Read the analyst's reaction to Aviva's first-half results here. The full analysis is below.
Fair Value Estimate: 430p ¦ Uncertainty Rating: Very High ¦ Economic Moat: None
Thesis (Last updated 17/06/10)
On the basis of premiums, Aviva is the fifth-largest insurance group in the world, offering life, health, and property/casualty insurance (P&C) along with other financial services such as global asset management. The insurance giant transacts business worldwide and boasts 53 million customers across the United Kingdom, Europe, North America, and Asia. Yet for all these advantages Aviva realises only average profitability and the firm's equity is among the thinnest in the industry. From a shareholder standpoint, owning shares in Aviva is a risky proposition not to be taken lightly.
Life insurance, Aviva's largest product line, is an unattractive business with commodity-like characteristics that negate the ability of almost any participants to attain a sustainable competitive advantage, in our view. About 70% of Aviva's worldwide premium is generated by the life insurance business which also contains pensions and annuities. The problem with this line of business is that Aviva must match long dated obligations (life insurance and commitments) with fixed income of similar duration, leading to wild swings if markets become unstable, as they did in the recent worldwide financial crisis.
Most of the remaining premium comes from the general and insurance business which, we think, has better potential to foster a competitive edge. Yet even in this area Aviva struggles to turn a profit. In each of the last two years underwriting income (earned premium minus expense) has been at close to break-even, making investment income the overwhelming contributor to profit. Although most P&C insurers have seen their underwriting margins erode over the past few years, the better ones have still managed an underwriting profit.
Global asset management is the one solid business that appears to be working in Aviva's favour. With more than £250 million under management, Aviva is slowly developing a worldwide reach. Still, asset management is also a business that is prone to reflect the severe ups and downs of the market, adding yet another volatile business to the mix.
In stretching for yield, Aviva exposed its underlying weakness--a thin balance sheet levered to investments that can perform erratically. The firm also invested heavily in mortgage loans and, to a lesser extent, sub-prime and Alt-A RMBS, ABS, CDOs, and CLOs. It also has sovereign debt exposure to Greece, Spain, and Portugal. Debt is substantial, adding yet another reason to be leery of the company's ability to reward shareholders into the future. One positive is that Aviva appears to have learned its lesson, as management now speaks to the need to focus more on the bottom line and less on revenue growth. Additionally, it has raised capital internally, selling off its Australian life insurance business and completing an IPO of Delta Lloyd. But while Aviva may be able to reduce its exposure to the ups and downs of financial markets, the fundamentals of the business cannot change enough to overcome elevated risk to shareholders.
Valuation
We are reducing our fair value estimate to 430p from 499p. Our fair value estimate is based on a scenario analysis that averages a base, upside, and downside case estimate. Our base-case fair value estimate is 415p, which is derived by using a 4% average annual profit margin through 2014. We think premium growth will average about 3% over the next five years as Aviva reins in premium growth in favor of more profitable business. For our upside and downside scenarios, we assume a 2% increase and a 5% decrease, respectively, in the investment portfolio which yields fair value estimates of 724 pence on the upside and 165 pence on the downside. Our downside scenario assumes that the decrease in the value of the investment portfolio creates the need for a capital raise that would be highly dilutive to shareholders. Our fair value uncertainty rating is very high because of the wide range of expected outcomes.
Risk
A financial market decline of even moderate severity could have a significant impact on Aviva's equity. With common equity to investments at 8%, Aviva has one of the thinnest margins among all insurance companies. The problem is compounded by the firm's investments in real estate, both commercial and residential. We think Aviva's uncertainty is very high.
Management & Stewardship
Appropriately, Aviva is moving towars executive incentive compensation that is more focused on capital conservation and strengthening of liquidity than it has been in the past. CEO and senior management payouts are largely paid in stock, a provision we think aligns management actions with shareholder interests. Andrew Moss is the current CEO, a position separate from the chairman role, which is occupied by Lord Sharman of Redlynch. Prior to joining Aviva as Group Finance Director in 2004, and subsequently promoted to CEO in 2007, Moss was director of operations at Lloyds. As of year end 2008, Moss held shares valued at about 74% of his basic salary, a bit on the light side, in our opinion. Overall, we think stewardship is acceptable.
Overview
Growth: We think revenue growth will slow as Aviva puts more emphasis on capital preservation and liquidity, a weakness that became apparent in the recent financial crisis. Our forecast is that annual premium growth will fall to about 3% through 2014 as the firm retrenches to boost profitability.
Profitability: Profit margins have averaged only 3% since 2005 but we think the renewed focus on the bottom line over the top line can boost it to about 4% beginning in 2011. We think long-term return on equity can average about 14%, but that is largely driven by the undersized equity of the company.
Financial Health: Aviva's financial health is improving as financial markets around the world slowly recover, in addition to asset sales. But with thin equity/investments and debt that is very high relative to others in the industry, we think the firm remains on shaky footing.
Profile: Aviva is the world’s fifth-largest insurance group, serving 53 million customers across Europe, North America, and the Asia-Pacific region. The firm's main business activities are life insurance, fund management, and general insurance. About a third of sales are from the UK, where Aviva is the country's largest insurance services provider. Aviva is one of the leading providers of life and pension products on the continent.
Strategy: In the past, Aviva's strategy revolved around growth, both in its UK home base and internationally, but recent actions confirm that the company is retrenching in its insurance businesses. Aviva will continue to grow, especially in Asia, but more carefully than in the past.
Bulls Say
1. Aviva's balance sheet is on the mend as a result of actions taken last year and improvement in financial markets worldwide.
2. Management is shifting its focus and backing away from less profitable business, and management incentives reflect the change in direction.
3. Aviva sold almost £3.5 billion of equities, a substantial portion of their portfolio, near the height of the market in September of 2007, sparing shareholders from hefty losses.
4. With only 7% of sales coming from the Asia-Pacific region, Aviva still has an immense territory available for future expansion.
Bears Say
1. With less than 5% equity to investments any substantial downturn in financial markets could cause Aviva to raise capital, diluting shareholders.
2. Return on equity looks better than it really is due to undersized equity.
3. 80% of earnings stem from the life insurance business, where it is difficult to dig an economic moat.
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