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Morningstar | PICC P&C’s Net Profit Growth of Zero Was Dragged by Increased Tax Expense in the First Half. See Updated Analyst Note from 29 Aug 2018

No-moat PICC P&C's first-half net profit growth was solid, with premium growth increasing to 17% from 11.6% in the year-ago period. Top-line growth and underwriting margin were in line with our expectation, representing 47% and 66% of our full-year forecast, respectively. However, net profit growth was a bit disappointing at 0.1% versus 17% in the first quarter, primarily driven by a 55% increase in tax expenses, as selling expenses, which exceeded the regulatory ceiling, were not tax-deducted. Excluding this, 10.6% operating profit growth was largely in line and slightly lower than the 11.8% growth rate in the year-ago period. We made no changes to our key assumptions, but we slightly lower our fair value estimate for PICC P&C to HKD 11 from HKD 11.67 to reflect the latest Chinese yuan/Hong Kong dollar exchange rate. Shares are trading at a 16% discount to our fair value estimate and 1.2 times 2018 fair price/book value, which is the low end of its historical valuation range since 2011 of 1.0-4.0 times.

We believe this presents an attractive entry point for long-term investors, as the market is overly concerned about the negative impact of ongoing auto insurance pricing reform and weakening profitability with the increased tax expense on above-quota selling expenses. However, we see potentials for easing regulations on selling expense quotas and increased pricing coordination among industry leaders in the second half. Given its enormous scale, relatively strong bargaining power over distributors, and sufficient capital, PICC P&C will benefit from pricing reform in the long run.

Other highlights in the result included a healthy improvement in premium growth and investment return. Contrary to peers, PICC P&C’s net investment return and gross investment return slightly improved to 4.2% and 5.2% despite fluctuating market conditions. The company’s prudent investment approach was evidenced by its lower-than-peer investment return volatility over the past five years. Year-on-year premium growth increased to 17% from 11.6% in the year-ago period. Market share further gained 0.9 percentage points to a record high at 34%, thanks to slowing industry growth as competition intensified. The strong premium growth was driven by 34% growth in nonauto insurance, which contributed 40% of total premium, while auto insurance grew 3.9%.

Underwriting profitability dropped slightly, with the combined ratio rising 40 basis points to 95.8%. This was attributable to 30-basis-point and 10-basis-point respective increases in the claim and expense ratios. By product line, the auto insurance combined ratio rose 70 basis points to 96.7%. Despite the drop in underwriting margin, the company maintained the lowest costs among peers, which posted 97.2% and 98% respective combined ratios for Ping An and CPIC.

Nonauto insurance lines were the bright spot of the results, with premium and profits growing 33% and 40%, respectively. Major profit contributors were agriculture, commercial property, and liabilty insurance, which contributed 21%, 12%, and 9%, respectively. Agriculture insurance premium surged 64% and the combined ratio dropped by 4 percentage points to 88.9%. However, the commercial property combined ratio deteriorated by 4 percentage points to 86%, continuing its upward trend of the past two years. We expect weaker underwriting profits for nonauto insurance in the second half due to seasonal patterns, while the auto insurance margin is likely to see slight improvement, given the increasing proportion of high-quality customers. As a result, the combined ratio is likely to climb to over 16% but should remain below the 17% level in 2017.