Category Archives: Value Stocks

ITE PLC (ISIN GB0002520509) – Super profitable market leader in Russia at a bargain price ?

After a “Near death” experience with Sistema, I am nevertheless still interested in companies with significant Russian exposure as a “counter-cyclical” EM play, however preferably with less “Oligarch” risk. A very interesting company with a significant Russia exposure is ITE Plc, the UK-based company. According to Bloomberg

ITE Group Plc is an international organizer of exhibitions and conferences. The Company provides
its services to customers in a variety of commercial and industrial sectors, including travel and
tourism, construction, motor, oil and gas, food, security, transport, telecommunications, and
sports and leisure.

The good thing with UK companies is that usually some blogger has covered the stock already. WIth ITE, this is the case as well. Among others, there is a very good Seeking Alpha post, from the Portfolio 14 blog and als the Interactive Investor covers the stock.

I agree with all posts. Organizing exhibitions is good business:

+ you don’t need a lot of capital (negative working capital due to prepayments)
+ once an exhibition is established, it creates a network effect which is relatively difficult to duplicate
+ although the business fluctuates with the cycle, costs are to a certain extent variable
+ it’s a nice b2b business, connecting a large number of exhibitors of with a large number of interested visitors
+ despite or because of e-commerce, personal contact in the form of trade fairs etc. seems to become even more important
+ the company has no debt

The “catch” is of course that most of their exhibitions take place in Russia and the former GUS. Clearly, not the easiest part of the world to be at the moment.Looking at the past 16 years since their “reverse IPO” in 1999, we can see that the business has suffered in downturns such as the Russian default but always recovered. However, mostly due to the weak ruble, comprehensive income in the last few years was mostly lower than stated income:

Year EPS Compr. Income In% of EPS
29.12.2000 0,03    
31.12.2001 -0,13    
31.12.2002 -0,01    
31.12.2003 0,03    
31.12.2004 0,04    
30.12.2005 0,07    
29.12.2006 0,07 0,07 99%
31.12.2007 0,09 #N/A N/A #WERT!
31.12.2008 0,09 0,09 97%
31.12.2009 0,13 0,11 86%
31.12.2010 0,10 0,12 121%
30.12.2011 0,13 0,10 82%
31.12.2012 0,13 0,13 98%
31.12.2013 0,14 0,09 64%

The valuation looks quite cheap, especially the EV/EBIT and EV/EBITDA ratios for such a business with high (historical) growth rates:

P/E ~9
EV/EBITDA 5,9
EV/EBIT 7,0
P/B 4,4
Div. Yield 5,0%

After reading some of the reports, I found a couple of things I didn’t like:

- focus on “headline” profits, excluding amortizations and “restructuring charges”
– Management fully incentiviced on “Headline profits”, not ROIC or ROE etc..
– Falling knife Stock chart
– one of the biggest “rainmakers”, Edward Strachan retired a few months ago.
– trade fares and exhibitions often have a time lag of 6-12 months to the general economy. So the worst in Russia for ITE might come only in the next few quarters.

Peer Group

There aren’t that many “pure play” trade fare /exhibition companies listed but I tried to compile a list to the best of my knowledge. Two of the companies listed below (Kingsmen & Pico) are actually more supliers to exhibitions than promoters/organizers:

Name Mkt Cap (GBP) EV/EBITDA EV/EBIT P/E P/S
ITE GROUP PLC 434,5 5,3 7,0 9,9 2,2
TARSUS GROUP PLC 198,7 7,7 12,0 16,4 2,6
UBM PLC 1267,5 9,6 14,4 9,9 1,7
MCH GROUP AG 237,8 7,2 13,9 11,9 0,8
FIERA MILANO SPA 182,0 156,0 #N/A N/A #N/A N/A 0,9
KINGSMEN CREATIVE LTD 87,1 5,9 6,4 10,9 0,6
PICO FAR EAST HOLDINGS LTD. 182,6 6,7 9,6 11,2 0,7

If we look at P/Es, most of the companies trade relativelly cheap at around 9-11 times earnings, but long term ROE and margins at ITE are clearly a class of its own. The big question is: Can they sustain those margins in the long run ? Many of the listed peers as well as the unlisted ones like Deutsche Messe tried (at least before the crisis) to get into the Russian market.

The problem could easily be that ITE is too profitable. Past average net margins of 20%-25% are far higher than any of the competitors. Deutsche Messe for instance, which aggressively expands into EM earned a net margin of 3% in 2013. Clearly, It is not so easy to kick out ITE, but if the difference in margins is so big, at some point in time competition will begin to bite. although it’s not easy to establish a succesful trade fair or exhibition, it is relatively easy to start one. So yes, there is a network effect but the barriers to entry are still relatively low. A good example for this can be seen currently at TESCO in the UK. For quite some time it looked that they are protected by their dominant position and had margins 2 or 3 times higher than their continental peers. But once the competitors like Aldi and Lidl, who could only dream of such margins in other markets, were big enough, margins for the leader deteriorated pretty quickly.

Valuation

Based on what I described above, I would make the following assumptions:

- going forward, net margins will be lower than in the past. In the past they achieved margins of 20-25%, I will calculate with 18% (thats what they made in 2012 and 2013)
– in order to reflect the additional risk in Russia, I will require more return. My normal requirement would be 15%, here i need 5% more or 20% p.a.

So if I assume that in 3 years time, ITE will again do the same amount of sales as in the FY 2013, this would be 0,80 GBP per share. At 18% Net margin, they would then earn around 14,4 pence per share. A “fair” P/E for such a company could be around 15. So the 3 year target price would be 14,4*15= 2,16 GBP.

However, in order to earn my 20% p.a. , I need to discount my target: 2,16/ (1,2)^3 = 1,25 GBP. This is however a lot lower than the current price of 1,70 GBP

So for me, under those assumptions, LTE is not a buy, I would buy once the price is at or below 1,25 GBP per share.

Summary:

It really took me some time with ITE Plc. I really like the business model of trade fair /exhibitions. Although cyclical, it seems to be good business with a certain protection. For ITE however, I fear the worst is yet to come. With the oil price plunging and the “Russian situation” unchanged, including more potential trade sanctions etc., the next year will be even harder than the last for ITE.

I would stil buy them if they are cheap enough, which, at the moment they are not. They would need to drop a further 30% in my opinion to make them really intersting and compensate me for the additional risk. I will however try to look at some other similar companies going forward. Especially Pico Far East and Kingsmen looked interesting at first sight.

It could easily be that I am too cautious due to my losses with Sistema (“Recency bias” ?), but at the moment I rather make the mistake of being too conservative.

Short cuts: KAS Bank & Van Lanschot

Both Dutch Banks in my Portfolio, Van Lanschot and KAS Bank reported 6 month numbers last week.

Van Lanschot

Van Lanschot’s 6 month numbers were relatively solid in my opinion. 6 months EPS were 1,14 EUR per share, however this includes certain one-offs from asset sales. The underlying wealth manangement business seems to have stabilized. Net interest income is slightly going down but this is the result of shrinking their loan portfolios and was expected. The stock price reacted quite positively on those numbers:

What I didn’t like at all was the fact that within the comprehensive income, they burried a large increase in their pension reserves of around -82 mn before tax. This is around 10% of gross pension liabilities and wiped out all the profit of Van Lanschot in the first 6 months (comprehensive income was actually negative). Unfortunately, there is no explanation given. I Have sent an Email to IR in order to understadn this better.

KAS Bank

Similar to Van Lanschot, KAS Bank presented very solid 6M numbers including a big one time effect. They received 20 mn EUR as compensation for letting German dwpbank out of an outsourcing contract. Underlying profit without this one off increased nicely, although mostly due to cost savings than higher revenues.

Compared to Van Lanschot, the stock price did very little:

Maybe this has to to with a somehow muted outlook and the decission to fully reinvest the dwpbank payment. Nevrteheless, for me KAS Bank seems to be on a very good way and is rather a buy on weak days. I still think that KAS Bank should trade at least at book value which is around 14,50 EUR per share.

KAS Bank in my opinion is also a very good and cheap interest rate hedge. If short term rates rise, this will directly benefit KAS Bank’s result within a very short time frame. I do not have an active opinion on interest rates, but it is a nice “add on” to the investment case.

Short cuts: Installux, Gronlandsbanken, Admiral

Installux

Compared to Poujoulat and other French company, Installux released almost sensationally good 6M results. Sales went up +3% which is quite impressive for a domestic, France focused company and net result went up almost +14%.

According to the half year report, cash is now around ~86 EUR per share. Only with the 15,80 EUR 6M Earnings per share, Installux would trade at a single digit p/E ex cash even if they make no profit at all in the second 6 months. With a realistic 25-30 EUR per share for the whole year, we are at an cash adjusted P/E of somewhere between 5-6. In my opinion, despite the illiquidity, Installux still offers a great return/risk profile.

Gronlandsbanken

Grondlandsbanken delivered very strong 6 month numbers. 6 month profits of 30 DKK per share were almost 20% higher than in 2013, althhough there were significant positive one time effects included (valuation and disposal gains). Nevertheless, operating results also increased yoy despite overall still muted economic activity. What I found most interesting in the report was this statement from the outlook:

After a weak socio-economic growth and negative GDP in 2012 and 2013, no or a weak growth in the Greenland economy is expected in 2014, however, still with much uncertainty. In the expectation that the prices and
quantities of fish hold steady, that no raw material projects are initiated, but that large construction activities will start in the second half of 2014, the bank expects an increase in activity in 2014. It is, however, si gnificant that the activity in Nuuk remains low, while there is in creased activity in a number of coastal towns. A noticeable activity increase is thus essentially not expected until 2015.

So it seems to be that finally the big projects will be realized with a delay. As Gronlandsbanken has shown that they can increase earnings even without economic growth, I think the stock is “worth” to be upgraded to a “half position”. I will therefore increase the position from 1,9% to around 2,5% at current prices.

Admiral

Already a few days ago, Admiral released H1 2014 numbers. Looking at the stock price, many investors seem to have been dissapointed:

Analysts have mostly lowered their ratings and/or price targets:

Firm Analyst Recommendation Tgt Px Date↑ 1 Yr Rtn BARR Rank
Credit Suisse Chris Esson neutral 1350 08/18/14
Canaccord Genuity Corp Ben Cohen sell 1220 08/15/14 4th
Berenberg Sami Taipalus sell 1168 08/14/14
Nomura Fahad Changazi buy 1493 08/14/14 10.64% 4th 5th
Exane BNP Paribas Andy Hughes underperform 1070 08/14/14
Deutsche Bank Oliver Steel hold 1260 08/13/14 2nd
Keefe, Bruyette & Woods Greig N Paterson market perform 1227 08/13/14
Oriel Securities Ltd Marcus Barnard sell 900 08/13/14 6th
Numis Securities Ltd Nicholas Johnson add 1720 08/12/14 10.97% 3rd
Barclays Andrew Broadfield equalweight 1428 08/12/14 3rd

Tha analyst “consensus” rating in Blommberg is 2,57 which is pretty bad and one of the worst for all European insurers.

Actually, Admiral posted higher profits than the comparable 6 months in 2013, however the released above average reserves. On the other hand, they still invest a lot, especially in US price comparison and the international business. For me, the results were pretty inline with what management has been saying all along. UK car insurance is in a tough spot and will remain so for some time. Interestingly, the all important “auxiliary” income remained constant despite lower premiums which in my opinion is a very good sign.

International premium has increased by 10%, however the loss has increased as well. Allthough I usually don’t like investor presentations that much, but the Admiral presentation is extremely good. There is also a lot to learn about insurance in general, such as the claim inflation example on page 20 or the detailed reinsurance terms on page 48. Also their view on the US market is quite interesting, especially slide 35 with the acquisition cost per insurance contract. For me, this is showing that the Admiral guys know what they are doing which is unfortunately not the general rule in insurance.

The only disappointing part in my opinion is the Italian subsidiary. Admiral says that they didn’t undwrite more as prices were un attractive. Other than that the international business seems to expand nicely.

Reader Musti forwarded me a link why Morgan Stanley sold out Admiral in one of their funds.

The team became more wary of Admiral (LSE:ADM) after the 2011 turbulence in the stock price, after a scare about the potential for large personal injury claims. While the 2011 claims ratio eventually turned out to be fine, it caused a revision in our view of the quality of the name. The combination of the stock’s recovery, and long-term concerns about the effect of autonomous driving on the motor insurance industry, caused us to reduce and then exit the position.

I think this is quite interesting and revealing. They became nervous because the stock price was volatile and that caused a revision of the “qualitiy of the name”. Self driving cars is definitely something to look at but I think no one can say now how quickly this will come and what impact this will have. A self driving car will still need insurance, so much should be clear.

Overall, for me nothing has changed with regard to Admiral. If you want to see smoothly increasing earnings then you have to go somewhere else. If you want a truly great business at a fair price then you should hold or buy more which I might do if the price falls further. I plan to make this a “full” position until the end of the year.

Bouvet ASA (NO0010360266) – 40%+ ROE micro cap from Norway

DISCLAIMER: The stock which is discussed in this post is an illiquid micro cap stock. The author will most certainly have bought it before writing the post and will not necessarily tell you when he sells. This is not an investment advice. Please do your own research and never rely on stock tips without carefully scrutinizing th motivation and assumptions behind them.

The company

Bouvet ASA is a small Norwegian IT consulting company operating almost exclusively in Norway.

The company is the result of a merger of several smaller Norwegian IT consulting companies and, after a management buyout went public in 2007 on the Oslo stock exchange. Current market cap is around 850 mn NOKs or ~ 100 mn EUR, so it is really small.

Valuation wise, the traditional metrics are OK but not spectacular (at 83 NOks):

P/E: 11,8
P/B: 4,8
P/S: 0,7
Dividend yield 7,2%
EV/EBIT: 8,1
EV/EBITDA: 7,3

No debt, the company has net cash of ~15 NOK per share.

Clearly the dividend yield looks attractive but P/B for instance looks quite expensive, so it’s definitely not a Graham cigar butt.


The business

Consulting business itself is a relatively straight forward business. You hire bright young motivated people and “sell them” on a daily basis to companies at a higher price. In between you have to train and motivate them. This business requires very little capital, mostly it is the receivables from clients and some office supply in a small company office. You don’t need big offices anyway as the consultants are usually at the client’s site.

In my opinion, barriers to entry and therefore competitive advantages in consulting can be achieved via:

1) “Brand name”

The brand name is important for two purposes:

a) For clients: Hiring a “famous” consultant is more expensive but also lowers the “reputational risk” for a project sponsor. If “xyz consulting” is screwing up a project, then the project sponsor has a problem because he hired and unknown consultant. If McKinsey screws up, than it’s not his fault. Achieving a brand is not that easy, so entering the market on the “High end” is not that easy either. It needs time to build up the reputation, although in IT consulting the brand name is a little less relevant than in typical management consulting.

b) For employees: In order to get the best employees, you must have a good reputation with Students, MBAs etc. Without good people you cannot charge high prices, so this is a self-reinforcing cycle once you are on the list of the “High potentials”. High potentials these days have many options, consulting companies, start-ups, investment banks, Google, brand companies etc.

2) Existing client list

It is always easier to pitch “from the inside” than from the outside. Once you are inside a company as consultant, you have access to decision makers which is essential to sell new projects. If you do a good job, many managers will think twice to go through an official bidding process and give the follow-up work to the consultant who is already there. Even for projects with a competitive bidding, it is always better to have some “Inside” knowledge, especially about the client company culture etc. The bigger the client company, the better the chances to get additional projects. Large companies have a surprisingly large “thirst” for consultants.

3) Network effect of “old” consultants with important function

Consulting is not a job to get old. Most young employees will switch to a “normal” job at some point in time. If you treat your employees well, they will be proud of having worked there. Often consultants switch to relatively senior jobs or get hired straight way by clients. If they then search for consultants, they will often give the first shot to their former colleagues (and friends…). This is even more important in management consulting but also important for IT consultants. Good consulting companies “groom” their network of ex colleagues via regular “off site” meetings in nice location.

So how does Bouvet score on these 3 categories ? From my armchair perspective, it is clearly difficult to judge. With regard to attractiveness to employees; Bouvet seems to do some things right, as they are regularily among the “top places to work” both in Norway and Europe. Employee reviews are generally good, although I found one comment that the atmosphere might be a little bit “too relaxed”.

I cannot judge how good their network is, but at least the “Brand” seems to be good in Norway. The client list seems to be as good as it gets in Norway, with Statoil being a big client as well as the Norwegian Government.

Additionally to their consulting (or as a result of it), they also seem to develop some specializes software, for instance this one which measures electricity consumption of trains.

Financial track record

The easiest way to look how Bouvet is doing is of course to look at their financials

EPS ROE NI margin Div Payout ratio
2006 3,04 53,6% 7,7%    
2007 3,96 39,3% 8,3% 3,70 121,8%
2008 5,51 42,3% 9,8% 4,00 100,9%
2009 4,21 34,3% 7,2% 3,75 68,0%
2010 4,78 40,1% 6,8% 4,10 97,3%
2011 6,13 50,0% 7,0% 5,00 104,6%
2012 5,41 40,2% 5,4% 5,00 81,6%
2013 6,75 46,2% 6,2% 5,00 92,4%
2014       6,00 88,9%
           
CAGR/avg 10,5% 43,2% 7,3%   99,4%

Them most remarkable part is clearly that they managed to grow EPS by 10,5% p.a. and distribute 100% of their profit as dividend. This shows that consulting can be really good business if done right and Bouvet at least in the past seems to have done a lot of things right.

Let’s look at a quick peer group comparison:

EPS Growth NI margin ROE Payout ratio EV/EBIT
Accenture 14,3% 7,5% 64,4% 146,0% 12,0
Cap Gemini 3,0% 3,9% 8,8% 103,0% 8,8
Atos 5,6% 1,7% 5,7% 109,0% 9,3
Bechtle 10,2% 2,8% 13,6% 100,0% 12,1
Reply 16,2% 5,4% 16,4% 100,0% 8,8
Tieto -3,6% 3,90% 12,3% 89,0% 17,0
           
Bouvet 10,5% 7,3% 43,2% 99,3% 8,1

Interestingly, payout ratios are in all cases around 100%. However margins and especially return on equity are very different. Clearly US behemoth Accenture shows outstanding ratios in any category, but the stock is also priced a lot higher than the competitors. The comparison in my opinion shows that Bouvet is cheap compared to how good the business look. Bouvet has at least double the profit margins and multiple time ROE compared to those peers and still trades as the cheapest stock in this group.

Other considerations

Management / compensation

This is CEO Sverre Hurum, who owns 4,9% of the Bouvet SA:

He earned around 330k EUR total comp in 2013. This is actually slightly less than what he earned as dividend on his ~5% stake. So at first sight, comp seems to be reasonable and aligned with shareholders. One has to mention that he seems to have sold 1,4% some years ago, he used to own 6,3%.

Other than for instance the Akka CEO, he is not into motor racing but seems to enjoy cross-country skiing. The CFO Erik Stuboe owns another 2,35% in the company.

Analyst coverage /shareholders

Only 2 analysts are covering the stock according to Bloomberg and only one analysis is actually from 2014 (ABG, price target 110 NOK).

Other shareholders:

No dominating shareholders, mostly Nordic pension funds and asset managers. The biggest shareholder is Varner Kapital, the investment arm of a rich Norwegian textile family, followed by Stenshagen, another Norwegian investor with 8%, Interestingly, none of the big international investment companies is invested, this seems to be a “Local” stock.

Stock price & performance

Shareholders who bought Bouvet at the IPO and held the stock, will be very happy. They made 21,9% p.a. or 320% in total compared to only 3,9% p.a. for the Norwegian Stock index.

Despite the stock price increase, the valuation of Bouvet stayed mostly in the 11-13 P/E range as profits rose proportionally to the stock price. The stock has a very low beta to the stock market (0,38). That is not terribly important but good for my nerves especially in volatile markets….

“Flying under the radar” or why is the stock cheap ?

Bouvet is a micro cap stock. Most of the stock is held by pension funds etc, so although free float is theoretically there, trading volume is very low, around 60k EUR per day. So for many small cap funds, this is not interesting as they want to be able to move in and out of a stock relatively quickly. On the other side, this is also a potential “double upside” for investors who are able to invest “under the radar screen”. If the company continues to grow, at some point in time the market cap, free float and trading volume get so big that smaller funds become interested. In such a case, multiple expansion is often very likely. So as an investor, investing in a small, unknown grwoth stock the upside is much better than compared to an “established” stock with a relatively big free float


Negatives:

- expansion outside Norway difficult. Norway is a high cost country, exporting Norwegian consultants to other countries will most likely not work that well
– CEO is 57, how long will he continue ?
– cost structure most likely not as flexible as in an US style company
– consulting is to a certain extent personalized business. If employees are unhappy they can leave the firm but keep the client

Valuation / return expectation

Instead of coming up with a valuation, this time I make an even simpler case. I want to earn 15% on this investment p.a. With the 7,2% dividend yield, I am almost half way there. In order to earn another 8% p.a. over 3-5 years I need either:

- a multiple expansion. Based on the current cash adjusted multiple of ~10xP/E, it is not unreasonable to expect a 12-13 multiple at some point in the future
– or, based on the same multiple ~7% p.a. which is slightly below the CAGR since IPO (around 8% pa.a.)

I am willing to “bet” that it ois likely that one of those 2 scenarios will happen. If both happen, then my upside would be much higher.

Summary:

Bouvet in my opinion is the perfect “boring” small cap company I am looking for. Although it is neither terribly cheap nor having a big moat, it is a very good business at a reasonable price. It is pretty much neglected from analysts and the shareholders seem to be “strong hands”. The company is very shareholder friendly and has good growth potential in a normal environment. There is no “catalyst” event around the corner, but I still think that it is a very good complimentary position to my current portfolio, adding some Norwegian exposure along my mostly continental Europe /UK stocks.

I will therefore establish a “half position” (2,5%) at current prices of ~85 NOK per share. My target would be a 50-75% gain within 3-5 years including dividends.

Lancashire Group (ISIN BMG5361W1047) – The UK equivalent of Buffett’s National Indemnity ?

While I was writing this post which I do normally over 1-2 weeks, the excellent WertArt Capital blog has released a very good post on Lancashire a few days ago. I higly recommend to read the post as it contains a lot of usefull information.

This saves me a lot of time and I only need to summarize the highlights:

- Lancashire is a specialist insurance company which insures mostly short tail “Excess loss” type of risks. It was founded by Richard Brindle, an experienced underwriter

- Since founding & IPO in 2009, the company has shown an amazing track record. No loss year, 59% average combined ratio and 19,5% ROE is simply fantastic.
– the company has a very disciplined underwriting focused business model, investment returns are negligible
– focus in on capital allocation and efficiency. If rates are not good, Lancashire returns capital to shareholders
good alignment of management and shareholders (majority of bonus depends if ROE hurdle of 13% + risk free is hit)
– The company looks cheap at ~8,5x P/E and 1,3 x P/B

For non-insurance experts a few quick explanations of insurance terms:

“Short tail” insurance business:

“Short tail” means that one is only insuring stuff where you pretty quickly see if there is a loss or not. For instance a “plane crash” insurance will be good for 1 year and if a plane crashes, the insurer will pay. After that 1 year there are no obligations for the insurer.

“Long tail” in contrast is an insurance policy which again covers a calendar year but where the damage can come up much later. A good example is D&O (director and officers) insurance. Often, when a big company goes bankrupt, some fraud etc. was involved at management level. Until a jury finally makes a verdict, many years can pass by but still the insurance company which has underwritten the policy remains liable. A good example is for instance the recent Deutsch Bank /Kirch trial where insurers will have to pay 500 mn EUR for something that happened 12 years ago.

Long tail has the advantage that the “float” can be invested long-term and illiquid, on the other hand the risk if a significant miss-pricing is much higher.

Excess Loss contracts

Excess loss contracts are contracts where the insurer only pays above a normally quite high threshold. This means that in normal cases, one does not need to pay but as a result premiums are lower than with normal contracts or “lower attachment points”. These kind of contracts are also often called “catastrophe risk” or “Cat Risk”. If such an event hits, then the hit will be big. Lancashire initially expected to make a loss 1 out of 5 years but up to now they had no loosing year. A company which has many excess loss contracts will report very good results in some years but very very bad in others.

What is the connection to Warren Buffett ?

Lancashire and Co. are relatively similar to Buffet’s National Indemnity Insurance, maybe the most overlooked part of his insurance empire after GEICO and Berkshire/General Re. Buffet has commented several times on National Indemnity and the competitive advantages of this company. The major competitive advantage of this business according to him was the ability NOT to write business if premiums are too low. The problem with this approach is of course that if you write less business, cost will be higher and the all important “Combined Ratio” (costs+claims divided by premium) will go up and investors will get nervous.

I wrote down this quote from last’s year Berkshire AGM from Buffett:

“I prefer the underwriters playing golf all day instead of underwriting risks at the wrong price. I don’t care of combined ratios grow well above 100% in such years.” For normal Insurance companies this is almost impossible to achieve as investors want to see increasing sales and profits any year and so most Insurance companies will underwrite no matter what the price is just to maintain the premium.

On the web I found similar quotes from him on the National Indemnity (NICO) which the bought in the 80ties:

Nevertheless, for almost all of the past 38 years, NICO has been a star performer. Indeed, had we not made this acquisition, Berkshire would be lucky to be worth half of what it is today.

What we’ve had going for us is a managerial mindset that most insurers find impossible to replicate.

and:

Most American businesses harbor an “institutional imperative” that rejects extended decreases in volume. What CEO wants to report to his shareholders that not only did business contract last year but that it will continue to drop? In insurance, the urge to keep writing business is also intensified because the consequences of foolishly-priced policies may not become apparent for some time. If an insurer is optimistic in its reserving, reported earnings will be overstated, and years may pass before true loss costs are revealed (a form of self-deception that nearly destroyed GEICO in the early 1970s).

Additionally, Buffett is already participating in the London/Lloyd’s market via another structure. Last year, he underwrote a socalled “side car” deal with Aon. The deal is still controversial but indicates a change of how things are being done at Lloyds. Funnily enough, Lancashire CEO Richard Brindle called the Buffet/Aon deal “foolish” in an interview last year.

Why is the company cheap ?

1. In general, all the socalled “London market” insurers are cheap. Let’s look at the “London” peer group:

Name Est Price/Book Current Yr P/E P/E FY1 Current Div. Yld (%)
         
LANCASHIRE HOLDINGS LTD 1,24 8,76 8,77 8,26
HISCOX LTD 1,62 10,47 13,48 8,21
BRIT PLC 1,23 #N/A N/A 8,59 #N/A N/A
BEAZLEY PLC 1,55 8,11 9,55 10,00
AMLIN PLC 1,36 7,94 11,13 6,07

Compared to those London players, all European P&C Insurance peers trade on average at~ 2,2 x book and 12 x earnings. So why are the London insurers so cheap ? In my opinion, the answer lies in the cyclicality of the business similar to Admiral. The “London market” is even more cyclical as it is primarily an institutional price driven market. The London market specialises in large and complex risks with “natural catastrophe” exposure. Despite the headline news, in the last years there were very few NatCat events which really led to large insured losses. In those times, profit margin increase and there is big pressure to lower premium. As companies accumulate capital, the appetite for risk increases, which further lowers premiums. This works as long as either a large NatCat event happens or capital markets crash and the insurers then have to raise premiums in order to restore their capital levels.

2. Management and strategy change

Lancashire so far has shown excellent underwriting discipline and outstanding an outstanding ability to allocate capital. However in the last few months a couple of things have changed:

a) The founder & CEO has “retired” in April at an age of 54. I haven’t found out why. Since 2005 I would guess that he has earned 50+ mn GBP, maybe he thought that this is enough ? At least he got an extra 10 mn package according to this article. He has been selling shares before his retirement.

b) In a change of strategy, Lancashire bought at the end of 2013 a Lloyd’s syndicate called Cathedral for ~200 mn GBP. Although the Lloyd’s business is not necessarily bad business, it is clearly a change. Lloyd’s underwriting is often reinsurance in contrast to Lancashire’s direct insurance. In their previous reports they claimed that their strategy of insuring directly was a competitive advantage. The Lloyd’s market on the other side is mostly reinsurance and more vulnerable.

c) Finally, after having been invested in short-term no-risk bonds since their IPO, they suddenly disclosed beginning at year-end 2013 that they now invest also into stocks and “Low volatility” hedge funds. Most likely not a good idea at this point.

For me, the cyclicality of the business itself would be no problem. But the combination of Management change and strategy change is very hard to swallow. I would happily invest if there would be EITHER a management change OR a strategy change but not both.

Summary:

To quote Donald Rumsfeld, those two changes lead Lancashire into the “unknown unknowns” territory. Sure, the new CEO is at Lancashire since 2007 and an underwriter, but overall I am not sure if the superior capabilities of the forme CEO have been “institutionalized” in the 8+ years of company history. Having three platforms instead of one sounds great, but it can also mean a loss of focus. So at the moment, Lancashire for me is not a “buy” as I do not have a clear idea how and if they can replicate their past results. T

However in general, the business model is attractive and the “London Insurers” could become interesting, especially if the market softens further so I will try to look into the others at some point in time.

Edit: I have just seen via the “Corner of Berkshire and Fairfax” board a link to an “Insurance Insider” article which states that the former CEO has completely sold out and is expected to launch a new company. A reason more not to rely on past results as this business is very dependent on the persons and the old CEO wil be a pretty tough competitor if he starts over again.

Vetropack Update – SELL

Vetropack is one of the original constituents of the portfolio. A few weeks ago I already posted my doubts on Vetropack.

So why did I decide to sell now ? Despite the Ukaraine issues, one other aspect caught my eye while reading the annual report:

Market trends.
Unlike the packaging market for glass containers, which is growing worldwide, the glass market in Europe has been trending negatively since 2012. Regional differences in purchasing power and consumer behaviour have also affected this trend. In the Eastern European countries, it is primarily declining purchasing power that is increasingly causing consumers to turn to cheaper products in alternative packaging.

Vetropack is mostly making beer bottles. For me, this looked like a utility business. From my own (Western European) experience I know that for instance German beer drinkers don’t easily change their favourite beer brand for a cheaper one. As it does not make sense to transport glass bottles across Europe, a local glass bottle manufacturer should enjoy some “utility like” competitive advantages and stable sales.

But it seems to be that in Eastern Europe, where Vetropack makes a large amount of business, people just subsitute more expensive brands in glass bottles with cheap ones in cans or plastic bottles. This basically eliminates a large part of my investment case.

On top of that, Vetropack did nothing with regard to share repurchases that year and the chart looks quite ugly:

So overall, after holding the share for 3,5 years, I will sell Vetropack at current prices as I do not have any indication of a clear higher value of the stock. Including dividends, I lost ~ -6% in total on this position.

The last remaining “intitial” positions are now Hornbach, Tonellerie, Draeger and HT1.

Admiral Plc (ISIN GB00B02J6398) – Short candidate or “Outsider” company with a Moat ?

Disclosure: The author might have bought the stock well in advance of publishing the post. In this special case, the idea has been presented already some weeks ago to a group of value investors.

Introduction

Admiral is a UK based P&C insurance company. A brief look into Admiral’s multiples would single it out as a potential short candidate (~15 GBP/share):

P/B 8,0
P/S 4,5
P/E ~14,5
Div. yield 3,7%

Especially P/B and P/S look overvalued if compared to other P&C companies. The average multiple for European P&C companies is ~2,1 for P/B, 1,6 for P/S and 11,6 P/E. So the company looks wildly overvalued.

Admiral – “The UK Geico” ?

Admiral is definitely no stranger for value investors. Metropolis Capital, a value investing shop with a good reputation presented Admiral as their pick for the London Value Investor conference some weeks ago.

The pitch is relatively simple: Admiral is the UK version of GEICO, the famous low cost direct insurer owned by Warren Buffet. Just look at the cost ratios of Admiral compared to its 4 main competitors:

Cost ratio P&C 2013
Aviva 32,8%
RSA 32,6%
Direct Line 22,3%
Esure 23,8%
Admiral 19,9%

Clearly, the cost advantage against “traditional” companies like Aviva and RSA comes from the fact that they don’t have to pay insurance agents. But even compared to the direct competitors, Admiral seems to have a cost advantage. Among other things, Admiral is the only FTSE100 company located in Wales which implies quite “reasonable” salaries.

However there is a big difference compared to GEICO:

GEICO’s business model as we all know, combines low cost / direct with investing the “float” Buffet style, so every premium dollar earned is kept and invested as profitable as possible, preferably in stocks. In principle, this is the strategy of all insurance companies, but very few are able to get “Buffet like” returns.

So I have compiled 3 statistics which show that Admiral “ticks” differently:

2013 Ratio Financial income /total profit Net retained premium “Other” in % of profit
RSA 116,4% 93,6% 0,0%
Aviva 72,9% 88,2% 0,0%
Direct Line 35,2% 101,6% 36,3%
Esure 11,3% 91,4% 40,1%
Admiral 3,3% 25,0% 85,0%

A quick explanation of those ratios: The net profit of an Insurance company is the result of 3 major components:
a) Underwriting result
b) investment result
c) “other” stuff

The first column in the table above shows what percentage of the total result in 2013 can be attributed to the investment result. RSA for instance actually makes a loss in insurance, so more than 100% of their profit comes from the investment portfolio. Admiral, on the other end, attributes only 3% of the total profit to investments. So what’s going on here ? Do they manage their investments so badly ?

The second column explains this “conundrum”: All the other players keep more or less all the insurance premiums they are collecting. Admiral, on the other hand only keeps 25% of incoming insurance premiums, the other 75% get “ceded” to Reinsurers.

Finally, the third column shows, that Admira is actually earning most of its money with “other” stuff whatever that means. To solve the puzzle, one has to look back into history of Admiral: Admiral was founded by a Lloyds syndicate to act as a kind of “Underwriting agency” in order to generate premium for the syndicate. So from the start, Admiral had a very lean structure, selling only direct etc. At some point in time they decided that the syndicate was too expensive and that they actually want to issue the policies themselves. Nevertheless, they kept their lean set up and lined up reinsurers to shoulder the majority of the risk.

Most people familiar with Insurance would say that the concept of Admiral doesn’t make sense. Why should you give up profits both, on the insureance side as well as in investments by passing 75% ? The answer is relatively simple: Capital efficency. Most insurance companies are notouriously capital inefficient. Long term ROEs for most major players are below 10% p.a. despite often significant leverage through subordinated debt. The main reason for this is the fact, that in many jurisdictions, the “GEICO” model requires to hold a large amount of capital to buffer capital market movements. Unless you are Warren Buffet, the returns on those investments are often below average so as a result, ROEs are bad. Plus the fact that growth often requires a lot of upfront capital as well.

For Admiral, the big structural problem of course is the following: If I pass most of my premiums and cash to reinsurers, how do I then earn money ? This is where the “other” column from my table above comes into play. Due to this business model, Admrial very early concentrated on making additional money by selling “ancillary” stuff.

This is what Admiral writes in its latest annual report (by the way: all annual reports since 2003 are highly recommended for clarity and insight !!!):

Other Revenue
Admiral generates Other revenue from a portfolio of insurance products that complement the core car insurance product, and also fees generated over the life of the policy. The most material contributors to net
Other revenue are:
> Profit earned from motor policy upgrade products underwritten by Admiral, including breakdown, car hire and personal injury covers
> Profit from other insurance products, not underwritten by Admiral
> Vehicle Commission (see page 25)
> Fees – a dministration fees and referral income (see page 25)
> Instalment income – interest charged to customers paying for cover in instalments

This additional income is extremely high margin with almost no capital requirement and drives the profitability of the company.

The result

This low capital requirement leads to ROE’s which are compared to its peers “from outer space”:

Name ROE FY ROE 5Y
     
Average 16% 17%
ADMIRAL GROUP PLC 59% 59%
TOPDANMARK A/S 26% 31%
TRYG A/S 19% 21%
LANCASHIRE HOLDINGS LTD 15% 17%
BEAZLEY PLC 21% 16%
GJENSIDIGE FORSIKRING ASA 16% 15%
SAMPO OYJ-A SHS 14% 14%
GRUPO CATALANA OCCIDENTE SA 13% 14%
EULER HERMES SA 13% 13%
ZURICH INSURANCE GROUP AG 12% 12%
ALLIANZ SE-REG 11% 12%
AMLIN PLC 19% 10%
MAPFRE SA 9% 9%
XL GROUP PLC 9% 9%
RSA INSURANCE GROUP PLC -11% 5%

Other unique aspects of Admiral’s business model

Comparison sites

Admiral runs in addition to its insurance operation, its own insurance comparison sites (e.g. Confused.com in the UK). Although those comparison sites themselves only contribute less then 10% of total profit, it gives Admiral a strategic advantage: Via their comparison site they can monitor in real time what competitors are doing and how they are pricing stuff. Other comparison sites also sell this kind of data but usually with a significant time delay. So running its own comparison site is clearly an advantage against a “normal” onilne insurer.

Capital allocation

With regard to capital allocation, again look at this statement from the 2013 annual report:

Admiral believes that having excess cash in a company can lead to poor decision-making. So we are committed to returning surplus capital to shareholders. We believe that keeping management hungry for cash keeps them focused on the most important aspects of the business. We do not starve our businesses but neither do we allow them the luxury of trying to decide what to do with excess capital.

Charly Munger would say at this point “I Have nothing more to add”. This is how it should be done but rarely found especially in the Insurance industry.

Managment & Shareholders:

The current CEO, Henry Engelhardt founded the company on behalf of the Lloyds Syndicate in 1991. He still holds ~12,8% of the company.

Co-founder David Stevens owns around 3,8%. Both founders only pay themselves ~400 k GBP per year salaries and no bonuses. The only exception is the CFO, who is relatively new. He earns around 1 mn GBP including a bonus and doesn’t have a lot of shares. There are quite some interviews available on Youtube with the CEO, among them this one is especially interesting:

Largest outside shareholder is MunichRe with 10%, who is also providing the majority of the reinsurance capacity. Other noteworthy shareholders are PowerCorp from Canada and Odey, the UK Hedge fund with a -0.79% short position. All Admiral employees are shareholders and there is a program for employes to purchase shares.

Stock price

Since going public, Admiral has performed very well:

Including dividends, Admiral returned 25,5% p.a. since their IPO against ~8% p.a. for the FTSE 100. Since 2004, EPS trippled and dividends per share increased by a factor of five. Interestingly, Admiral never traded at a level which one would asociate normally with such a growth stock, at the peak, the share had a P/E of 22 in 2006. I think this has to do with the general discomfort that many investors have with financial stocks.

Challenges for Admiral

Some of the additonal income sources for Admiral are clearly under regulatory thread. Referral fees, bundling etc. are currently investigated by UK regulators (see here and here) but especially Admiral seems to be quite creative on how to find different ways to earn fees.

Another and maybe the biggest strategic issue is that in theory comparison sites could start to sell additional products as well as we can see in the car rental market. However Admiral has the big advantage as they cover both, the comparison area and the insurance “sales funnel”.

I also think that for the comparison sites, it is not that easy to sell additional insurance products. Insurance policies are less standardized than rental cars, with very individual pricing so it is harder for a comparison site to actually close the deal intead of passing the client on to the insurer for a fee. Clearly comparison sites will try to get into this game as well but again, Admiral is the best positioned insurer.

Finally, the UK car insurance business shows almost a “brutal” cyclicality, for instance in 2013 premiums for the whole market dropped ~20%. Nevertheless, Admiral has shown that they are profitable over the cycle.

Opportunities

Admiral is currently trying to expand its business model into 4 other countries: Spain, France, Italy and the US. An earlier attempt in Germany failed a couple of years ago, mainly because the German market renews policies only once a year and Admiral was not able to really use its strengths (dynamic offers and pricing) on that basis.

If they succeed in any one of those markets similar to the UK, then there would be significant upside in the stock. If they suceed in 2 or more, Admiral could become a multibagger. If they don’t succeed at all, one could imagine that they might take additional market share in the UL, but then the upside is limited.

Although the subs are growing strongly, they still made a loss in 2013. Car insurance is however to a certain extent a scale business. You need a certain scale to become profitable. Clearly, just buying a competitor (and paying a lot of goodwill) would look better in the short term. Building up your own operations takes longer, but if you do it right, the value generation is significantly better than via M&A.

SUMMARY: Bringing it all together

Personally, I think Admiral has a very unique “outsider” business model. Reinsuring most of their business allows them to focus on the core product, car insurance underwriting and ancilliary services. They don’t have the complexity of traditional insurers with complex investments, expensive investment management and “asset liability management” departments etc. etc.

This keeps structural complexity low, lowers cost and allows them to scale up business much quicker than any “traditional” model and with very low capital intensity. Traditional insurance companies have always the option to realize investment profits in order to make results look good in the short term. In the long term, this often leads to a detoriation of the core business. Admiral doesn’t have this luxury. Additionally it insulates Admiral mostly from capital market volatility and enables them to move aggresively if other insurers are nursing their investment losses. Additionally, they don’t need to sell complicated subordinated debt etc.

Overall, I think the likelihood that someone succesfully copies Admirals business model is low, because for any Insurance executive, it is extremely counterintuitive to give premium away. Any insurance CEO would rather sell his grandmother than increase the reinsurance share and give away investment money. GEICO for instance in my opinion is not a “real” outsider company. It is a traditional insurer with a focused direct sales force. Admiral is really a very different animal.

Clearly, the thread of Google & Co is real, but on the other hand, Google & Co hesitate to to move into regulated areas. However if they would want to seriously move into this business, I would think that Admiral could be an interesting acquisition target for cash rich Google & Co.

Against the traditional competition, in my opinion Admiral has a 10 year headstart in understanding how to sell insurence and especially “others” over the internet. I think they will chuckle when they read how for instance AXA tries to become “digital” as they were already selling 70% of their policies over the internet in 2003.

I would go so far as calling the combined business model a “moat”. Yes, it is maybe not that difficult to start an online insurer and does not fit into the classical moat categories, but to scale up quickly and get the whole package right, this is another story and in my opinion very very unlikely. Even the direct clones like Esure only go “Half way” by keeping all the premiums and exposing themselves to capital market volatility.

I also think that this is still a “value investment” despite the optically expensive multiples. In my opinion, the value lies in the business model plus the headstart in online insurance. To put it into s short thesis: This is a high quality company at a “Normal company price tag” and an “above average” growth opportunity due to the cost advanatges.

For the portfolio, I had bought already a “half position” in April at 13,80 GBP per share as I have briefly mentioned in the April post. I know this is a little unfair but I just didn’t have time to finish the write up.

P.S. There will be an extra post for this, but I have sold the rest of my April SA position in order to keep the exposure to the financial sector (~20% of the protfolio including the bonds) constant

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