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Admiral Group Plc Interim Update – 12 November 2014 

Company Overview:

Admiral Group Plc is the UK’s leading motor insurer and has been listed since 2004 on the FTSE 100 index of the London Stock Exchange. Its primary line of business is motor insurance although the group also draws substantial revenues from the sale of ancillary services such as breakdown cover.

Today the group operates 14 brands worldwide and employs 7,000 members across the globe, with 2,900 of these based in the group’s Cardiff head offices.  In 2013 the group insured 3.7 million vehicles and reported revenues in excess of £2 billion.

Brands include: Admiral, Elephant, Diamond, Bell, Confused.com, Gladiator and 11 others

Index FTSE 100 Ticker ADML.L Latest Close 1,205.00
52 Week High 1,582.89 52 Week Low 1,173.66 P/E 11.52
Dividend Yield % 6.68 Dividend Cover 1.07 CEO: Henry Engelhardt
CFO: Kevin Chidwick Price Target 1,350.00

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Q4 yields positives and negatives for Admiral Group; interim update in detail

Since our last update, Admiral Group Plc shares have remained under pressure as a result of increasingly negative investor sentiment toward the sector, and a deepening sense of doubt over whether or not the group will be able to keep pace with its own previous rates of growth.

After a report detailing a minor increase in motor insurance premiums during Q3 was released by the AA, the shares rallied hard during October however; they have since fallen further and are now in danger of reaching a new 12 month low.

While on face value this is a positive event, with any potential for premium growth being an earnings positive event, Q3 this year would not be the first time that premium rates have risen only to resume their decline at a later date.

We believe that this fact has further compounded the effects of some dovish interim updates from UK motor insurers over the course of October and November. 

Thus, the outlook for premium growth and earnings from operations will form the key drivers of share prices in the sector over the months ahead.

Admiral Group Plc Share Price // Hourly Intervals

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Admiral Group Plc Share Price // Daily Intervals

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Earnings outlook deteriorates for Admiral

While earnings expectations for the current year remain stable, the November interim update saw management refer to the likelihood of lower earnings in future years as a result of recent price pressures, while adding to the overall message of previous statements that future claims losses could also rise.

This we take to mean that underwriting standards may have been compromised after the group entered into the race to the bottom with premium prices, thus implying a likelihood that it’s industry leading combined ratio may deteriorate to some degree during the coming quarters.

When taken in combination with the anticipated annual costs (£4.3 million) associated with the group’s regulatory capital raising earlier this year and a further deterioration of investor sentiment toward motor insurers, the possibility that both bottom line results and share price performance at Admiral Group may suffer during the 2015 year rises.

This holds negative connotations for our own near term outlook for the group, most notably its ability to reach our price target of 1,620.00 during the near to medium term.

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In the medium to longer term; Admiral remains an attractive growth story and our preferred play on motor insurance

Despite the lower expectations for earnings over the near to medium term, we reiterate our attraction to Admiral Group as both a growth story as well as our preferred play on UK and international motor insurance.

On this note, our core attraction to Admiral in comparison with its peers remains the group’s lower cost base and a nimbler, more disciplined, operational structure which supports industry leading margins.

We view the above as key to Admiral’s ability to maintain a strong track record in terms of claims management and customer service, which further supports the group’s ability to retain and grow customer numbers over the life of the insurance cycle.

The group’s across the board approach has consistently led to greater returns for shareholders throughout Admiral’s life as a listed company.

In 2013 management reported returns on equity of 58% as well as a combined expense & loss ratio of 87.8% of premiums written; both of which are results that claim top spot on the industry leader board by a significant margin.

These 2013 results are also consistent with the longer term historical trend in performance for Admiral Group Plc.

 

Admiral Group’s strategy on growth is another key attraction

Looking past the immediate in core markets, another key attraction of ours to Admiral centres on the strategic direction of the group.   On this note, we believe that management have underlined their abilities in strategic decision making to investors when drafting the group’s strategy for growth in future years.  

Simply put, the board have have set out to take something that Admiral already does well in a competitive market, and to replicate such operations and services in overseas markets that have been deemed as generally under served or lacking in dynamism.

“Admiral Group’s strategy is not complicated. Based on the premise that the internet is an irresistible force, our strategy is to continue to progress in the UK market while taking what we know and do well, which is internet and telephone delivery of car insurance, beyond the UK” – CEO, Henry Engelhardt

An example of this in action can be seen in the group’s decision to target the US motor insurance market through its Elephant Auto and Comparenow.com brands.

This has seen the group taking its expertise as the engineer behind confused.com, and investing to become the pioneer of both price comparison technology and on-line insurance in the US. Until Admiral’s entry, the US lacked an effective form of live price comparison for motor insurance.

The group’s international expansion comes amidst an environment of overall stagnation among competitors in the UK motor insurance market who, rather than planning for growth, are focused more upon increasing efficiency and cost savings in order to better their earnings performance for shareholders.

We believe that this disparity in strategy highlights the potential for out-performance at Admiral in future years relative to its peer group. This is because efficiency improvements and cost savings can only yield so much for investors, while the presence of such requirements are not problems that Admiral have to contend with.

The group’s policy of combining disciplined underwriting with the use of reinsurance as a means of avoiding the need for an extensive investment management operation, and higher capital reserves, provides it with a much nimbler operational structure relative to the competition.

As a result, and from a growth perspective; Admiral Group remains an attractive proposition to us and our preferred play upon UK motor insurance.

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Balance sheet, dividend and valuation update

Until the £200 million capital raising in summer 2014, Admiral remained one of the few UK insurers to have nil debt attached to its balance sheet. However, the group opted to take advantage of low interest rates this year in order to bolster its regulatory capital buffer ahead of  the Solvency II implementation date in 2016, without compromising capital returns to shareholders.

This leaves the group with £200 million in 10 year borrowings which are expected to cost the group an estimated £4.3 million net of investment returns annually; an amount equivalent to 1.5% of 2013 earnings.   

While the introduction of leverage to the balance sheet is less than ideal, we see no real cause for concern at the current time. This is as the £200 million bond is a long term liability that raises debt to equity to just 0.38X and does little to stress the overall financial position of the company.

Furthermore, given that the bond issue was undertaken as a one time event in order to boost regulatory capital, there is little evidence to suggest that this marks the beginning of any form of trend toward ever higher levels of indebtedness.

On the contrary, when factoring in Admiral’s pending application to use its own internal model to derive its regulatory capital requirement, there is every chance that the reserve requirement of this nature will actually fall in future years; thus reducing the likelihood that further cash will be required while offering scope for Admiral to pay down its debt ahead of schedule.

In relation to the dividend, 2014 is likely to mark the tenth year that Admiral shareholders have enjoyed dividend growth which has averaged double digit figures consistently.

However, given the group’s policy of returning all excess capital to shareholders by way of a special dividend at the close of each year, and in light of reduced earnings expectations for the subsequent year; we now expect that the shareholder payout will fall in 2015.

While the combined yield is likely to remain substantially ahead of the FTSE 100 average, uncertainty over the pace of decline in both earnings and capital returns could weigh on the shares going forward.

From a valuation perspective, Admiral currently trades on a multiple of 11.5X 2013 earnings, which is markedly reduced from the 14.24 X multiple for the group in June but moderately ahead of Direct Line and Esure’s current valuations at 11.2X and 9.1X respectively.

In short, we believe that the price to earnings valuation for the group is cheap, particularly given its proximity those of the competition, which for the reasons outlined earlier in our report; lack the same growth potential as Admiral.

In regard to earnings in the near to medium terms we maintain our earlier view that the two year decline in premium prices, and its consequent effect upon margins and COR’s (combined loss and expense ratios), is likely to mean that the industry is approaching an inflection point whereby premium prices will soon need to begin rising.

On this note, we are optimistic that October’s AA report detailing the first rise in average motor insurance premiums (1.2%) since early 2012 could mark the beginning of a positive cyclical shift in rates.

Should these beliefs prove to be valid then we would expect pressure upon valuations across the sector to begin to recede.

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Looking ahead; earnings for the full year

Looking ahead, we note that management remain optimistic regarding 2014 earnings, which is an outlook that is supported by expectations for further “above average” reserves releases. This is in turn made feasible by the benign environment for insurance claims which has persisted throughout recent years.

As a result, we also expect some form of earnings growth for the 2014 year, although we anticipate that this will be at a lower rate than in previous periods where earnings have increased at an average rate of 13.8% over a five year time horizon.

To derive our earnings forecast for the group we acknowledge the decline in EPS growth from 10% during 2013, down to 5% during H1 2014. In light of management guidance, we assume that this rate has held constant into the second half which implies a full year growth rate of 5% and earnings per share of 109.8 pence.

We then factor in estimated interest and expense costs of £4 million associated with the group’s £200 million bond issue to arrive at our full year headline EPS projection of 108.3 pence per share.

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Summary

While we remain attracted to Admiral Group as both a growth story and a preferred play upon the motor insurance space; we acknowledge that the Group’s engagement in a race to the bottom with premium rates during late 2013 and early 2014 is likely to have compromised future earnings, potentially as far out as into 2016.

With this, we expect that the resultant uncertainty over both earnings and the dividend will weigh on the shares throughout the near to medium term.

Therefore, we are sceptical as to whether the shares will be able to meet our price target of 1,620.00 within a reasonable time-frame, which would require a further leg upwards of 40.00 pence, past their earlier 2014 high at 1,580.00.

As a result, we reduce our price target for the group today to 1,350.00 pence in order to reflect the above headwinds, along with challenges posed by the third quarter’s losses for the shares.

In revising our price target we consider both greater prospects for long term growth relative to peers and the potential for earnings out-performance over the near term as denoting an oversight by the market in relation to the valuation it has assigned Admiral.

As a result, we expect a re rating to come with a best in class performance for the full year 2014, which should help drive the shares closer toward the non-life sector average of 14.79X earnings; although we price for a return to 12.5X earnings over the near term.

In the interim, we anticipate limited downside from the current level and a moderate recovery in the shares ahead of the new year, although in the absence of positive news flow we see any substantial gains as unlikely to be sustained.

The next scheduled event of significance for the group is the release of full year results for 2014 on 05 march 2015. Accordingly, we shall endeavour to update all of our members at, or ahead of, this time.

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