to labour intensive and skilled fundamental actuarial and underwriting work. Nevertheless, with this in mind, the threat of being unable to attract and keep key employees remains a consideration. This is especially relevant when the share price goes through periods of low growth and employees are demotivated by the falling returns from the share plan. To supplement this cost-saving approach Admiral maintains a streamlined structure. Being focused on UK Car Insurance and not being part of a larger or international group means that bureaucracy can be removed. The Head of Investor relations also believes that middle management has been removed where possible to enhance communication and reduce costs. Key Risks Economic: The current economic situation in the UK is not the best environment to operate a business. However, car insurance, and particularly Admiral, is somewhat sheltered from this. Admiral is a low cost provider so as monetary concerns enter the minds of the population customers may begin to trade down to lower cost providers using price comparison sites. This will benefit Admiral. On the other hand the reduction of cars and increasing unemployment will reduce the number of insurance contracts written. This will reduce volumes and premiums. Claims: Claims are considered the main risk and the main drag on Admiral’s share price over last year. Some analysts are worried that Admiral’s portfolio is particularly risky and susceptible to the high value claims. They believe that the previous low costs attracted higher risk individuals. The increase in claims value means that Admiral will have to hold more back in reserves and incur increased costs. This uncertainty and projected lower profits provides downside risk for the stock. Regulation: Referral fee ban is the first attempt by the government to curb the “compensation culture” and reduce insurance premiums. When the regulation is implemented personal injury details will no longer be sold by insurance companies to lawyers. This means that claimants will have a reduced incentive to sue as the chance of winning is reduced. Referrals are said to encourage personal injury claims such as whiplash. Currently accident victims are being approached to make claims by cold-calling injury lawyers who have purchased the accident details. This ban could reduce claims and therefore reduce the premiums, whilst insurers’ margins would also be maintained. The government is also planning to stop losing defendants having to pay a "success fee" to reimburse the claimant's lawyer for unconnected cases he may have lost. The government proposals mean people making the claim will have to pay the success fee, which will be capped, rather than the defendant. Generally the government’s attempts to reduce claims and insurance costs are targeted at the lawyers as opposed to the insurers. This is most likely due to the lawyers making large profits whereas the insurers are generally just breaking even. These proposals are neutral to Admiral but in the future could be more damaging. Financial Analysis Admiral has an impressive track record financially. The below graph shows the impressive revenue growth over the past 5 years, a CAGR of 19% (2005-2011). 2011 H1 has also seen an impressive 43% growth compared to 2010 H1. Revenue growth has been driven by increases in market share and rising premiums. Millions In terms of profitability, Admiral has been equally impressive. Admiral has kept costs under control and achieved net profit margins of around 30% for the past few years. Net income has grown at a CAGR of 18% (2005-2011). This level of growth has outperformed rivals and expectations, this has driven share price over the past few years. If this performance is maintained then Admiral will continue to be an excellent investment. The revenue growth in H1 2011 was impressive but was not matched by profit levels in the same period, which grew at 12.5% compared to the period 12 months earlier. This highlights the impact increasing claims are having on profitability. It is also a concern that Admiral is increasing customers during this period. It may be that rivals are cutting back their exposure whereas Admiral are still pricing aggressively. This could cause considerable long-term problems in terms of a less desirable insurance portfolio which is more susceptible the claims. Financial Analysis (cont.) The below chart highlights the rising importance of claims on Admiral’s business. Claims have increased significantly over the past years and this hits profitability. 2011 H1 saw a 94% increase compared to the same period a year later. Admiral are unsure of the reasons behind this sudden increase, it may just be random. However, the general increase over the past few years is a result of a developing claims culture in the UK. This is driven by injury lawyers and also possibly the harsher economic climate resulting in more of an incentive to claim. The UK Government are putting in place measure to try and moderate the claims culture – a ban on referral fees is part of this process. A key part of determining the future profitability is in regards to whether these claims will continue to increase, whether Admiral has a particularly susceptible client base and whether the increase in revenue in 2011 H1 was attracting clients who were more likely to suffer personal injury (the key claim driving the increases). Additionally, Admiral has an increased reliance on reinsurance of claims. There were worries that the cost of this reinsurance would increase in light of the increasing claims, however this was confirmed not to be the case. 50% 52% 47% 46% Recoverable from 42% reinsurance: 21% Admiral has maintained an exceptional Return on Equity over the past few years. Rarely falling below 50%. This has been achieved without leverage and highlights how impressive the performance of Admiral is. It is also the result of a generous dividend policy which means that Admiral is running on a lean capital base and returning cash to shareholders. The below chart shows the previous dividends of Admiral. The company states a dividend policy of 45% of profits, however if they feel that the company does not need the money then they are happy to pay out to shareholders in the form of a dividend. Payout has been around 80%-90%, therefore the long-term sustainability of this dividend growth is questionable. Millions Financial Analysis (cont.) Other considerations and abnormalities in accounts. Analysing Admiral Group’s 2011 interim balance sheet the majority of assets are in the form of Cash (£281m), Reinsurance Assets (£479m) and Financial Assets (£1,319m, of which £579 are AAA investments, £303m are deposits and £436m are receivables owed by policyholders). Admiral has low equity, due to high payout ratios, and no debt. Current liabilities consist of Insurance contracts - claims (£1,084m) and Trade payables (£748m, mainly to reinsurers). The key changes to the balance sheet since the last reporting period are: 1. Reinsurance assets have increased 70%. This is consistent with Admiral’s increasing insurance book and also the increasing claims. Admiral recovers a large portion of claims from reinsurers so the receivables increases. 2. Trade and other receivables, including from policyholders increased 60% over 12 months to 30 June 2011. This is consistent with the increase in trade for Admiral. 3. Trade and other payables, increased 83% this comprises largely of fees to reinsurers. The increase is consistent with the increasing revenue and also increased reliance on reinsurers. Forecasts Excessive growth is expected for a further 3 years as Admiral is well managed, the lowest pricer of insurance and expanding out to Europe and US. However, Admiral is beginning to reach maturity in the UK insurance market and may see little substantial future growth in the domestic market. There is also the possible problem of competitors pricing more aggressively. Digitallook Forecasts: Digitallook Broker Views: Brokers are largely neutral about Admiral. There is no consensus in regards to the prospects for the company. Investec are the most bearish broker. Valuation Discounted Cash Flow Below shows a Discounted Cash Flow model which is set roughly to the current value of Admiral (£2,860m). The model shows what the variables would need to be to justify the current valuation. Admiral is entirely financed by equity. Below are the assumptions regarding the cost of equity. Cost of Equity (CAPM): Beta ~0.7 (Bloomberg and FT) 5 year government bonds = 0.96% Risk Premium = 8% Cost of Equity = 6.56% 2011 2012 2013 2014 2015 Revenue Growth rate 12% 10% 9% 8% 7% Net Revenue (£m) 717.7 789.5 860.5 929.4 994.4 Operating Costs % 60% 61% 62% 63% 63% Operating Costs (£m) 430.6 481.6 533.5 585.5 626.5 Operating Profit (£m) 287.1 307.9 327.0 343.9 367.9 Tax % of Operating profit 28% 28% 28% 28% 28% Tax (£m) 80.4 86.2 91.6 96.3 103.0 After tax profit (£m) 206.7 221.7 235.4 247.6 264.9 Net Investment % of Net revenue 0.9% 0.9% 0.9% 0.9% 0.9% Net Investment (£m) 6.5 7.1 7.7 8.4 8.9 Working Capital 11 11 11 11 11 Change in working capital (Will leave at 0 as relatively random) 0 0 0 0 0 Net Cash Flow 200.2 214.6 227.7 239.2 256.0 Cash Flow growth rate -0.2% 7.2% 6.1% 5.1% 7.0% PV of Cash flows 187.9 201.4 200.5 197.7 198.5 Terminal Value (Using exit multiple model) 2138.5 Assumes current PE would be same in 5 years to calculate a terminal value (note: this amount is roughly the same value as a zero-growth perpetuity when r=7%) Fair value of Admiral Equity (£m) 2936.6 Fair value per share (£) 10.86 Valuation (cont.) Dividend Growth Using the dividend discount model we can attempt to value Admiral based on expectations on future dividends. A key consideration for Admiral is in regards to the sustainability of the dividend. Admiral has a very high payout ratio, this leaves the dividend more susceptible to downside. The below model uses the 2010 dividend of £164m and then applies the Gordon Growth Model valuation technique based on the below variables. Highlighted in green are the variables which would give Admiral a positive valuation. Current Market Value £2,860m Long-term dividend growth 0% 1% 2% 3% 4% 5% 6% 7% 8% 5% 3294 4159 5600 8482 17129 6% 2745 3327 4200 5655 8564 17294 7% 2353 2772 3360 4241 5710 8647 17458 WACC 8% 2059 2376 2800 3393 4282 5765 8729 17623 9% 1830 2079 2400 2827 3426 4323 5819 8811 17788 10% 1647 1848 2100 2423 2855 3459 4365 5874 8894 11% 1497 1663 1867 2121 2447 2882 3492 4406 5929 12% 1373 1512 1680 1885 2141 2471 2910 3525 4447 As you can see the market is currently not pricing in much future growth for Admiral. Unfortunately there are not comparables for us to take a relative valuation approach for Admiral.
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