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Saga Plc; initial thoughts – 19 May 2014

Company Overview:

Saga was initially established in 1950 as a holiday provider for the over 50s generation. Since the group launched, it has diversified the range of products offered to its clients to include insurance, health care services and media (magazine).

The group claims to be the only commercial organisation in the UK that has an exclusive focus on the growing over 50s demographic. It holds a database of 8.4 million contactable households which, management estimate, covers more than 50% of the UK over 50s demographic.

The group is owned by a consortium of private equity groups made up of Charterhouse Capital Partners Llp, CVC Capital Partners and Permira Advisers Llp. Saga is currently held alongside AA within the holding company Acromas, which was created during a 2007 buyout of the two groups. The private equity consortium is expected to maintain full control of the AA, which is not included in the sale.

The private equity owners have made several attempts to exit their stakes in the business before now although it is not entirely clear why previous IPO plans never went ahead. The consortium is expected to maintain a meaningful portion of their stake in the business after the planned IPO.

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Saga, Initial Thoughts

Riding high on a wave of earlier IPOs, mergers and buyouts, the April announcement by the owners of Saga that they intend to float 18% of the group on the London Stock Exchange on 23 May has led to weeks of building expectations that another Royal Mail-style bonanza could soon be in the offing.

Today’s report sets out to explore what life as a listed company is likely to have in store for Saga, while attempting to answer a number of questions that have been mooted throughout the build up to the IPO.

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Changing Demographics and What They May Mean for Saga

Saga has traditionally been a travel and holiday’s group that caters for the over 50s market; however, over time it has expanded to develop a significant footprint in the motor and home insurance markets. In response to the ageing population of the UK, the group has more recently entered the health care arena with a home care offering to local government authorities.

The 2013 year saw the group win an additional contract for the provision of domiciliary and home care services on behalf of Kent County Council. Under the terms of the contract, the number of hours of care provided by the group will triple from 4,400 to 13,800, which bodes well for management’s long term plan to dilute the business’s reliance upon insurance services.

While the board’s plans may enable Saga to avoid being completely reliant upon earnings from insurance, it will first have to manoeuvre around the intense competition for local government contracts on a broader basis before the health care division will be able to meaningfully dilute the contribution to earnings of the breadwinning insurance business.

In addition to a push into home care, Saga also intends to cultivate a greater wealth management presence. Although this could prove a potentially lucrative proposition over the longer term, the market here is intensely competitive. This is also an area where the group’s existing database of eight million contactable households, while reducing marketing costs, may not actually improve upon Saga’s ability to penetrate the market.

There are a number of reasons for this, most notably that many active investors are likely to question the experience and skill set of Saga when it comes to wealth management. This is while alternatives to an in-house “full service” offering such as the once popular white label and IB agreements (introducing broker) have now worn thin among the retail investor community, with many now sceptical over the cost effectiveness and overall value proposition of such schemes.

As a result, any eventual success that the group has within this arena will be likely to accrue slowly over time. For this reason and in a similar manner as with the health care proposition, it is unlikely to have sufficient impact upon the business’s earnings over the near term in order to mitigate the risks that come with its high degree of exposure to motor and home insurance.

This is while the more traditional Saga offering such as travel and cruise services comprise only a small portion of earnings today. Although many will argue that demand for the group’s products and services should increase broadly over the medium to longer term given the increasing proportion of the population due to reach retirement over the next two decades, this is not guaranteed.

With UK household savings rates in terminal decline, living costs rising and the prospect of home ownership for much of the population rapidly diminishing, future pensioners are now facing the possibility of spending many of their retirement years having to manage higher costs with reduced real incomes and lower capital provisions relative to the retirees of today.

This presents Saga with the risk that discretionary spending among the senior population will decline over the years and decades ahead, which will more than likely negate or detract from the effect of growth in the proportion of the population that is old or retired.

The below graphic details the 45 year trend in UK household savings rates as a proportion of overall household income, as recorded by the Office for National Statistics.

UK H SAVE

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General Insurance Outlook

One of our preferred themes throughout much of 2013, as well as the current year, has been a renaissance in the general insurance market. Much of the rationale relating to our positive bias toward these insurers is centred on the gradual withdrawal of monetary stimulus which is now taking place across the UK and the US.

Central bank policies lifted global stock markets, in many cases to record highs, throughout the last eighteen months. One area where they haven’t had such a positive impact, however, is in the performance investment portfolios for many of the general insurers in western markets. 

Given the significant exposure to fixed income assets within many such portfolios, and yield compression which has resulted from central bank monetary policy, under performance and reduced income has been a prevalent theme in the financial results and investor presentations of many leading UK insurers for some time.

When defending a 2013 dividend cut, Aviva Plc Chief Executive Mark Wilson described the battle to sustain the group’s shareholder pay out, against a backdrop of declining yields, as like “walking up a never-ending escalator that’s going down — it’s possible to climb up but eventually the escalator wins.”

With the Federal Reserve now slowing the pace of its record QE programme, and the UK predicted to be the first developed nation to raise interest rates, it is fair to say that the slow transition toward a rising rate environment has already begun in some places. When interest rates do eventually rise, we would expect investment income for general insurers (non-life) to slowly begin to improve. This will be positive for earnings at many of the UK’s insurance houses, including at Saga.

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Motor and Home Insurance Outlook

Changing regulations have proven both costly and challenging to other motor insurers. This is while intense competition in the UK market has driven down premiums persistently over a sustained period. The current outlook for premium rates, according to most industry participants, sees little chance of a change in this dynamic over the near term.

Other motor insurance companies such as Admiral Group have made efforts to diversify away from sole reliance upon the UK by expanding into Europe and the US. Direct Line has attempted to offset the impact of changing regulations and falling premium rates by diversifying into other lines of insurance.

At present the outlook for home insurance premiums also remains uncertain. The ABI (Association for British Insurers) told the Financial Times, during  an interview at the beginning of the year, that the bad weather which swept across the country over the Christmas period is unlikely to materially affect overall 2013 results for UK home insurers. This was while James Rakow, insurance partner at Deloitte, described the 2013 year as “one of the best years for claims since 1994”.

Given a decline in the volume of claims recorded by the Association of British Insurers (ABI), many analysts expect premiums to fall over the course of 2014. While not guaranteed, this could have an impact upon the bottom line of home insurance businesses over the course of the 2014 year, particularly in the event of an extreme weather event. Under this scenario Saga would certainly be affected.

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Sweet Carrots for Early Investors

While concerns exist about a number of aspects relating to the May IPO, Saga and its private equity owners cannot be accused of not at least trying to sweeten the offer for prospective investors. This is as the group has pledged to provide all who subscribe to the IPO, under the customer and employee offers, with one free share for every 20 that they purchase.

The offer is subject to a minimum holding period of one year but nevertheless sugar coats a pill that after much thought and consideration may not quite be so deserving of all of the positive publicity which has surrounded it and the IPO over recent weeks.

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An Identity Crisis or Something More? The Tale of a “Non-Insurance” Business that Draws 88% of its Profits from Insurance

At the company level, the outlook for Saga on a fundamental basis is uncertain. This is while much of the present opinion and feeling toward the flotation remains mixed due to concerns over the categorisation and valuation of the shares.

In our view, and given that 88% of 2013 underlying EBITDA (earnings before impairments, taxes, depreciation and amortisation) came from the group’s insurance lines, it seems as if it would be a natural move to label Saga as an insurer and to see it listed under the non-life segment of the FTSE 350.

Despite the fact that the future plans management have for Saga are likely to require time before they have a meaningful impact upon the business’s earnings profile, the private equity owners of the group have, against conventional wisdom, pushed to see Saga Plc listed within the consumer services sub-sector of the FTSE 350.

Dignity Plc, the funeral provider, is the only other listing within this segment and currently trades on a multiple of 18.6 X 2013 earnings. Should Saga float at the mid-higher end of the offer range, it will easily achieve a valuation of between 18.5 and 24.5 X 2013 earnings.

Such a multiple, although still in premium territory, is more palatable when stood next to the 18.6 X earnings of Dignity as opposed to the 11.9 X earnings multiple average of the UK non-life insurance sector.

In our view, it is for this reason that the current owners have chosen to pursue listing under the consumer services sub-sector which misrepresents the true nature and value of the business.  This is because, if Saga were to list in the non-life insurance section of the FTSE 350, the private equity consortium behind the IPO would be likely to find themselves force fed an exit price that is considerably lower than the 245.00 pence they are set to achieve this month.

Based upon the industry average earnings multiple and Saga’s 2013 EPS, we calculate that a fairly priced IPO, under the non-life insurance heading, would see the current owners achieve an exit price which is at or slightly below the 119.00 pence level.

When viewed from this perspective, it is understandable how one can begin to see the private equity consortium, the Saga IPO and all of the hype as well as hoorah that have so far accompanied the process in an entirely different light.

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Smoke, Fire and some Mirrors; Poor Performance of Year Ending January 2014 Relegated to Page 100 in Prospectus

In line with the adage that there is no smoke without fire, the attempt by Saga’s owners to outmaneuver a fair valuation of the shares has not been the only example of distasteful practice during the run up to the IPO.

The prospectus issued earlier during the month provided an overview of Saga’s financial position and performance during the 2013-14 year. In it, the group described its recent performance by saying that it had grown both revenues and profits by 7%  and 1.3% respectively between the January 2012 and January 2014 period. (pages 8 and 9 – excerpts at the bottom of this section).

The group attributes the increase in top and bottom line to the acquisition of Allied Healthcare Group at the close of 2011; however, it does also state that gains here have been “partially offset” by one-off refinancing costs, integration costs and the recognition of fair value losses. What this segment of the prospectus does not explain, or draw reference to, is what happened during the year of January 2013 to January 2014, the more recent and most relevant reporting period. During this time, unbeknownst to many, the group actually experienced a decline in both revenues and profits.

This is completely ignored until page 100 which is far, far from the areas where material information should be contained. Some would even go so far as to suggest that this information was deliberately left out, while the reporting period was changed from one to two years in length in order to disguise the fact the group is exhibiting symptoms that suggest it could be experiencing a slowdown in its core markets. Once eventually onto the subject, the group cites declining premium rates in the motor insurance market and increasing competition as the main drivers behind its reduction in earnings.

While such action is questionable from a regulatory perspective, it also leaves a sour taste in the mouth for other reasons. For one, it denotes a sense of urgency or desperation by the owners to begin its exit from the group.

Secondly, with very little financial information or professional opinion available in the mainstream outside of the prospectus, and given that the over 50s customer base is the demographic which the shares are being most heavily marketed to, it is difficult to envision that very many of the IPO investors will fully understand the group’s financial position, recent performance or the challenges it is likely to face in the future.

The obvious consequences of this are potential bad feelings from investors toward the group as well as increased volatility in, and potential downward pressure upon, the shares over the near to medium term. The below graphics are taken from the full prospectus for the share offer. 

Income 1

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Extraction from the Accompanying Text

Saga Income Statement Text

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Valuation and Dividend

On a valuation basis, the shares are due to commence trading at a significant premium to any comparable company. Based upon the price range provided, Saga should achieve an earnings multiple that is somewhere between 18.5 and 24.5 2013 earnings.

This is significantly more expensive than the many higher growth insurers listed on the FTSE 350. Hiscox Ltd, a rapidly growing and diverse business with good underwriting history, trades on a multiple of just 10.5 X 2013 earnings.

In a similar fashion Admiral Insurance, the immensely successful pure motor insurance business, currently trades on a multiple of 13.5 X 2013 earnings. This is while Aviva Group, which is perhaps one of 2014’s more promising recovery plays, currently trades on a multiple of 7.9 X 2013 earnings.

Prudential Plc, a diversified financial services group with significant exposure to life assurance and asset management, currently trades on a multiple of 15.3 X 2013 earnings.

The aforementioned companies combined form a significant chunk of the UK listed insurance sector that, on average, trades on a multiple of 11.9 X 2013 earnings. As a result, the offer price range put forward by the private equity owners of Saga Plc leaves the group considerably overvalued, on a price to earnings basis, relative to any other comparable company.

Although some would argue that Saga management intend to diversify the business away from insurance and towards other areas such as health care, the day when the group is likely to earn a significant enough income from such operations to warrant classification as either a health care or an outsourcing firm remains some way off.

For this reason, we view the existing business as one concerned predominantly with the provision of insurance services and have used this view as the basis for forming our valuation perspective. We believe, based upon the information available, the proposed offer price will leave the shares excessively overvalued from a price to earnings perspective.

In relation to dividends, the group is expected to adopt a progressive dividend policy that will see 40 – 50% of post-tax earnings returned to shareholders through dividends. Based upon 2013 earnings per share (proposed number of shares) of 10.00 pence, a 40/50 % pay out will provide Saga with a yield of just under 2%, assuming a flotation at the higher end of the offer price range. Should the shares IPO close toward the lower end of the range then we would expect a yield that is in the region of 2.5%.

Our view of the dividend is one of disappointment. This is because, for a company that is paying out half of its earnings in dividends, most income investors will expect a yield that is greater than 2%. We feel that the inability of the group to pay a reasonable yield with the shares, despite stretching the pay out: income ratio as far as is prudently possible, is a further indication to us that the shares are being priced excessively high by the exiting private equity consortium.

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Risks

While over the medium to longer term Saga management have every chance of successfully diversifying the group’s income stream and continuing as a successful business, the short-term outlook sees a high degree of risk attached to the actual shares.

The most predominant risk facing investors in the near term relates to the valuation that will result from the proposed IPO price. The earnings multiple that a flotation at the higher end of the range would imply will mean the shares begin trading at a price to earnings multiple that is more than double that of even the most impressive FTSE-listed insurer.

Based upon the same metrics, the shares would also commence trading at a 30% premium to that of the single other Consumer Services Sector listing on the FTSE. This is while a dividend pay out of 40-50% of earnings implies a yield that will, in all probability, struggle to keep pace with inflation. Each of these dynamics leaves the shares vulnerable to a substantial revaluation toward the downside over the months ahead.

In addition to this, the underlying business also faces challenges within the external environment, most notably that the motor insurance market remains subject to declining premium rates and the costs of increasing regulation. This has the potential to keep already declining revenues and profits under pressure which, again, threatens the shares.    

Further, considering that the group has marketed a large portion of the allotted shares to its customer base, it also runs the risk of accruing bad feeling toward the company should the shares perform poorly over the months and years ahead. This could also threaten revenues and profits in the future as much of Saga’s business comes from repeat custom (80% +).

The group also carries a substantial debt burden upon its balance sheet which threatens to become more and more expensive to service once interest rates begin rising. This is because the group’s track record with hedging interest rate risk appears poor.

Acromas, the holding company, revealed in its full year 2012 results that the group had suffered due to taking on costly interest rate swaps while base rates were in terminal decline. As a result, the group is believed to have terminated the swap agreements and replaced them with variable interest rate caps which, according to the report, will expire at their current levels in September 2014.

While not an exhaustive list, the final risk that we shall draw attention to today involves Saga’s expansion plans. These see the group moving further and further into highly competitive areas of business that could be said to be outside of its skill set.

While the plans have the potential for success, they could also, over the longer term, prove to have been a costly exercise either because of failure or because they were slow to get off the ground.

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Summary

We believe that the current owners will achieve the higher end of the offer price range at IPO and that the potential exists for over subscription to result in the shares being chased higher throughout the days immediately following the float. Despite this, and based upon the information available at present, our initial thoughts on the shares remain uninspired while our outlook over the medium to longer term is, at this point, broadly negative.

The group’s deliberate assignment to the consumer services segment of the FTSE 350 appears to be an exercise by the private equity owners to avoid a fair valuation of the shares. This is most likely so that the consortium can boost profits and ensure an above fair value sale price across the multiple public offerings that will need to take place over the months and years ahead in order for them to fully exit their stake.

We also hold concerns over the way in which material information has been presented in the prospectus and, as a result, are unsure if the over 50s client base, which as a group is likely to form the largest buyer of them, has a clear understanding of either the group’s recent financial performance or the future investment case for or against the shares. If this is the case, uncertainty surrounding the future trajectory of the shares is likely to increase during the weeks and months ahead.

In short and to summarise, we maintain our view that Saga Plc is an insurance business and that it warrants classification as such.  We feel it is more likely than not that the market will eventually re-rate the group as an insurer, once floated, and that this would involve a substantial reduction in the share price.  

Consequently, we believe that the shares would be fairly valued at or around the 120.00 pence mark, and not within the intended 185.00 – 245.00 pence range. While our outlook at present is a bearish one, we will monitor the group over time and endeavour to keep all of our members up to date with developments that affect the outlook over the shares.

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IMPORTANT:
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