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Aviva Plc; Price Target Hit, Friends Life Merger Comment – 12 December 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 487.10
52 Week High 542.39 52 Week Low 413.7 P/E (F) 10.1X
Dividend Yield % 2.9 Dividend Cover 4.4 CEO: Mark Wilson
CFO: Tom Stoddard


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Aviva Plc under pressure on all share merger announcement; price target hit

Since last updating on Aviva in early November the shares have embarked upon a strong recovery, in line with the wider market, before succumbing once again to selling pressure on the back of an announcement that the group is looking to merge with fellow competitor Friends Life. On Friday morning, they struck our price target of 480.00 pence per share. 

The deal has been proposed as an all share acquisition that values Friends Life at £5.6 billion, which translates into a 399.00 pence per share offer to its investors.

The offer also represents a 15% premium to the market price for Friends Life shares at the time when the two companies announced that they were in talks to merge, although it will be paid in shares of the combined entity at a rate of 0.74 Aviva shares for each Friends Life ordinary share.

The market in general, as well as the wider analyst community, has been quick to voice displeasure with the decision to merge; with some calling it a “rights issue in disguise” on the part of Aviva Plc.

Despite our less than favourable coverage of Aviva to date, as well as the prevailing market opinion at present, we approach the proposed merger with an open mind. Below we assess the relative pro’s and con’s of the deal.  

Aviva Plc Share Price // Hourly Intervals

AVDECE

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About the Aviva Plc/Friends Life all share merger – the positives

As would be imagined, cost synergies are a big theme in the all share merger of Aviva and Friends Life.

This is because of the broadly similar nature of both businesses where the combined entity will benefit from greater scale, as well as reduced platform costs and lower physical infrastructure costs when it comes to things such as buildings and people.

Management estimates suggest that the combined entity could save as much as £225 million on an annual basis, while industry projections see the group beginning married life with as much as £600 million in surplus cash. This holds positive connotations for overall regulatory capital at Aviva, as well as for those shareholders who are holding out for a return to better days in terms of dividends.

The group will also benefit from greater cash flows and lower leverage as Friends Life assets dilute the gearing of Aviva’s balance sheet. This is further positive news from a risk perspective as it reduces the threat posed by the coming implementation of the EU’s Solvency II directive in 2016. In short, making it less likely that the group will fall short on regulatory capital.

The move would also enable both companies to minimise the impact of any further fallout in the UK annuities market as the effect of new pension rules becomes embedded.

This is as both companies previously drew significant revenues from their annuities businesses before changes to pensions regulations place the future profitability of these areas under threat. However, the tie up would enable Aviva/Friends to reduce costs here and to increase exposure to other areas of core competence, such as protection and pensions management.

In short, the upside in relation to the merger is the creation of a combined entity with lower leverage and a greater exposure to businesses which haven’t been as severely affected by the changes announced in the Chancellor’s budget earlier this year.

Such an entity would also be likely to have greater free cash flows and a brighter outlook for growth, therefore; Aviva would also have better chances of shoring up shareholder support with gradual increases to the dividend over the medium term.

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About the Aviva Plc/Friends Life all share merger – the negatives

Despite the obvious benefits to the Aviva Friends Life merger, there are also drawbacks, or to be more precise; risks for investors to consider.  

This is as, historically, the outcomes of M&A activity for both companies have been largely uninspiring; while history in general suggests that when it comes to large complex companies, there are a number of key risks that investors will need to assess going into the deal.

Most notably, cost synergies and scale benefits will rely heavily upon both platforms and processes being integrated or harmonised successfully, which is something that does not always happen.

Further from here the complexity added to the operation by combining two businesses together, at a time when simplification is a big part of the group agenda, could also deter or discourage investors.

Despite these misgivings, we feel that there is scope for the integration process to form a challenge that management are able to live up to over the longer term, as efficiency and cost control are fast becoming key strengths of Aviva under the stewardship CEO Mark Wilson.

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Summary / Verdict

In short, the proposed merger conforms with the strategic objectives of new management at Aviva in that it will be likely to generate both increased cash flow and growth.

We believe that the deal could be good for Aviva and therefore, that it would provide good value to Aviva shareholders. However, the question of whether Friends Life investors will take up the offer remains to be seen.

So far Aviva shares have taken news of the merger badly, falling substantially throughout late November and early December, to reach lows of 467.40 pence this Friday.

While the combined book values of both group’s could ultimately boost the shares in the long run, the current price for Aviva values the 0.74X shareholding of prospective Friends Life investors at just 360.00 pence, a greatly reduced premium upon the pre-offer price of 347.00 pence.

In addition to this, Friends Life investors will also need to be comfortable with forsaking a 6% dividend for what is today, a 2.9% yield at Aviva Plc.

Although there is scope for a return to dividend growth at Aviva, as a combined entity, this is only likely to happen over the medium to longer term and it is not yet clear whether the current offer is going to prove sufficiently attractive for Friends Life shareholders.

On the one hand, further share price growth at a standalone Friends Life will depend very much upon its ability to increases the dividend in future years, something which is far from guaranteed given the pace of progress in recent periods.

On the other hand, while offering a reduced dividend in the interim, Friends Life investors may be able to benefit from both further share price appreciation as well as what may be a faster growing dividend, given the reduced leverage and greater scale of a combined entity.

The above is in addition to the premium offered under the terms of the deal.

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Action

While it may take time to finalise, we ultimately believe that shareholders on both sides of the deal will endorse the merger and that over the longer term, the tie up will likely offer good value to both groups of investors. However, concerns over integration and complexity risks will also be likely weigh on Aviva’s shares for some time past the point of any shareholder approval in the New Year.

For this reason we see little scope for a sustainable recovery in the shares over the near term, and a high degree of likelihood that they will fall further from the current 467.40 pence during the weeks ahead.

Nevertheless, with the shares already down by 13% since reports of the deal first began to emerge, the further downside we speak of should be limited. Accordingly, we see strong support at the 450.00 pence level, while today we reaffirm our price target at 480.00 pence, reflecting our anticipation that the shares will average this price for the foreseeable future.

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