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Beazley Plc – Initiating Coverage; 04 December 2014

Company Overview

Beazley Group was established in 1986 as a Lloyd’s market syndicate operating under the name of Beazley, Furlonge & Hiscox.

Today, Beazley Plc is a FTSE 250 listed specialist insurer in its own right, with a global reach. The group offers specialist risk insurance along with reinsurance services and a range of additional lines. It operates under a number of segments, which include; (Life, Accident and Death), (Marine), (Aviation), (Political Risk and Contingency), (Property), (Reinsurance) and (Specialty Lines).

2013 saw Beazley celebrate 28 years of profitable growth, which culminated in total managed gross premiums reaching $1.98 billion during the period. For the same year the group also achieved a return on equity of 21%, an industry leading combined ratio and paid dividends that when toted up, equated to a total yield for investors of almost 10%.

Index FTSE 250 Ticker BEZG.L Latest Close 271.90
52 Week High 274.20 52 Week Low 227.78 P/E (H) 8.27X
Dividend Yield % 3.4% Dividend Cover 3.7X CEO: David Horton
CFO: Martin Bride Price Target N/A

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Non-life insurance sector investment case revisited

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 also reached record lows and many have been forced to restructure their balance sheets as well as seek alternatives to traditional fixed income.

The consequence of this has been highlighted in dividend cuts by both RSA Insurance and Aviva during the early stages of 2013. However, with both the US and UK economies firmly on the road to recovery, the Federal Reserve has completed its tapering program and the Bank of England has also repeatedly signalled that a tightening of policy could now be on the horizon.

With this, two of the world’s major central banks have de-facto announced the beginning of the end for an era of ultra loose monetary policy in developed markets.

Just one of the obvious consequences over the coming quarters will be a moderate trend higher in fixed income yields of most maturities. With this in play and valuations across the sector still attractive, we turn once again to the insurance sector for opportunity by introducing Beazley Plc into our coverage universe.

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A best in class performance from Beazley Plc so far in 2014

While 2014 has proved a lacklustre year for many of the blue chip indices in the UK, Beazley Plc shares have continued to outperform both the non life sector as well as all major indices throughout the period. More interestingly, both companies have now outperformed their peer group over a 1, 2 and 5 year period.

This follows several years of strong performance where, despite a low interest rate environment, the group has continued to generate attractive levels of earnings growth and consistent increases to returns on equity.

In addition to earnings growth, Beazley has also adopted a conservative approach to the management of its reserves throughout the years since the financial crisis, which supported higher cash returns to shareholders for the 2013 year and is expected to continue doing so in subsequent periods.

In the remainder of this report we outline why we believe that there is scope for Beazley’s relative out-performance is set to continue for the foreseeable future.

Beazley Plc Share Price // Weekly Intervals

BEAZLEYPLCINITIATINGCOVERAGEWEEKLYCHART

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Beazley Plc & general non-life insurance sector outlook – earnings in the spotlight

Despite the difficult macroeconomic backdrop, earnings have proven resilient at the UK’s major insurers during recent years.

Some have cited that much of this is due to “earnings lag”, or the delay between when policies are written and when those policies become actual earnings, therefore implying that the difficulties of recent years will be reflected by lower earnings in future periods. However, we disagree with this sentiment.

While we acknowledge that strong financial market performances during 2013 had a substantial positive impact upon earnings for many insurers, and that this is unlikely to be repeated again this year; we see no reason for a significant or sustained backwards movement in earnings for the non-life insurers here in the UK.

Although there are sector specific, as well as case by case, risks to this outlook; we believe the best days for general and specialist insurers are still to come.

In support of this view, we note stable earnings expectations for insurers over the last 18 months, reflected by a lack of upgrades or downgrades to consensus estimates.

This comes in contrast to other sectors across the wider market where, in most cases, upgrades have been frequent as economic growth expectations were revised higher throughout late 2013 and early 2014.

With economic growth, most notably in the euro-zone & the US, under-performing against upwardly revised estimates throughout the year to date; some segments of the analyst and investor community now see it as most likely that earnings expectations across the wider market are overdue a downgrade.

“Given Eurozone GDP was precisely zero in H1 2014, we would question whether in fact we are not due another round of earnings downgrades in a number of sectors during the months leading up to year-end results – absent a very strong economic recovery that is so far proving elusive” – Berenberg Bank, September 2014

This implies that a certain degree of out-performance from the sector is still likely, relative to the market, which supports our long held view that certain segments of the insurance industry continue to offer good value. This is particularly the case when considering the evolving monetary policy environment in the UK and the US, which we still expect to boost earnings over the medium to longer term.

The sector currently trades on a multiple of 11.44X projected 2014 earnings, which compares well with the FTSE average of 15.4X, the life insurance average of 16.4X, the financial sector average of 18X and the banking sector average of 25.1X.

We see this valuation as providing a firm cushion against any notable downside for the large cap non-life general insurance sector. The below graphic illustrates the out-performance of Beazley Plc relative to many of its nearest competitors, as well as the FTSE 100, throughout recent years.

The graphic also highlights the out-performance of the specialty end of the general non-life sector, with both Hiscox Ltd and Beazley Plc holding a clear lead over the rest of the class.

Non-life Insurance Sector Overview (Benchmark FTSE 350, Yellow)

INSURANCESECTORTHEONE

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Divisional overview and assessment; Significant unlocked value exists within Beazley’s largest insurance book

In addition to the potential for an improvement in investment income over the coming periods, we also see further unlocked value within Beazley’s existing insurance books. Most notably, the group’s specialist lines division is of particular interest to us.

We see substantial value in this book, which currently accounts for 36% of premiums written, but yields little profit at present. With premium rates having traced a downward trajectory for a number of years since interest rates reached their current record lows, the division’s combined ratio has deteriorated markedly; remaining close to 100% for an extended period.

More of interest to us, is the 2012 & 2013 trend in pricing within specialist lines. This is as both years saw a 3% increase in average premium prices, indicating that a cyclical turn could be underway. If this is the case, or when does happen; there will be scope for the recent increase in the group’s expense ratio to become diluted. This would be expected to have a net positive effect upon earnings at Beazley.

Our calculations show that if the Specialty Lines division’s combined ratio were to converge with the group average, while gross premiums held constant, then this could add as much as 9% to earnings at Beazley Plc.

In addition to the potential within specialty lines, the group holds a significant exposure to reinsurance, property and marine insurance.

The current environment for reinsurance is not favourable and many of the diversified insurers are scaling down their participation in this area for the time that rates remain under pressure.

The group’s property division is the second largest within the business, after specialty lines. This underwent an upturn during 2013 as both costs and claims fell throughout the year, reflecting a benign environment for weather related incidents; despite floods in certain segments of the UK and Europe.

Marine insurance, the third largest business segment, also experienced a good year as both claims and costs fell here too.

However, the group’s life insurance business went from fractional profitability to running at a loss throughout 2013 leading management to begin further scaling back their exposure to this area.

All in all, Beazley is an attractive business that has, like Hiscox, enjoyed a long stretch of uninterrupted growth. This has been reflected in the group’s share price which, similar to its leading competitor, has outperformed the wider sector several times over in recent years.

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Balance sheet, dividend and valuation

In relation to the balance sheet, leverage at Beazley appears to be relatively low. The group currently has $169.5 million in borrowings, which rises to $394.5 million when undrawn bank credit lines are factored in. This leaves debt to equity for the group at 0.09, or 9%; which is low for any blue chip listed company.

For this reason we see little cause for concern on the liability side of Beazley’s balance sheet, with overall leverage low and liquidity measures robust. However, we do caution that this is subject to change.

Should group claims be impacted by any one of a number of events, then it could of course be forced to either tap undrawn lines of credit, or to raise additional debt; which would have a detrimental impact upon earnings and balance sheet health.

In terms of dividends, 2013 saw the group pay both an interim and final dividend which totalled 8.8 pence per share, equating to a yield of 3.4% at current prices.

In addition to this, management also paid a special dividend of 16.1 pence per share, taking the total payout to 25.0 pence per share for the period. This provided investors with a total dividend yield of 9.2% for the year.

The standard dividend was covered 3.7X over by earnings, while the total dividend was covered 1.15X over. Consensus expectations are for a similar payout policy to be maintained for the current and subsequent year, supported by conservative management of reserves throughout previous reporting periods.

From a valuation perspective, the group currently trades on a multiple of 8.27X 2013 earnings and 10.33X consensus projections for 2014/15 earnings. This compares well against the industry average of 11.44X.

Our own internal model suggests that fair value for the shares exists somewhere between 299.00 pence and 322.00 pence per share. This is as on a price/TNAV basis we see fair value at 307.00 pence, while on a price to earnings basis we see the shares fairly valued between 299.00 pence and 322.00 pence per share.

Both of the above measures suggest a minor discount by the market, which currently prices Beazley Plc at 279.00 pence per share.

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Risks

Beazley Group is exposed to the risk of natural disasters and other 1:100 and 1:200 year events that could have a significant adverse impact upon earnings without warning. The group is also exposed to political and geopolitical risk through some of the larger ticket and more specialist policies which it underwrites.

A reasonable portion of our investment case is dependent upon the normalisation of monetary policy in core markets such as the US and the UK. While the US remains on track to raise interest rates in 2015, and a consensus remains in place for rates to reach 3% by 2016, this outlook could change if macroeconomic factors were to lead to a downturn in economic activity and the data no longer supported a return to normal policy conditions.

The above changes have been seen in the UK during the third and fourth quarters of 2015, where a persistent deceleration in inflation expectations has led to interest rate expectations being revised backwards, or kicked further out along the road. A repeat of this in the US could lead to an extended period of suppressed investment returns and lower pricing in reinsurance, which would have a negative impact upon earnings expectations for both Beazley as well as its peer group.

Beazley also faces significant regulatory risks in that the new Solvency II regime in Europe, due for implementation in January 2016, could see the group forced to hold more capital against its insurance book.

In addition to this, the renewed focus of UK regulators upon systemic risks posed by insurers could also see the group forced to keep more capital in reserve, or to raise more cash through debt or equity capital markets, in order to satisfy reserves requirements. While we view the risk of this happening as slim, it has to be acknowledged as a possibility.

Overall we believe the risk facing Beazley investors are moderate. While it is not possible to predict when either a 1:200 year event will occur, or when regulatory changes will wrong foot management, we believe that the group’s conservative approach to reserve’s management during recent years is sufficient enough to minimise the fallout from either of these.

If anything, of greater concern would be the out-performance of Beazley relative to its peer group during recent periods and the resultant sensitivity to a downgrade to earnings expectations or a deterioration of the external environment for the group.

However, our attraction to the shares is greater in relation to the medium – longer term and our investment case factors in, if not, depends upon the likelihood of a correction over the near term.   

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Summary

All in all we are attracted to Beazley Plc both because of an attraction to the non-life insurance sector in the UK as well as because we believe that there remains unlocked value within the business.

Our assessment of the group sees the shares currently trading at a reasonable discount to fair value, with a positive outlook for growth over the medium and longer term. This is while we see risks to the overall business as moderate and balance sheet risk as minimal.

To repeat our valuation assessment; our own internal model suggests that fair value for the shares exists somewhere between 299.00 pence and 322.00 pence per share. This is as on a price/TNAV basis we see fair value at 307.00 pence, while on a price to earnings basis we see the shares fairly valued between 299.00 pence and 322.00 pence per share.

Both of the above measures suggest a discount to fair value of between 7% and 15% by the market, which currently prices Beazley Plc at 279.00 pence per share. We see no reason for this, given that both the group outlook as well as the sector outlook is largely positive. Therefore, we expect this discount to diminish over time.

However, from a technical perspective the shares are now entering into overbought territory, following their strong run throughout 2013 and 2014. Therefore, we caution that a correction is likely in the near term, and are reluctant to become overexcited about the shares until this has played out.

Our technical analysis suggests that any downside from the current price should remain limited to 240.00 pence, although this itself implies potential losses of 15% from the current level.

In short, we see scope for further gains over the medium to longer term, beginning with the erosion of a 15% discount to fair value. However, we also see scope for losses of up to 15% in the short term. This is largely the result of technical factors.

To conclude, our baseline is that the shares are attractive at current levels although we anticipate that a correction in the near term will provide a more favourable entry point for new investors, while medium to longer term price action would be likely to yield a more favourable exit opportunity for existing investors.

 

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