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Aviva Plc – 20 June 2014

Company Overview

Aviva Plc is an insurance group headquartered in the UK. The group’s core service offering is centred on life insurance and general insurance products. The life insurance business accounts for nearly 70% of group income, while the general insurance offering sees the group provide everyday insurance cover for homes, health and motors to its 30 million-plus customer base.

Officially, the group operates under four geographical segments – UK, Europe, North America and Asia Pacific. Under each segment, Aviva offers its life insurance and general insurance products through a complicated structure of divided and separate subsidiaries.

Index FTSE 100 Ticker AV.L Latest Close 522.00
52 Week High 536.50 52 Week Low 319.55 P/E 7.9
Dividend Yield % 2.87 Dividend Cover 4.4 CEO: Mark Wilson
CFO: Tom Stoddard

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Insurance Outlook and Rationale for Coverage

While central bank policies have lifted global stock markets over recent years, quantitative easing has weighed on the insurance sector heavily. With artificially inflated bond prices leading to yield compression, investment income for insurers has declined rapidly. The consequence of this has been highlighted in dividend cuts by both RSA Insurance Group and Aviva Plc during the early stages of 2013.

However, with developed economies such as the UK and the US now transitioning towards an environment of gradually tightening policy, the era of ultra-low interest rates is unlikely to prove a burden upon the balance sheets of insurers for much longer. This is because when interest rates do begin to rise, many insurers will be likely to experience a rise in investment income and an overall improvement in underlying earnings, which bodes well for future profitability, valuations and share prices within the sector.

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Restructuring Strategy and Cost Cuts Drive a Return to Profitability at Aviva Plc

Despite the fact that a number of issues still exist, the 2013 year proved to be one of resolution and resurrection for Aviva Plc as the group returned to profitability following two back-to-back years of escalating losses.

The group reported full year results in March, where it revealed a 7% reduction in operating expenses, £360 million in permanent cost savings, a 40% increase in group cash flows and a £2.15 billion post-tax profit. The post-tax income for the year equates to earnings per share of 65.3 pence, which compares favourably with the 2012 period when the group unveiled a per share loss of 113.00 pence.

All in all, the group made good progress toward longer term objectives, with performance across a number of key metrics coming in ahead of consensus estimates.

The group also achieved a simplification of its operational structure over the period, which has seen all international subsidiaries positioned directly beneath the holding company in the reporting and ownership chain. The below diagrams illustrate the simplification.

Old Group Structure

Old Group Structure

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New Group Structure

NEWGROUPSTRUCTURE

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Strategy Update and the Road Ahead

The group’s strategic objectives for 2014 see improvements in inter-company cash flows, growth and financial strength continuing as key priorities.

Much of the additional improvement in cash flows is set to come from further cost reductions and an anticipated turnaround of struggling European operations, some of which have already shown signs of turning (France & Poland). 

In relation to growth, management see a reduction in the group’s combined operating ratio and further improvement in the VNB (value of new business) metric as being critical to success in this area. In order to reduce the combined ratio, management plan to invest heavily in underwriting systems and analytics over the months and quarters ahead. This is while a remodelling of pricing strategies and product mix is expected to drive further appreciation in the value of new business.

In terms of financial strength, management expect further disposals of non-core assets to support a reduction in the capital intensity of the business while cost savings are to continue in order to support an ongoing reduction in both internal and external leverage.

Measures and efforts to improve upon financial strength are critical for both Aviva at the operational level as well as for the group’s shares, given the looming implementation date for the European Union’s Solvency II regime. This we will cover in more detail later in this report.

Aviva Plc Hourly Chart

Aviva Plc Short Chart

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Emerging Markets Joint Venture Highly Positive for Earnings Growth Potential

In January this year, Aviva Plc signed a joint venture agreement with Astra International in Indonesia. Under the terms of the agreement, Aviva is set to become the preferred provider of life insurance for the group, which employs 189,000 people in the world’s fourth largest country by population.

The venture not only offers Aviva the opportunity to increase its customer base by close to 0.5%, but also provides it with an attractive base from which it can begin its expansion into one of the world’s fastest growing economies.

Typically underserved as a life insurance market, a rapidly expanding population, economy and middle class make Indonesia an attractive proposition for any international conglomerate seeking growth opportunities.

The group estimates that during the decade spanning 2002 – 2012, the life insurance market in Indonesia grew by a compounded annual growth rate (CAGR) of 25%. While the exact contribution to earnings that the 50/50 venture is likely to make is difficult to accurately predict, Astra Aviva Life will provide the parent group with a hedge against underperformance in some of its core markets where headwinds still exist.

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The Elephant in the Room, Changing Pension Regulations in the UK

While the opening stages to 2014 saw Aviva Plc confirm its return to profitability, it also saw another bombshell dropped upon the UK business. At the budget announcement this year, the Chancellor announced that from April 2015 retirees would no longer be forced to purchase an annuity, but would instead have a greater degree of freedom over how to use their savings in retirement.

Effectively, the changes mean that each pensioner will be able to release all of their pension funds, subject to the applicable rate of income tax, and spend or invest it as they see fit. While a positive development for future generations of retirees in the UK, it is estimated by Barclays Capital that the outcome of the budget will shrink the £14 billion annuities market in the UK by as much 60 – 70% over the medium to longer term.

On the other side of the same coin and while conscious of the potential impact upon the sector, Chancellor George Osborne insisted that the changes would not lead to a long-term decline of the industry. While there is always the potential for this to be true, the unavoidable certainty to have emerged from the budget announcement is that now, more so than ever, the industry that has often been perceived as providing poor value for money will have no choice but to reform in order for it to prosper.

In the immediate aftermath, Moody’s revised downward the outlook for Aviva Life and Pensions UK’s credit rating, while management at Aviva Plc admitted that it had accelerated the pace of its product development cycle and had brought forward plans to unveil new savings vehicles to counter any downturn in sales.

Nearly three months on, and earnings updates from some of the UK’s key life and pensions players suggest that sales of annuities have declined substantially throughout the intervening period, although exact estimates of how much  vary significantly.  

While management at Aviva have made every attempt to reassure investors that the group’s long term growth prospects remain on a sound footing, it appears most likely that it will be difficult for any of the life and pensions businesses to avoid further downward pressure upon revenues and profits. This is given that consensus estimates expect sales to decline by roughly 60-70 % over the next 12 -18 months, while the current rate of decline shows the contraction that has already taken place over the last quarter is somewhere between 30-50%.

When considering that over half of group sales and earnings are drawn from the UK,  it becomes an increasingly challenging argument to suggest that Aviva will remain immune from any further reduction in sales at the industry level. This is while management’s international expansion and product innovation efforts are likely to require time before they are felt on the bottom line.  

In short, recent changes to pension rules have the potential to constrict the current earnings rebound at Aviva and consequently could undermine management’s efforts to turn the group around.

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Another Elephant in the Room, Internal Leverage and the Solvency II Directive

Another elephant in the room for Aviva Plc is the ongoing saga of its inter-company loan (internal leverage), its external debt profile and the looming implementation date of the European Union’s Solvency II Directive.

At the time of the 2013 dividend cut, the group was being pushed by the new regulator (PRA) into a restructuring and simplification exercise as part of a requirement to demonstrate how the group would resolve itself in the event of financial collapse or crisis.

This led to the elimination of a number of corporate structures and a shorter, slimmer reporting chain, which was a positive step toward making the group’s financial position easier to interpret. The not so positive outcome was that the restructuring never quite managed to make the group’s financial position and corporate structure as opaque or easily interpreted as some analysts and investors would have liked.

The clarity surrounding the nature of the group’s use of off balance sheet vehicles could still improve further, while the creation of a multi-billion pound inter-company loan during the restructuring has increased the group’s debt and overall risk profile.

Although the group reduced its debt pile by £240 million this April, it remains highly leveraged relative to its industry peers. At the close of 2013, total borrowings stood at £7.8 billion, with debt to equity at 0.96 X, which is high when compared with the 0.76 reading of the same gauge for one of Aviva’s nearest competitors Prudential Plc.

While management have made improving the financial strength of the business one of their top strategic priorities, the looming implementation date for the EU’s Solvency II regime in January 2016 makes it a necessity. Under the new regulations, Aviva Plc will be classified as a Global Systemically Important Insurer and subjected to a number of new regulatory standards as well as capital requirements.

Among the new standards will be tweaks and changes to the way in which assets and liabilities are valued, along with a number of new disclosure requirements relating to risks facing the business, capital adequacy and risk management systems. The purpose of the new disclosure system is to make the financial structure of the subordinated organisations more opaque, which is intended to encourage market forces to impose greater discipline upon the relevant parties.

Aviva Plc management have expressed their confidence in the group’s ability to be ready in time for the new regime; however,  a sudden change for the worse in UK income and/or the ongoing indebtedness of the group could both potentially scupper these efforts.

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Dividend and Valuation

Following the 44% cut to the dividend in 2013, management have “re-based” themselves to a position where they have the potential to grow shareholder cash returns steadily over time, as both earnings and capital strength improve. For the full year 2013, the group paid total dividends of 15.00 pence, which was covered 4.4 X over by earnings.

From a valuation perspective, the group currently trades on a multiple of 7.9X 2013 earnings which, on the face of it, compares well with the 19X earnings of Standard Life and 13X earnings multiple of Prudential Plc.

Aviva Plc Daily Chart

Aviva Plc Long Chart

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Risks

While Aviva Plc appears to have a bright long-term future ahead of it, there are no shortage of risks facing the group over the near term. The most notable of these is that an immediate drop in sales and earnings in the UK business undermines efforts to rebuild investor & regulatory confidence, as well as group financial strength ahead of the implementation of Solvency II in January 2016.

Under a worst-case scenario outcome, the group could remain over-leveraged and fall short of the regulatory capital required of it as a Global Systemically Important Insurer. This could lead to a rights issue or some other form of capital raising that impedes upon both investor confidence as well as share price performance.

In addition to the above vanilla scenario, a slowdown in the UK economy could also lead to a further protracted period of low interest rates, which may further undermine investment income, annuity sales and the ability of the group to meet is liabilities to clients and customers. This could again result in the worst-case scenario outcome described above.

Further from here, increasing regulations and the higher costs associated with these may have the potential to detract from earnings improvements, and continue to distract management from right-footing and growing the business over the quarters ahead. If allowed to continue over a sustained period, this could also weigh on the share price.

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Summary

Following the adverse developments of recent years and its nascent return to profitability, Aviva currently holds recovery play status among the investor community. While in some respects this may be warranted, we feel that its share price performance of the last year indicates that the market may have underestimated the number of near-term headwinds facing the group.

The most notable of these is the impact that changes to UK pension regulations are likely to have upon sales in one of the group’s core markets which accounts for over 50% of income. This has the potential to impact upon investor sentiment toward the Aviva recovery as well as the group’s ability to meet the European Union’s Solvency II regime requirements.

Looking further out, Aviva has a lengthy reach into both maturing as well as emerging markets that are independent of the UK. Given the growing middle class and a higher interest rate environment in the emerging world, Aviva has the opportunity to take the experience gained in mature markets and implement that in an environment where life insurance and income security during retirement are attractive prospects to large numbers of consumers.

This casts a ray of light across a murky horizon. Nevertheless, given the share price appreciation of the last twelve months, short-term risks attached to the shares leave them vulnerable to a period of under-performance. Although management have not yet released precise earnings figures since the UK budget changes, first half results are scheduled for release to the market on 7 August. It is the outcome of these results that will dictate the near – medium term direction of the shares.

To summarise, the longer-term outlook for Aviva does offer an attractive growth story however, near term challenges have significantly impacted upon the risk reward ratio attached to the stock.

As a result, we find the shares are unattractive at present.

In terms of price targets, we view a retracement from the current level of 521.00 pence, down toward the 480.00 pence level as the most likely outcome for the period ahead of H1 results in August.

Onward from here, a notable deterioration of group performance against estimates could lead to another leg downward toward the 440.00 pence mark.

Looking further out and once through the storm of the current downturn, we view the group’s longer-term prospects as being supportive of a retracement toward the 560.00 pence level, which would represent a post financial crisis high for Aviva Plc.

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