Coface SA (ISIN FR0010667147) : Ultimate death spiral or contrarian opportunity in an attractive industry ?
Coface SA is a relatively simple contrarian “mean reversion” case:
- the company at the moment has some specific issues which in my opinion can be solved
- the industry as such is attractive (within the generally problematic insurance space) with significant barriers to entry and little exposure to interest rates
- Even in a bad case, the downside at current depressed levels is small. A conservative “mean reversion case” would indicate ~75% upside without assuming any growth
- no hard “catalyst” and fundamentally it could get worse before it gets better
- For exposure management reasons, NN Group will be sold and replaced by Coface
- As always the reminder DO YOUR OWN RESEARCH. THIS IS NOT INVESTMENT ADVISE !!!!
Coface SA is a French “Trade Credit Insurance” company and one of the Big 3 players of this industry which together have 80% market share.
Coface interestingly went public twice. For the first time they went public in 2000 but were then taken over by French Bank Natixis in 2002. In June 2014, Natixis then sold the majority of the shares in a new IPO and is currently still the dominant shareholder with a 41% stake.
Some numbers (at EUR 4,55 per share)
Market Cap : 715 mn EUR
P/E 2015: 5,7
P/E 2016: 16,9
Perf. YTD: -47,8% (incl. dividend)
The stock chart looks really ugly, very much like a “death spiral”:
Trade Credit Insurance – high barriers to entry & network effect
A trade credit insurer insures a company against a default in any of its receivables, so “claims” come up when a customer of the insured gets into trouble, not the insured himself. In general, Credit insurers do not insure single risks but the whole receivable portfolio. Different to banks, the underlying exposures are very short-term, typically up to 90 days.
Underwriting a trade credit policy therefore is different from normal insurance. In normal insurance, you “only” have to assess the risk of your contractual partner and match this to a historical pattern. In a typical trade credit insurance contract however, for instance if you underwrite a policy for a German exporter, you will have to understand and price hundreds of different potential risks on a global basis. So if you start at scratch and have to analyse every counterpart, the cost for this first contract will be prohibitively high. If you have the all the names already in your database, the cost is however negligible.
Therefore Trade credit insurance is one of the most concentrated insurance markets. 2015 global premium volume is ~6,5 bn EUR. The largest 3 trade credit insurers account for ~81%. I found an interesting report which shows the concentration process over the last 2 decades:
The current market shares are as follow:
Euler-Hermes ~36% (Cost ratio 2015: 27% , CR 2015 80,1%
Atradius 25% (Cost ratio 2015: 34%, CR 2015: 75,6%)
Coface 20% (Cost ratio 2015 29,5%, CR 2015: 82,5%)
Coface is the smallest of the “Big 3” but the numbers I have shown above make clear that there doesn’t seem to be a systematic size/cost relationship within the top 3.
So overall I would say that Trade Credit insurance is a quite interesting market with significant barriers to entry.
Credit Insurance, diversification and investment risk
Another Trade credit insurance specific factor is the following: In normal property and casual insurance, claims are independent from capital market developments, so it can make a lot of sense to invest their money backing insurance reserves (Float) into riskier type of assets. For a Trade Credit insurer however this is a little bit more tricky. Claims normally increase when there are many defaults, which in the same time could hurt the investment portfolios. Therefore, Trade credit insurers have only a limited capacity of taking investment risk, especially credit risk as they are already exposed on the insurance side.
Additionally, claims in Credit Insurance have naturally less diversification then for instance earthquake insurance. For this reason, Credit insurance is relatively capital-intensive for a “short tail” P&C insurance business. Coface for instance has around Equity of ~2 times net earned premium, a “normal” P&C insurance company would have rather a ratio of around 1:1.
I think the combination of restricted investment activities and large capital requirement is the main reason why trade credit insurance is structurally much more profitable than most other insurance sectors. In contrast to other insurance companies, the trade credit insurers could never rely on making their all money solely with investments. They always had to make sure that they earn money in insurance.
Additionally, the correlation of the technical insurance results with capital market makes the sector less attractive for “alternative sources of capital” which is a big issue at the moment for “traditional” P&C insurance.
That’s why I think Credit Insurance is structurally a very interesting business with overall very attractive economics despite the inherent volatility.
Coface specific issues (1): Loss of the French Government contract
For 70 years, Coface administered the French Government Export Guarantee program. In 2015 however, the French Government decided to move the program to another supplier BPI France (state owned entity).Coface will receive compensation (~80 mn EUR pre tax) but lose ~20 mn net profit per year. The effective transfer will happen at the end of 2016.
Although this is not fresh news, it seems to have some effect on the share price as investors in general don’t like a reduction in profits.
Coface specific issues (2): Emerging markets exposure
This is from a JPM research report in July 2015 when EM troubles started brewing:
We downgrade Coface from OW to N and reduce our Dec15 SoTP-based TP from €13.39 to €12.1. We do this for three reasons:1. 2Q15 earnings miss due to higher claims in emerging markets;2. relatively low compensation to be paid by the French state for the loss of the state guarantee business;3. 1.4pct lower pro forma return on average tangible equity, as a result of the loss
Interestingly, the 3rd reason is a direct consequence of the first 2, but anyway….
The next leg down came then in February 2016 after the 2015 numbers. Again JPM in February 2016:
The Coface earnings were inline but the outlook was relatively prudent. The newCEO arrived on the date of the results and highlighted only that the 8.3% reported return on average tangible equity reflects current market conditions.We believe the new CEO will cut costs aggressively and we therefore believe that the full €51m net of tax compensation payment by the French government for the loss of the state guarantee business will be used to fund restructuring. In addition, as the group stressed that the benefit of volume reduction in China would be fully reflected 2H16, we believe that the group’s combined ratio will be higher than we originally forecast FY16e. We therefore cut our earnings and dividend forecasts, and reduce our Dec16 sum of parts based target price to €7.7 from €11.3.
The last “leg down” so far then came in July after a profit warning. Again, JPM in early July:
Coface published a profit warning after COB on 4 July: Coface guided that its loss ratio in FY16 would be 63-66% up from 52.5% FY15 and vs our forecast FY16e of 51.5%. Coface noted that this was due to higher claims in its Emerging Markets units in Asia and Latin America, and higher claims from exporters in mature markets (mainly Europe) to Asia and LatAm. Coface sees an increase in the number and cost of mid size claims of €500,000 or more in these emerging markets. We now cut our forecast net profit by 64% for FY16e, -35% FY17e and -31% FY18e. We revise our SoTP -based Dec16 target price from €8.3 to €5.5, and downgrade the stock to UW from OW.
If we look at this we can see that JPM reduced the price target within 12 months from 13,39 to 5,50 EUR based on information which was maybe not that unexpected.
Analyst consensus according to Bloomberg is pretty bad, from the 7 analysts, 3 have a “sell”, 2 are neutral and only 2 rate the stock “buy”, although the consensus price target still is 6 EUR per share.
Coface has traditionally a relatively high “overseas” exposure. This is a result of the administration of the French Export guarantee program which traditionally led to many contacts thorough out the world. At the moment this is clearly a disadvantage for them, as those markets, especially China, Brazil anD Turkey suffer.
However, as always in insurance, high claims are also often an opportunity, both to sell more coverage and ask for higher prices. So I do not see this as a structural issue but rather a cyclical one. No or very little claims for a long time is actually not good in the long-term.
New Management & other factors
The board of Coface is still dominated by Natixis. The CEO of Natixis, Laurent Mignon is actually Head of the Supervisory board. Obviously they were not happy with the performance of Coface, so they replaced the old one with a new one in January 2016.
Natixis does not plan to hold the shares forever, but in a recent call Mignon mentioned that they plan to hold the stock langer than they initially planned.
Xavier Durant, the new CEO is French but worked for GE Capital mostly in Asia.
A new CEO clearly has an incentive to “kitchen sink” everything in the first year and I think that is something we already see at Coface as well. He already announced a significant cost reduction program with significant one-off costs. This should have been compensated by the payment from the French Government for the loss of the export program, but as it looks now, the gain might materialize only in early 2017. So it is not unlikely that we see more bad (accounting) numbers within 2016 and only a small profit if at all for the current year.
Nevertheless, I do think that this also presents a potential opportunity for the contrarian investor. IF Coface manages to return to “Normality” which I think is not unlikely, then investing at a high P/E during a “kitchen sink year” could be potentially attractive.
As a side remark: I do think that Coface has “best in class” reporting in the insurance industry. For instance this detailed explanation how the calculate cost and combined ratio from the half-year investor presentation is something I haven’t found in most other Insurance presentations:
As my readers know, I try to keep it simple. The two traded peers Euler-Hermes and Atradius (Catalana) both trade at P/E ratios of around 10 (10,2 and 9,8), so aI assume that for Coface 10x P/E is a fair multiple.
Further I do not assume any growth, so I assume stable 920 mn net earned premiums and 2,5 bn total investments. Then we can do a relative simple valuation grid how profits and valuation per share behave assuming different long-term Combined ratios And investment returns:
I have marked 3 boxes which to me are most relevant:
The green one at 89% Combined ratio and 1% investment yield would be my base case. Why ? 89% is the long-term average Combined ratio of Coface (including the financial crisis) and I see no reason why they shouldn’t achieve this level again in the future over the cycle. A 1% yield on the portfolio should be achievable in the current environment, especially considering that part of the business (and subsequent reserves) is done in high yield countries like Brazil or Turkey. The base case therefore would imply an upside of +75% against the current share price.
The orange box would be my “bad case”. There I would assume that they would earn only half a percent on investments and the CR structurally deteriorates by 5%. Interestingly, this is very close to the current share price.
The blue box basically would be the upside case. In all cases, no growth is assumed and no multiple expansion either. Of course I haven’t considered a rerun of the financial crisis either.
Overall to me this looks like an extremely attractive risk/return scenario. Very little downside risk but significant upside opportunity. Of course timing is difficult and it could get worse before it is getting better but again, I do not see a structural issue with Coface but rather a temporary / individual issue.
Why not buy Euler-Hermes or Catalanea (Atradius) ?
Catalana in my opinion is difficult because you get a lot of Spanish exposure on top of Atradius. The problem with Euler Hermes in my opinion is that despite it looks optically cheap and is the market leader, I do think that the current combined ratios around 80% are not sustainable. On a normalized basis Coface is a lot cheaper than Eurler Hermes. From my own market research I learned that none of the big 3 seem to have specific advantages vs. each other. Coface is seen as the most aggressive player of the big 3. Coface is also the only of the Big Three who could be a potential M&A target at some point in time.
As my exposure to financial services now has reached almost 30%, I am hesitating to put another position on top of that. I do like the financial services sector, but I don’t want to bet the house on it. So I decided that one of the existing positions has to go. When I look at my financial stocks all of them are relatively cheap and have in principle good upside::
At the end of the day however I decided to take out NN Group. Why ? Because I think NN Group, despite being in my opinion one of the better managed European Insurance groups, has the biggest fundamental issues with continuous low interest rates.
With current interest rate levels, Life insurance is not a viable product anymore. Yes, you could run off the company and realize part of the book value, but in my opinion the life insurance industry currently is where banking was 3-5 years ago. I think the market hasn’t realized how bad the situation actually is for life insurers. I expect increasing pressure from regulators and significant capital raising rounds in the next few years.
So Coface will replace NN Group in my portfolio as I see better visibility of a “mean reversion” here.
As outlined above, I do think Coface at current levels represents a very decent risk/return proposition and looks like an attractive “contrarian” investment. The market currently seems to take the “downside case” as given. A likely base case already offers significant upside.
Therefore I have allocated 2,8% of my portfolio into Coface at a price of around 4,65 EUR per share. This has been financed by my ~2,8% stake in NN Group which i sold fully at around 26,50= EUR/share.
Edit: At the time of writing, the stock hovered between 4,55 and 4,70 EUR, all my calculations are based on that level. I know it is kind of unfair to post a purchase price which is now, at the time of publishing, already a few % higher. But I usually buy when I have finalized my analysis but before I have “fine polished” my write-up, which takes me ususally 3-5 days. Those kind of delays are inevitable. This also goes into the other direction. For instance I did sell my Hornbach Shares without publishing yet at around 25,50 EUR and now the stock is at 28,50……