2023-03-10 10:08:28 ET
Summary
- Aviva has undergone significant transformation in the past decade, improving its business mix and risk profile through major disposals, capital returns, and de-leveraging programs.
- The company's continuous share buyback program and dividends will be of paramount importance to equity investors.
- It's possible that a positive valuation re-rating could occur as a result of the positive story surrounding the stock in my view.
Overview
To begin, Aviva (AVVIY) is a company that has undergone substantial transformation. Over the past decade, the company's current CEO has significantly improved the business mix and risk profile through multiple divestitures and the start of a strong capital return story. From the perspective of equity investors, I believe that the continuous share buyback program and dividends payout will be of paramount importance going forward because of the positive impact it will have on the stock's attractive capital return narrative. Additionally, Aviva stands to gain from its position as a leading player in the UK Pensions Risk Transfer market. In addition, Aviva Investors' ability to source and originate attractive illiquid assets to back bulk annuity liabilities should help support EPS and FCF growth. And if we look at the FY22 results, they appear to be better than expected overall with several highlights. In terms of capital returns specifically, management has announced a £300 million buyback for 2023 and raised its dividend guidance, which would indicate a mid- to high-single-digit increase in DPS for FY23. Second, regarding the capital adequacy, the generation of own funds under Solvency II was 42% higher than anticipated and in accordance with IFRS. Notably, I think the underlying looks better, and management is aiming to beat its £1.5 billion OFG target for 2024. The Solvency II ratio was also higher than expected, coming in at 207%.
Looking at the big picture, the next few quarters or years look promising. In my opinion, Aviva has grown into a diversified UK insurer. It's possible that a positive valuation re-rating could occur as a result of the positive story surrounding the stock, which focuses on strong capital returns and positive earnings growth. As such I recommend a buy rating.
Capital allocation
Aviva has stated that it will repurchase £300 billion in shares in 2023 and has increased its cash dividend by 5% for the same year, both of which suggest that the DPS will increase by more than 5% as a result of the lower share count. On top of Aviva's diversified business model, I find this appealing because it implies a capital return yield in the high single digits to low teens, which is attractive and sustainable. Although the current guidance only extends to 2023, I expect Aviva to be able to maintain its current annual buyback volume given its strong capital formation and cash inflows.
The pro forma Solvency II ratio for FY22 was 207%, which is higher than the hurdle rate set by management of 180%. Given the uncertainty of the market, I think this puts Aviva in a strong position, as the company's management can rest easy with the surplus capital at its disposal. A stronger balance sheet is essential in my opinion because the current interest rate environment is unlikely to return to the days of zero interest rates. This is consistent with management's goal of increasing the capital ratio in the long run, which, in my opinion, is a prudent move on their part given that the company can easily afford to pay its dividends and repurchase its shares using internal resources alone, leaving the stock of capital available for more strategic investments.
Annuity volume
Since interest rates have increased and the UK is implementing its own Solvency regime, I anticipate a rise in the volume of potential bulk annuities in the years to come. Management has stated that it is not averse to making larger deals and is sticking to its £15-20 billion bulk annuities guidance for 2022-2024. However, the deal's financials have to be more attractive than other uses for the company's spare cash. For me, it's crucial that upper management sticks to its stated goal of diversification, and they have communicated that diversification is a key focus area. As such, growth in bulk annuities would be consistent with that priority. This furthers my conviction that Aviva stock has been subject to a steadily improving storyline over the years.
P&C
The decline in underwriting ratios among UK personal lines insurers is one area of concern for me in the UK P&C market. Despite management's assurances that Aviva is safe, I think it's important to keep an eye on this. Aviva has taken some positive steps, which is encouraging. To begin, they have raised prices, which has helped to stabilize its underwriting margins. As for the second strategy, diversification, I wholeheartedly support it. Aviva has benefited from its diversification strategy in that the company anticipates that Canada will soon deliver a combined ratio of greater than 94%, offsetting some of the higher combined ratio in the UK.
Conclusion
Overall, I recommend a buy rating for Aviva's stock, given the positive story surrounding strong capital returns and positive earnings growth. With a potential rise in bulk annuity volumes and a commitment to diversification, Aviva's stock offers an attractive valuation risk-reward for investors. However, it's important to keep an eye on the decline in underwriting ratios among UK personal lines insurers and ensure that Aviva continues to take positive steps to stabilize its underwriting margins.
For further details see:
Aviva: Attractive Capital Returns Story