Admiral Group ADM LN
July 20, 2015 - 3:16pm EST by
rickey824
2015 2016
Price: 1,453.00 EPS 0 0
Shares Out. (in M): 279 P/E 0 0
Market Cap (in M): 6,000 P/FCF 0 0
Net Debt (in M): 0 EBIT 0 0
TEV: 0 TEV/EBIT 0 0

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  • Insurance
  • United Kingdom
  • low-cost producer
 

Description

 

Admiral Group is the fifth largest motor (AKA auto) insurance company in the United Kingdom with ~12% market share and, we believe, one of the best insurance companies in the world.  While we realize this is a controversial claim, objectively, the facts seem to support it.  We highlight three data points in particular:

 

·         Consistently profitable underwriting results:  ADM is one of only four global publicly-traded insurance companies that has generated a combined ratio of less than 98% in each of the last 14 years. [1]  ADM’s UK combined ratio averaged just 84% over this period and exceeded 90% in only three years. [2] 

 

·         Extremely conservative reserving: Reserve releases have averaged 13% of premiums earned over the last 14 years.  ADM has never strengthened its reserves.  This means earnings quality is high as profits are recognized later when losses are more predictable.

 

·         Large outperformance vs. peers:  Since 2001, ADM’s accident-year combined ratio has averaged just 79% compared to 107% for the broader UK insurance market.  This means that ADM earns an extra 28 cents for every dollar of premium that it collects.  This outperformance is especially impressive given ADM sells a highly-commoditized product.

 

ADM’s operating performance is mainly the result of two process-based competitive advantages which, while not uncopiable, provide a formidable moat in tandem.  The first is ADM’s low cost structure.  ADM’s expense ratio is 13 percentage points lower than the market’s on average.  Similar to a mining company with easily accessible reserves, ADM’s lean expense base allows it to remain profitable during downcycles and capitalize on higher prices as the market firms up.  The second is ADM’s data-driven pricing discipline.  ADM’s loss ratio has been about 15 percentage points lower than the market’s on average.  From our research, we have learned that ADM collects and uses more data than any of its peers in pricing its policies.  ADM constantly reevaluates its pricing and is not afraid to change rates when facts change.

 

 

The thesis here is simple.  ADM currently trades at 14x core UK earnings (near historical lows) and, given its unique capital-lite business model, is able to pay a 7% dividend.  In today’s interest rate environment, this multiple seems reasonable for a company of ADM’s quality without factoring in any future growth.  However, we believe the market underestimates the potential for ADM’s earnings power and dividend to meaningfully grow as it gains share when the market inevitably hardens.  While the scope and timing of this growth is difficult to pinpoint, it does not take heroic assumptions for ADM to offer 10-15% annualized returns over the next five years without any multiple expansion.  In a more-bullish scenario with modest multiple expansion, ADM shares will appreciate 15-20+% annually.

 

 

 

The GEICO of the United Kingdom

 

In July of 1976, a 45-year-old Warren Buffett sent an internal memo to a Berkshire Hathaway executive named George Young, who was then running one of Berkshire’s insurance subsidiaries, National Indemnity. In the memo, Buffett walked through his rationale for an investment in GEICO, a company that was then struggling with losses, but in the 29 years since has become widely recognized as one of the most dominant auto insurers in the United States.

 

“I hope it is not a governing factor in any way, but I do have some sentimental reasons for wishing GEICO to survive… I just have pulled out of the bottom drawer of my desk a statement of my net worth at the end of 1951 when I was 21 years old. I showed net assets of $19,737, of which $13,125 was in GEICO stock. That was the year when I first started selling securities, and I told everyone who would listen to me that they should put every cent they could scrape together into GEICO. A number of friends and relatives did so, and enjoyed a significant change in their financial fortunes because of this. It provided the first big boost to my own small savings, as well as an even more important boost to my reputation in the Omaha investment community.

 

 

At that time I felt that GEICO possessed an extraordinary business advantage in a very large industry that was going to continue to grow. Since that time they never have lost that advantage—the ability to give the policyholder back in losses a greater percentage of the premium dollar than any other auto insurance company in the country, while still providing a profit to the company. I always have been attracted to the low cost operator in any business and, when you can find a combination of (i) an extremely large business, (ii) a more or less homogenous product, and (iii) a very large gap in operating costs between the low cost operator and all of the other companies in the industry, you have a really attractive investment situation. That situation prevailed twenty-five years ago when I first became interested in the company, and it still prevails.”

 

 

Like GEICO, Admiral’s competitive advantage is rooted in its low cost structure. 

 

“Cost consciousness has to be engrained to be effective, a core part of ­the way in which we do things. It is everyone’s responsibility, not just that of­ the Finance team” (Chairman’s Letter, ADM 2013 Annual Report). 

 

 

It’s been this way since Admiral was founded in 1992 in Cardiff, Wales.  Why Wales?  Because “they paid us” proclaims Admiral CEO and Founder, Henry Engelhardt.  In fact, ADM sent letters to 10 local governments where he might headquarter his new company and only one, South Glamorgan County Council, responded. ADM was granted a whopping £1 million, which was enough to persuade frugal Mr. Engelhardt.  ADM’s Cardiff rent is currently just £17 per square foot, a fraction of that of ADM’s London-based competitors.

 

 

However, ADM’s main cost advantage, again similar to GEICO’s, is that it was founded with a direct-to-consumer distribution model, which avoids paying costly commissions to brokers.  ADM actually took this a step further by launching the first price comparison site in the United Kingdom, Confused.com.  Here consumers can easily compare motor insurance quotes from different insurers with full transparency online, eliminating the need for brokers.  Because of its low expense base, ADM has “the ability to give the policyholder back in losses a greater percentage of the premium dollar than any other auto insurance company in the country, while still providing a profit to the company,” which means they often offer the cheapest price.

 

 

Over the last decade, the UK consumer has rapidly migrated towards using price comparison websites to purchase motor insurance.  In 2013, 67% of UK policyholders used price comparison sites when shopping for motor insurance.  For context, only 30% of US policyholders “shop” at all at renewal and there is currently no useful price comparison website available, though ADM is trying to change that.  More on ADM’s US expansion in the risks section.

 

In the chart on the right you can see ADM’s expense ratio compared to the market.  ADM’s average expense ratio advantage of 13% shows no signs of eroding.

 

Data-driven pricing

 

The source of ADM’s loss ratio outperformance (13 percentage points on average annually) is more complex and difficult to pinpoint. However, we have been able to glean some insight into ADM’s unique underwriting strategy and culture.

 

 

 

According to Alastair Lyons, ADM’s Chairman, “data analysis lies at the heart of our pricing algorithms. With three million customers and substantial amounts of data our experienced pricing team is excellently placed to derive competitive advantage.”  This sentiment is echoed by industry participants that we’ve spoken to.  According to one, “ADM looks at data like a trader.”  This approach is differentiated from the herds of other insurers, who ride the ups and downs of the cycle with largely homogeneous pricing.

 

One source of data is ADM’s own UK price comparison site.  By controlling confused.com, ADM can choose which questions policyholders must answer prior to receiving a quote.  ADM asks significantly more questions than their peers.

 

 

 

 

 

ADM also subscribes to external databases (credit, vehicle, demographic and claims) where they can cross-reference data.  One former employee gave the example of how ADM uses postal codes, which are much more precise in the UK than in the USA, to narrow down the potential occupations of a given applicant.  ADM can then cross-reference this information against its other databases to predict behavior. “There’s a lightness to how they interact with data daily,” she claims.

 

 

In a 2010 analyst presentation, ADM’s Pricing Manager, Peter Marissen, explained ADM’s approach to pricing:

 

“It is something that is obviously quite numbers oriented. I don’t want to give the impression that it is purely about using sophisticated statistical techniques because it is not. The course we take is much more driven by common sense, understanding the customer, trying to find innovative ways of using the data to price the customer accurately. Because we constantly work on looking at the portfolio and analyzing that, that also results in a lot of changes that we make. We probably change our rates once a week, twice a week, something like that on average. And we have a system there where we can do that very quickly and quite easily. We are not afraid to do things differently. We are very driven by what the data tells us.

 

 

In the first nine months of 2008 alone, ADM disclosed over 58 ratechanges.

 

 

 

 

Once a trend is deciphered, we understand that all pricing changes must be approved by Mr. Engelhardt and David Stevens (COO), who is one of the most-respected executives we have ever encountered.  This makes sense given the commoditized nature of the product and automated pricing algorithms; small pricing changes can have large implications on the overall portfolio.  ADM has managed to keep this small-company culture despite its rapid growth. 

 

 

ADM’s approach to claims management also seems to be data-driven:

 

“We have learnt over the years that speed is of the essence especially when settling bodily injury claims. The faster you settle them, they tend to be a bit cheaper and just as importantly the faster you settle them, it is much lower administration cost. Indeed our third party customer care team has been the team which has grown most rapidly over recent times.” 

 

 

 

 

An Insurance Company with 50+% ROEs

We initially stumbled upon ADM while screening for companies demonstrating exceptional and consistent returns on equity.  ADM is one of only nine public companies we found that has generated ROEs greater than 40% in each of the last eleven years.[3]  The other eight happen to trade at a mean P/E ratio of 25x and include household names like Colgate, Campbell, and Accenture.  Given the capital intensity of the insurance business, we were surprised find ADM on the list.

However, a cursory look at ADM’s public filings reveals its unique capital-light business model.  ADM reinsures 75% of its premiums through an increasingly diverse group of strong counterparties.


What is less obvious is the extremely favorable terms that ADM has been able to secure with these reinsurers.  While almost all market participants we spoke to were aware of ADM’s extensive use of reinsurance, none appreciated the terms of these agreements.  Furthermore, most viewed ADM’s reliance on reinsurance as an incremental risk to the Company because of the additional counterparty exposure. 

These views are misinformed.  ADM’s reinsurance contracts provide extremely efficient capital relief.  In its Q3 2011 conference call, ADM disclosed:

"If we were to achieve an 85% combined, what would be our share of the various different profit flows?"…looking at our more recent contracts we're up to knocking on the door of 90% of the return.”

In other words, ADM keeps approximately 90% of the profits while being exposed to only 25% of potential losses.

ADM discloses the terms of its proportional reinsurance arrangements covering 35% of their premiums.  Under the terms of these contracts, ADM is able keep 100% of the profits below a 98% combined ratio.  At an 85% combined ratio, this means ADM retain 87% of the profits (13% retained / 15% profit margin).  We can back into the economics of ADM’s 40% coinsurance with Munich Re, which appear to be similar to its reinsurance deals.

 

Importantly, the terms of ADM’s co/reinsurance arrangements have improved dramatically over time as ADM has diversified its counterparties; in 2005, ADM kept only 29.5% of profits under the Munich Re co-insurance agreement for example. This demonstrates the strong demand for ADM’s premium.  From a reinsurer’s perspective, ADM’s premium represents a safe and stable way to diversify their more volatile exposures.  While a 2% margin seems small, given the security of that return, we believe reinsurers allocate very little risk capital to ADM’s premium. 

ADM’s capital-light business model allows ADM to grow without consuming much capital, which in turn allows ADM to preserve its dividend.  We estimate that in a 13% annual premium growth scenario, ADM is able to dividend twice as much cash under its current reinsurance-dependent structure than it would if it were traditionally capitalized with equity.

Valuation: The ADM Bond[4]

While there is some noise in ADM’s current financials due to reserve releases, ADM’s current earnings power can be estimated as presented below.

·         Drivers: Per H1 2014 results

·         Average Premium: Per 2013

·         Combined Ratio:  In addition to its own loss reserves, which has over-reserved consistently by ~13%, ADM discloses its actuary’s best loss estimate, which has proven much more accurate (though still conservative) historically.  Since 2004, ADM has averaged an 84% combined ratio.  We have assumed 85%.   

·         Other profit per driver: based on current trends.  See risks section.

 

We believe that 14x (7% dividend yield) is a reasonable price for ADM without any growth.  However, it is highly likely this multiple will contract (and the dividend will expand) materially as the cycle hardens, which has been the historical pattern.  As COO David Stevens explains:

“In the great inflation of 2010–11 our increases lagged the market and we declined to participate in others’ large scale withdrawal from higher risk segments. As a result, we grew by nearly 60% in the two years – and quite rightly. It’s now clear that the business written at the time was very profitable. Conversely, as prices have fallen, we’ve lagged the market and reduced our share of new business volumes, particularly in the higher premium segments, currently (temporarily?) attractive to some of our competitors.”

 

Below, we present ADM’s earnings power in 5 years under various growth assumptions.  In our admittedly unscientific base case, we assume 7.5% annual driver growth, which is significantly lower than ADM’s historical 5 year CAGR of 13-19% since 2009 for conservatism and also because of the law of large numbers.  This implies ADM grows its market share to ~17%, compared to 12% today.  We have also assumed a higher combined ratio of 88% (vs. 83% since 2004) and a lower profit take of 88% (vs. 90% currently).   The data table shows ADM’s year-5 P/E ratio under various growth and combined ratio assumptions.

 

Ultimately, we like to think of ADM as a bond.  We believe ADM’s current earnings stream can support a ~6-7% dividend (“coupon”) and believe it is a fair yield in today’s interest rate environment.  For context, ADM’s recent 10 year subordinated bond yields just 5.3% currently.  However, we believe it is highly likely that ADM’s earnings power will grow meaningfully over the next 5 years.  If we are right, and ADM grows earnings by 6+% annually, our compounded annual rate of return will likely be in the teens.  In more aggressive growth scenarios, and/or assuming some multiple expansion, 15-20+% annual returns are not out of the question.

In terms of current price target, an 18x entry multiple (~£ 1900 currently) with 7.5% annual growth and a 14x exit multiple implies a 7% annualized return, which seems fair to us both intrinsically and compared to other yielding equities.

Closing Thoughts on Management

Assessing a management team is mostly subjective and we encourage readers to develop their own opinion.  However, we would be remiss not to mention the overwhelmingly positive feedback we have received from industry experts regarding ADM’s top management: Henry Engelhardt (CEO), Alastair Lyons (Chairman), David Stevens (COO and likely next CEO) and Kevin Chidwick (CEO of US Operations).  There seems to be a mystique to ADM’s extraordinary management and performance, which confounds competitors. 

ADM’s management team are iconoclasts.  The Company’s history is littered with examples of their “outsider”[5] culture:

  • ·         Headquartered in Wales, separate from other insurance companies located in London
  • ·        Founded first price comparison site recognizing that “the internet is an irresistible force”, while legacy insurers fought to retain their captive broker business
  • ·         Pricing policies driven by data (leader), not market trends (follower).  Not afraid to do things differently.  This enables ADM to take advantage of cycles.

Capital allocation decisions have also proven extremely wise and shareholder-friendly.

  • ·         Dividend ~90% of excess capital
  • ·         Extensive use of extremely favorable reinsurance
  • ·         Issued fixed rate debt in July 2014, taking advantage of extremely low interest rates:  £ 200 million of 10 year subordinated notes with a 5.5% fixed coupon.  The net cost of this offering to ADM is just 2%[6] and it provides additional capital buffer to support the dividend and/or take advantage of the cycle hardening.
  • ·         Rapidly expanded market share in 2010/11, which was controversial at the time, but has proven prescient.

ADM’s management team is also highly aligned with shareholders.  Recently-retired CEO Henry Engelhardt owns 12.2% and COO David Stevens owns 3.6%.

 

Alternative View / Risks

1.    Reliance on Reserve Releases: 

ADM has been criticized by the market for its reliance on reserve releases.  David Stevens explains the flaws in this criticism:

“Bizarrely, some commentators discount the value of reserve releases as somehow generating lower quality profits. I say “bizarrely” for two reasons. First, to my mind, underwriting profits derived from releases on older, more developed, more predictable years cannot be lower quality than underwriting profits reported on current, undeveloped, years. Second, in Admiral’s case, profits from reserve releases can’t be considered “one-off” – we have released reserves every year since our flotation in 2004, at an average of 12% of premium earned.”

2.    Dividend cut:

A dividend cut is not out of the question given a weak 2014 underwriting result.  ADM’s financial statements reflect a 2014 accident year combined ratio of 107% and loss ratio of 92%, which is elevated by historical standards.  ADM’s historical average initially-booked combined ratio and loss ratio of 99% and 84%, respectively.  ADM’s actuary has initially estimated a loss reserve of 82%, which is the highest in the Company’s history. 

It seems likely that 2014 has a larger reserve buffer than a typical year.  2014 was a similar to 2011 in that there were a few large bodily injury claims early in the policy year, which was surprising given the mix of business was less risky than other years.  In 2011, ADM’s actuaries initially booked a loss reserve of 74%, which was subsequently reduced to just 64%.  A similar 10% reduction in loss reserve would bring ADM’s 2014 combined ratio to 87%. 

ADM also has significant excess reserves to release.  We estimate ADM’s current reserve buffer by comparing ADM’s most-recently disclosed accident year booked loss ratio to its actuary’s best estimate loss ratio.  We estimate that ADM has booked approximately £500 million of excess reserves as of FYE 2014 and we estimate that this figure stayed relatively constant in H1 2014.  This is 1.5x ADM’s pretax profit. 

Lastly, ADM has £ 300 million of excess capital, more than at any point in its history.  In total, we estimate that ADM has total excess capital (including reserve buffer) of ~£800 million (20% of market capitalization).

3.    Technology and Self-driving cars:  If/when self-driving cars become mainstream, ADM’s profitability will be severely impacted.  Best estimates are 2-5 years until the technology is publicly available.  The adaptation after that is anyone’s guess, however, the benefits of the technology (cleaner, safer, cheaper) likely significantly outweigh the disadvantages (not as fun, perhaps) especially in urban areas.  On the other hand, given the average vehicle life is 11 years, it may take significant time for the technology to have a meaningful impact on ADM.  Furthermore, Generation 1 self-driving cars are likely to be capable of driving only in relatively benign climates as bad weather (as in the UK) provides additional hurdles technologically.  We do not profess to have any unique insight here, but will continue to monitor the situation and adjust the position size if needed. 

4.    US and International Expansion:  ADM is spending a substantial amount of money on its international expansion, especially in the United States.  It plans to spend £ 40 million on its US price comparison site, comparenow.com.  While business in the US is growing, it is still far from profitability.  While the opportunity in the US (as well as Spain, Franc and Italy) is large and management’s track record is strong, we assign no value ADM’s international businesses.

5.    Ancillary Income:  ADM, like all UK insurance companies, generates a significant amount of profit from selling ancillary products like legal expense cover, car hire insurance, and administrative fees.  Some of these products are under scrutiny from regulators and ancillary profit has been falling for ADM.  We believe long-term this helps ADM relative to other less-profitable underwriting franchises, who are more reliant on ancillary income to generate profitability.  Industry-wide premiums should adjust higher over time, which plays to ADM’s strength.

6.    Lack of growth:  The market is overly concerned about ADM’s lack of growth since 2012.  It’s unlikely that ADM will continue to grow at its historical pace, however, we believe it still has substantial runway in the UK and, potentially, abroad. 

7.    Management change/Retirement: The CEO recently retired.  However, COO David Stevens is equally (perhaps, more) talented. 



[1] Source: Capital IQ.  The other three are Progressive, RLI and HCC.

[2] In 2001, 2011 and 2012, ADM’s combined was 94%, 91%, and 90%, respectively.

 

 

[3] Source: Capital IQ.  United States, Canada and Europe Developed Markets only.  Excludes Oil and Gas Exploration Companies in order to avoid trusts.

[4] Our valuation assigns no value to ADM’s international business.  We also exclude UK price comparison (confused.com) earnings from our valuation as they approximately cover corporate overhead.

[5] Reference to William Thorndike’s book “The Outsiders”, which we highly recommend.

[6] Assumes 2.8% ROI and 25% tax rate.

 

 

 

 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

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    Description

     

    Admiral Group is the fifth largest motor (AKA auto) insurance company in the United Kingdom with ~12% market share and, we believe, one of the best insurance companies in the world.  While we realize this is a controversial claim, objectively, the facts seem to support it.  We highlight three data points in particular:

     

    ·         Consistently profitable underwriting results:  ADM is one of only four global publicly-traded insurance companies that has generated a combined ratio of less than 98% in each of the last 14 years. [1]  ADM’s UK combined ratio averaged just 84% over this period and exceeded 90% in only three years. [2] 

     

    ·         Extremely conservative reserving: Reserve releases have averaged 13% of premiums earned over the last 14 years.  ADM has never strengthened its reserves.  This means earnings quality is high as profits are recognized later when losses are more predictable.

     

    ·         Large outperformance vs. peers:  Since 2001, ADM’s accident-year combined ratio has averaged just 79% compared to 107% for the broader UK insurance market.  This means that ADM earns an extra 28 cents for every dollar of premium that it collects.  This outperformance is especially impressive given ADM sells a highly-commoditized product.