AMIGF - Admiral Group Is Actually Quite Admirable

Summary

• Admiral's strong capital release and dividend record has supported long-term shareholder returns.
• The market is overly pessimistic due to idiosyncratic issues at competitors, creating a variant perception opportunity.
• Admiral is the market leader in the UK, and inflation expectations should boost its all-important Group combined ratio.

It has been a difficult year for a lot of UK based non-life insurers. High inflation in the sector’s claims supply chains has messed with pricing structures, while vehicle-related claims have climbed steeply since pandemic restrictions lifted. Even worse for the insurers, they can no longer milk loyal policyholders with steadily higher rates now that the UK Financial Conduct Authority has forbidden “price walking”. This means the appeal of 12-month teaser rates has lessened, making potential customers much harder to win from competitors.

On balance, the sector looks like a dog with fleas. However, as Seeking Alpha readers will know, this kind of sentiment is just an invitation to an opportunity to secure good prices for excellent businesses. In this light and following some strong half-year results released back in August, I think personal insurer Admiral Group plc ( OTCPK:AMIGF ) the kind of contrarian bet that value investors will appreciate.

Cardiff, Wales-headquartered Property and Casualty insurance group Admiral, generates nearly all its profits from UK motor insurance. Back in July, investors saw a profit warning from premium peer Sabre Insurance and decided – by wiping off about one third of Admiral’s market capitalisation - that Admiral would face a similarly problematic spike in its combined operating ratio – the insurance industry’s standard measure of underwriting profitability.

Admiral’s half-year results in August were well received and the stock recovered somewhat but have drifted lower since. The half-year results showed the situation is starting to stabilise and highlighted the issues that all non-life insurers have been dealing with this year, but overall showed grounds for cautious optimism.

Most importantly, I think, is the fact that Admiral did not follow Sabre in issuing a profit warning prior to the half-year results. It seems to me that the company is coping with the current situation.

Admiral also stuck to both its regular and special dividends, via £0.442 and £0.158 distributions respectively, together amounting to 90% of total earnings for the six months through June.

Another £0.45 dividend was paid from the proceeds of the sale of Admiral’s insurance comparison website division Penguin Portals and this is the final payment related to that transaction. All in all, Admiral paid out £1.05 for the first half. This kind of commitment to shareholder returns is a strong signal that both management is confident in its financial position, and that shareholders will be rewarded for holding the stock. Indeed, shareholder distributions have made up around two-thirds of the stock’s above-average total return over the last ten years.

I think that Admiral has enough reserves to release more for shareholder distributions. Even after releasing £169 million in the first half of 2022, Admiral’s net claims provision increased by 6% to £1.72 billion. Admiral should be able to continue to pay out some reserves even in the current environment. Investors must differentiate between insurers with company-specific issues which are not sector driven, and those insurers who are still performing fine and in healthy shape. Additionally, Admiral has a reasonable Piotroski F-Score of 6 out of 9.

Now that the pandemic is subsiding, at the UK at least, it’s now fair to compare the current performance against 2019. The pandemic’s main impact was to artificially depress the company’s loss ratio, as millions of car and commercial vehicle drivers stopped driving and so claims plunged. This caused a drop in the ratio of losses paid to premiums earned (also known as the group loss ratio) to 49.1% in the first half of 2021, before returning to 67.6% in H1 of 2022. Compare this to 2019’s figure which was 69%, so we could say the current performance is far closer to the company’s expected average. Where inflation has played a part is on the group’s total cost ratio. This was 23% in 2019, but 29% at the last results as prices in the claims pipeline – for things like second-hand cars, repairs, and labor – all shot up thanks to the current inflationary environment.

Customer retention

One key question to the investment thesis is around the assumptions for the possibility of easing in inflation and cost pressures so that they could be matched with rises in premiums increases. Car insurance is a competitive business and some insurers have not matched premiums with inflation rates. This is probably why investors panicked at Sabre’s July profit warning, given it was seen as a bellwether - a benchmark in the car insurance sector.

Now we can say that those concerns were probably overstated, at least with respect to Admiral. I think the market underestimated Admiral’s ability to both keep existing customers and get new ones. For the Admiral Group, customer numbers are up 14% year-on-year, and up 35% since June 2019. Its UK lines saw customer growth of 12% to 6.9 million over the year, or 30% up against 2019 numbers. I think this is positive for margin expansion once inflation come down, especially given that Admiral is now the largest UK car insurer with about 16% of the domestic market, and so has more bargaining power over suppliers, which Michael Porter’s Five Forces would suggest is a very favourable industry position to be in.

Admiral has clearly shown good underwriting discipline, and along with the aforementioned economies of scale, another cause for Admiral’s recent outperformance versus its peers is from a more diversified business which enables a strong reserve base that can feed shareholder distributions.

Take Admiral’s personal lending business, Admiral Money, which provides unsecured personal finance loans. An improving outlook on net interest margins helped the segment make its first profit in the half. Although not yet a significant business for Admiral when compared against Admiral’s insurance businesses, it highlights the broader potential for growth in profitable niches, given that I estimate the division’s return on equity should be in the 30% to 35% range.

Risk Or Opportunity?

One risk for Admiral, however, is the US market, which it entered in 2009. Admiral US is unlikely to become a top 10 insurance provider, where Berkshire Hathaway is the king. It might be worth to cut losses here and exit this business and return proceeds to shareholders. Management will argue that operating in the world’s most mature car insurance market can provide useful insights for the rest of the group operations. This could be a catalyst, as Admiral hasn’t yet put the US business under review.

Valuation

The stock now trades on about 16x earnings, roughly in line with its five-year average. Its Shiller PE ratio is at 13.5x, which is right at the bottom of a wide 10-year range of 11.5x to 30x.

It might be that this is because investors are quite cautious on the assumptions embedded around the claims environment and Admiral’s ability to convert net earned premiums into net profits. Maybe investors have become too blinkered, as is often the case, on the near-term hit to earnings. However, given customer growth, excellent returns on tangible equity and my forecast of steady net income growth in the years to 2025 I think the stock has a lot of upside.

Management can let the Admiral’s dividend performance do the talking. Over the past ten years, no other constant member of the FTSE 100 has paid out a greater proportion of dividends relative to its 2012 market capitalization than Admiral. This statistic gives Admiral one of the best total return track records among the FTSE 100 thanks to its good balance between capital returns and growth.

Conclusion

In summary, Admiral’s consistent performance, strong profitability and market positioning gives me a lot of confidence in the years ahead. I am very strongly considering adding this stock to my portfolio.

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