Performance review June 2014

Performance June

In June, the portfolio gained 0,9% against -1,2% for the Benchmark (Eurostoxx50 (Perf.Ind) (25%), Eurostoxx small 200 (25%), DAX (30%), MDAX (20%)) an outperformance of +2,1%. YTD, the score is +10,2% against 4,1% for the Benchmark.

For June, positive contributers were IGE+XAO (+13,2%), Sistema (+7,5%), Admiral (+6,2%). Main loosers were Van Lanschott (-4,2%), KAS Bank (-4%,0%) and Energiedienst (-2,5%).

Interestingly enough, June was the fourth month in 2014 with negative BM performance and significant outperformance of the portfolio. This is how 2014 looks on a monthly basis:

Bench Portfolio Perf BM Perf. Portf. Portf-BM
Jan 14 8.849,21 181,48 -1,9% 3,7% 5,5%
Feb 14 9.306,80 186,34 5,2% 2,7% -2,5%
Mrz 14 9.228,53 187,18 -0,8% 0,5% 1,3%
Apr 14 9.203,99 189,76 -0,3% 1,4% 1,6%
Mai 14 9.499,94 191,22 3,2% 0,8% -2,4%
Jun 14 9.387,95 192,98 -1,2% 0,9% 2,1%

So whenever the market performs strongly, the portfolio underperforms significantly and when the market retreats it more then compensates. There is certainly some time lag involved here but I cannot completely explain what is happening here. At least it doesn’t look like a lot of beta ;-)

Portfolio transactions

June was a very quiet month, the only transaction was to sell the remaining April SA stake. Although I introduced Admiral in June, I had invested already in April. The current portfolio as always can be seen here.

Including all the earned dividends, cash is now at ~11,8% plus the 5% in the Depfa LT2 which I consider very close to cash.

Currently, Portugal Telecom is “under review”. I bought a small position in order to keep my interest in the PTC/OI merger, the recent news about the undisclosed Rioforte investment caught me by surprise. I have sent an Email to PTC IR in order to clarify the accounting, but overall I think this is not a comapny to invest in after this incident.

As I have already written, in early July I already invested another 2,5% of the portfolio into NN Group, the Dutch IPO and insurance subsidiary of ING.

NN Group NV – “Hands off” IPO or interesting special situation ?

NN Group is the name of the soon to be just IPOed Insurance subsidiary of Dutch ING Group. NN Group sounds a little bit strange but is the “traditional” name of the Dutch Insurance company, “Nationale Nederlanden”.

As a value investor, normally, IPOs are an absolute “No go”. Benjamin Graham famously said that one should never touch an IPO because almost always, the stock price is overhyped and the risk return relationship is not good. Especially now with the market reaching new highs, buying IPOs doesn’t seem a good idea.

So why could this IPO be different ? In my opinion there are some good reasons:

1. ING is obliged to sell.

ING had to be rescued in 2008 by the Dutch Government under the condition that they dispose their full insurance activities. They cannot simply spin off the business because they need the money to pay back the Dutch Government and shore up the bank balance sheet.

This is form a recent Bloomberg article what they have done so far and what they committed to:

ING, the recipient of a 10 billion-euro bailout from the Netherlands in 2008, agreed with EU regulators to complete its disposal program by the end of 2016 and to sell more than half of NN by the end of next year. ING also still owns about 43 percent of Voya and a stake of about 10 percent in Sul America SA (SULA11) in Brazil.

The company is open to selling the Sul America stake, worth about 566 million reais ($253 million) based on the Rio de Janeiro-based insurer’s market value, in a block trade, Chief Executive Officer Ralph Hamers said in an interview in Sao Paulo yesterday.

2. The company is an “ugly duck” at first sight

The remaining insurance compqny is a strange combination of Netherlands, Eastern Europe and Japan with some Investment Management thrown in. In German, one would call the business mix a “Resterampe”, so the remains of what could not be sold directly. The majority of the business is Life insurance, which itself is clearly suffering from low interest rates.

The company shows more or less zero profits for 2013, however a couple of items could be considered true “One offs” in order to look better in the future, for instance the large charge against the closed Japanese VA business. Also Q1 2014 showed a loss, this time because of a charge in relation to pensions.

So now one can accuse ING of “dressing up the bride”, rather the opposite.

3. European Insurance is one of the sectors with the lowest valuations anyhow

The Stoxx 600 has currently a P/E of 24,8 and a P/B of 1,9. Compared to this, the Insurance sector trades at a trailing p/E of 12,4 and P/B of 1,21. This is even cheaper than banks and utilities. Within the insurance sector again, the Life Insurance sector is even cheaper. There are clearly many reasons for those low valuations, especially that interest rates are so low which makes it hard for life insurers to earn their guarantees and a spread on top if this.

4. The IPO valuation looks cheap compared to the sector.

The company comes to the market at around 50% of book value. Considering that they don’t have a lot of Goodwill, this looks cheap even compared to the generally low valuations for life insurance companies. Dutch competitors Aegon and Delta Llyod trade at P/Bs of 0,7 and 1,3, the average for European Life insurers is ~1.4 including UK, and around 1 excluding UK.

5. The company looks like a target

Looking at this IPO, there seems to be a big sign on the company saying “split me up”. This strange combination of businesses is clearly not value enhancing. Splitting the company up for instance into a Dutch entity and selling down the rest could be a pretty easy exercise for an activist Hedge fund. I could also imagine that some Asian financial companies would be interested in acquiring a solid Dutch “brand”-.

6. The company is relatively solid

If one looks at the “usual suspects”, like Goodwill, pensions etc. there is not much to be found. The company had 6 bn of defined benifit liabilities in 2013 but actually got completely rid of them in early 2014 against an extra charge. I consider this as very positive and a good sign that they really cleaned up a lot of stuff befor doing this IPO. Additionally, another insurance specialty, so-called “DACs”, which are capitalized distribution costs only play a very minor role at NN compeared to other life players like AXA.

They do have some leverage but overall I would rate the balance sheet quality as “above average” for the sector.

7. The US IPO went relatively similar

There is a blue print for this transaction: Voya, the former ING US IPO. The US business was also supposed to be pretty ugly, so ING placed the first tranche very very cheap at below 0,4 times book value. Since then however the valuation seems to slowly approach those of other US life insurers and the stock almost doubled since IPO:

Other thoughts:

Management incentives
What I didn’t find out in the annual report or in the IPO prospectus was how the NN Group management is aligned with shareholders going forward.

In situations like this, a lot depends on Management, especially if they want to actually increase sahreholder value or if they want to maximise salaries which is easier in a bigger company and which would make reasonable spin-offs and disposals unlikely. So this is something to be watched.

Management has committed to a quite aggressive dividend payout ratio of 40-50%, starting with a large payout already this year in autumn. I am not a dividend investor, but this greatly reduces the risk of stupid acquisitions.

Distribution agreements with ING Bank

Life Insurance is mainly distributed via banks these days (often along with a mortgage loan). NN has an exclusive agreement with ING Bank according to the IPO porspectus until 2022. Although this is a limited time frame, this is very valuable as banks now charge high upfront fees in order to access their distribution channel.

Summary:

In my opinion this “IPO” of NN Group is much more similar to the classic “spin-off” than a “real” IPO. ING has to sell, the underlying business looks ugly at first sight and there is a lot of overall negative headline news for the sector and the specific business fields. As a result, other than with a normal IPO, the valuation is very cheap.

As I feel comfortable with the headline risks at this price level, I will invest a “half position” (2,5%) of the portfolio into NN Group at current prices (21,70 EUR). The short form investment thesis is that one gets an above average quality insurance business for a below average price.

Again, this is clearly not a “no brainer” and will need (lots of) patience, but over 2-3 years, the price of the shares could be easily 50% higher (including dividend distributions) if they reach average valuation ratios and the one-offs turn out to be real one-offs.

Book review: “Dream Big” (The 3G story) – Christiane Correa

To be honest, when Waren Buffet last year announced his intention to team up with the Private Equity company 3G in order to buy Heinz, I didn’t know anything about those Brazlian guys behind that company. Especially, the “Mastermind” Jorge Paolo Lemann who is now the 28th richest guy in the world with a net worth of around 25 bn USD was amlmost completely unknown to me.

During the Berkshire AGM, someone (I don’t know who it was, maybe Buffet ?) mentioned that they are selling 250 hard copies of the book which describes how those Brazilian guys got so succesful. However when I went to the bookstore, the copies were already sold out.

So as a kind of additional research when I looked at GP Investments, I downloaded the available Kindle verison of the book.

Jorge Paolo Lemann started his business carreer as a classical banker/trader. Relatively soon, he was able to buy a small brokerage which he renamed to “Garantia”. Over 20 years or so, Garantia was one of the most succesful investment banks in Brazil. The book lacks a little bit in detailed description what they actually did at Garantia, however it seemed to have been a mixture of investment bank and hedge fund, generating huge profits especially in those times when the Brazilian currency was in trouble.

One of Lemann’s key strategies was that he tried to hire “hungry” people and motivated them via huge bonuses which were distributed based on actual results and not, as with many other Brazilian companies based on seniority etc. So to a certain extent, Garantia seemed to have been not unsimilar to a typical “wolf of Wallstreet” boiler room where young and aggressive traders could get rich very quickly.

However the main differentiator of Garantia was the fact that Lemann didn’t pay out the bonuses but required his employees to use the bonus in order to buy shares in Garantia from the founders. So the most susccesful employees also became very quickly major shareholders and partners. In theory and practice, this aligned the interests very well. Lemann is cited several times that he wanted his employees to remain “cash hungry” which doesn’t work well when you pay high cash bonuses.

Relatively early, he also became interested in investing in “real” companies. The first succesful attempt was the Brazilian Retailer Lojas Amricanas. Especially when more and more cash piled up at Garantia, he didn’t want to pay out huge dividends, but used the cash to buy the then struggling Brazilian brewer Brahma for an amount of 60 mn USD. The story about that transaction sounds quite funny. The didn’t do a real due dilligence and only found out afterwards that the company had a 250 mn USD pension hole. Without knowing anything about breweries, they managed to turn around the company pretty quickly.

While being occupied with Brahma, Lemann seemed to have lost interest in banking. While he was still on the board, Garantia almost went belly up and was finally sold for 675 mn USD to Credit Suisse, however the Brahma shares were spinned off before that to the partners. In the book, at thwo instances he seems to have complained about his younger partners that they paid out themselves too much cash instead of adhering to his beloved partnership model.

Going forward, Brahma managed to acquire their biggest rival in Brazil, Antarctica. Further “rolling up” the beer industry, they “merged” with Belgian Interbrew and then finally, in 2008 made the all debt financed acquisition of Anheuser Bush for a whopping 50 bn USD, creating the largest brewing group in the world.

Overall, by only reading the book, it was hard for me to understand if Lemann and his close associates (Telles, Sicupira) are really genius and visionary business men and investors or if they are just aggresive “financiers” who got lucky.

In the time when they build up Garantia for instance, a lot of financial institutions in Brazil prospered, sometimes through questionable ways of information gathering. Also the essential Brahma and Antarctica merger, creating a dominating Brewery in Brazil with 70% market share would have not worked that well in a country with a tougher anti-monopoly regulation.

At least they were more cautious than another former Brazilian superstar, Eike Batista, who stayed in Brazil with his investments and almost lost it all in the last 2 years or so.

For me, the most crucial part of the “Lemann” story is his view on how to align Management and owners. Its seems that in the long term, the owner/manager model where managery invest their salaries back into the company is able to generate exceptional value compared to a “cash bonus/option” model for management.

Interestingly, there was a story earlier this year the Brito, the Brazilian AB Imbev CEO seems to have “gamed” his targets in order to earn a massive bonus. This would not be in line with Lemann’s philosophy. Still it doesn’t seem to have impacted the stock price of AB Inbev which has trippled over the last 5 years.

Overall, the book is written OK, not exceptional like Michael Lewis but still interesting to read. I think it is worth a read especially if one is interested in the Brazilian market and its history and in the alignment of management and shareholders. It is clearly not an “how to invest” book.

Other sources:
Bloomberg story on Lemann & 3G

Some links

Interesting “first hand” small cap activist experience by Ragnar the pirate.

Citron Research is short Zillow

Great write up on AGCO, an interesting US based agricultural equipment company from Wertart Capital

A very very good post on interest rates from the Slackwire blog. Also read the post on negativ rates.

Lots of investor letters from Bridgewater (Ray Dalio)

Frenzel & Herzing with a very good update on Hornbach Baumarkt. My last remaing German “Value stock”…..

GP Investments (GPIIF US) – Your chance to team up with Brazilian Investment Superstars like Uncle Warren did ?

That some Brazilian investors know how to make BIG money is no secret anymore, especially since Warren Buffet teamed up with Brazilian 3G to take over Heinz in a 26 bn USD deal.

What if you could team up with similar Brazilian guys like good old Warren did ? In theory, there is a good chance by buying shares in GP Investments, a listed Brazilian Private Equity company. GP Investments is not any Brazilian Private Equity company, but was the original Private Equity vehicle of “genius” investor Jorge Paolo Lemann. He sold the company in 2003 to his Junior partners and then went on to found 3G.

So in theory, GP Investments is like the “Junior” version of 3G with a LatAm focus and some of the employees of GP have actually been hired by the 3G guys which are all bilionaires now (Lemann is according to Bloomberg now number 28 in the world with a net worth of 24,8 bn USD).

Back to GP Investments:

There is a pretty comprehensive case study on Value Investor’s Club, so no need to replicate everything here.

The basic investment idea is simple:

GP investments trades at a discount to its holdings (in which it invests along its 3rd party private equity funds) plus you get the asset management company for free. On top of that, management is aligned with shareholders and repurchases shares.

Further, two “gold standard” value investment firms have large positions, Third Avenue with 11,65% and “legendary” Sequoia with 11,8%. Finally, GP Investments announced two very succesful exits over the last weeks which made them good money (BR Towers and SASCAR).

The stock price increased a little bit since then, but still, the stock looks very much undervalued and almost a “No brainer” if one is looking for a Brazilian investment opportunity.

What is the asset management business worth ?

My answer: Not much. Look at this table:

Management Fees Salaries, expenses Bonuses Net
2006 15.5 -18.99 -5.2 -8.69
2007 26.2 -38.1 -9.2 -21.1
2008 13.9 -47.9 -3.9 -37.9
2009 16.2 -47.9 -13.4 -45.1
2010 25.0 -48.6 -15.3 -38.9
2011 17.4 -45.4 -7.7 -35.7
2012 22.4 -60.2 -19.3 -57.1
2013 20.5 -74.9 -8.4 -62.8
Total 157.1 -382.0 -82.4 -307.3

Based on the available US GAAP account I created this table showing the assets maganagement fees charged to third party investors against salaries, expenses and bonuses for GP’s employes and operation. We can easily see that the balance has been increasingly negative over the years. Since the IPO, the “Asset Management Business” has cost the shareholders some serious money. Even if we assume that expenses include other general expenses, then to me the value of the Asset Manegement looks rather negative, it looks like that GP shareholders are subsidising 3rd party investors to a significant extent.

Private Equity track record

If you read through GP’s investor presentation, they always stress their great track record since 1993 with a lot of examples of exits where they made a lot of money. However, we never find a “real” track record which shows the real IRR for all assets. For an Asset Manager, the track record is the most important asset, before anything else.

In the following table, I tried to recreate their PE track record based on their published numbers since their IPO 2006 (in USD). I used disclosed US GAAP numbers and then calculated a simplified annual IRR. One remark: Minorities are a big contributor in GP’s P&L. I assumed that all minority results are PE related. In the table, a positive number in the column minorities means that the loss has been shared with minorities and vice versa for profits.

Investments eoy Realized gains, Div increase in value Minorities Total return in % a.m.
2006 173.9          
2007 1165 59.2 279.8 -169.0 170.0 25.39%
2008 1381 11.8 -513.9 304.2 -197.9 -15.55%
2009 1568 229.0 241.5 -284.0 186.5 12.65%
2010 1431 -47.8 -39.0 68.2 -18.6 -1.24%
2011 1173 38.3 -348.0 236.0 -73.7 -5.66%
2012 1279 133.0 -120.3 44.0 56.7 4.62%
2013 998.3 -284.2 191.6 89.6 -3.0 -0.26%
Total   139.3 -308.3 289.0 120.0

It’s not hard to see that the Performance only looks good the first year, after the they went public.Since then, the track record has been very weak. The Bovespa made in the same period a total return in USD of ~0,7% p.a. So yes, they performed slightly better than the Bovespa, but after bonsues and expenses, GP shareholders would have been better off with an index fund. Bad timing plays clearly a certain role here as well, however on the other hand it is hard to understand how the justify paying out more than 80 mn USD in bonuses for such a mediocre perfomance.

A few additional remarks on that from my side:

Debt/leverage

After the IPO, GP took on leverage, both as a bank loan and with an issuance of a perpetual note. Especially the perptual note in USD with 10% might have looked as a good idea when interest rates in Brazil were high and the real gained against the dollar, but now, with the real loosing significantly, this currency bet is of course making things worse. Additionally shareholders have additionally lost money via a “negative carry” on the debt funding compared to their low single digit investment returns.

Stock options / Alignment of interest

Since 2006, more than 50 mn options have been granted to the employees (against around 160 mn shares). Some are pretty far out of the money, but still, combined with the bonuses it doesn’t look like that there is “full alignment” between shareholders and employees. The executed share repurchases look rather small compared to the option grants.

“Diworsification”

In the last few years, GP diversified into infrastructure and real estate. For me, this is a clear sign that they focus on asset gathering rather than on performance. I think their problem is that they cannot raise a new PE fund as their perfomance is most likely substandard and many more competitors are now active in Brazil then when they started. Additionally, on of their recent pruchases, a Swiss based listed fund-of-fund vehicle called “APEN” s also not really consistent with their LatAm focused strategy.

So the big question is:

Is GP Investments a good investment despite the substandard track record ? Will they be able to generate better returns going forward ?

What I am concerned about is the fact that they seem to hang on their loosers and sell winners pretty quickly. Making 100% in 3 years sounds good, but the real money is made with investments that make 5 or 10 times their initial investment. Overall, to me it looks like that the bonuses which are paid independent of overall investment results are the biggest issue. In a “Good” private equity structure, the employees only cash out AFTER the full portfolio has been cashed out and the overall result. In my opinion, this is the only way how to align incentives in such an environment.

Finally, a few words on the “Lemann / 3G” connection: In the book “Dream Big”, which I just finished reading (review follows soon…) and which sketches the carreers of the 3G guys, Lemann is quoted that he left GP Investments because of 2 reasons:

1. GP did chase too many deals, as he wanted to focus only on a few for the very long term
2. He didn’t like the way his younger partners payed themselves big salaries. His credo was always that salaries and bonuses had to be fully reinvested into the company and employees should have a simple life style

So for me at this stage, I will not invest in GP. Despite the interesting and initially compelling story, I am simply not convinced that GP going forward will be a better investment than a Bovespa index fund. Full stop.

Book review: “Funny Money” – Mark Singer

“Funny Money” is a rather “old” book, originally from 1984, covering the story of the Oklahoma Oil boom in the early 80ties and the subsequent bakruptcy of Penn Square Bank.

The most interesting thing about the book is that nothing is ever new in finance and history always repeats although not exactly but in similar fashion.

Penn Square Bank was a small Bank in Oklahoma City which was lending to local Oil and Gas companies. When a big well was found (the “Tomcat”), prices in that area exploded and a great boom started. Very similar to the real estate boom many years later, Penn Square was lending against market values, which in boom times looks always good.

Penn Square could do even more harm via “syndication”, in many cases they did pocket the arrangers fee but only kept 1% of the loan and “upstreamed” the other 99% to bigger banks. One of those banks, Continental Illinois, one of the largest commercial lenders in the US at that time went under 1 or 2 years after Penn Square and had to be bailed out by the US Government. Although the instrument is different, this is exactly what happened with all the CDO structures 25 years later in our socalled “Financial crisis”.

The book also offers a lot of insight into the Oil and Gas explorer industry which I think is still relevant today. MLPs for instance were very popular already back then, but as always, mostly only some of the promoters became rich.

Funnily, one of the most notourious promoters at that time, Robert A. Hefner IV, seems to be still around.

The author originally covered the events as a reporter for the “New Yorker” and then packaged the stories into a book. So its a pretty good “real time” description of a classic boom & bust cycle fulled by credit and credit derivatives. It is also proof that you don’t need to combine investment banks and commercial banks to screw up, commercial banks can do that on their own pretty well. Interestingly in the book, one senator gets quoted that “bank deregulation had gone too far” back then in the early 80ties. But this was a time what we would consider now as “tightly regulated”.

Another similarity to modern cases is the fact, that none of the “big guys” had to go to prison, only “lower level” guys got sentenced and one of them only because his employer needed to cash in the fraud insurance policy. Finally, the main players of the Oil Boom behaved very similar to Investment bankers in the 2000s and Internet entrepreneurs today. Private planes, helicopters, 1000 USD dinners etc. were already standard for the high rollers back then.

I think the main take-away from the book is that boom and busts will always occur and banks are inherently instable especially when there is a lot of credit growth. As an investor, it usually pays to stay out of such areas, unless you are very close to the promoters, otherwise the risk to get “fleeced” is very high.

Summary: I can highly recommend the book to anyone who is interested in the history of capital markets, especially boom and bust stories. This is one of the “classics”. As an add-on it gives some insight into the Oil and Gas explorer/drilling industry.

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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