EUR 850.00 For Business Accounts Only

Morningstar | Corporate Action: IAG Shareholders Should Vote in Favour of Capital Management Proposal at AGM. See Updated Analyst Note from 12 Sep 2018

We recommend that no-moat Insurance Australia Group shareholders vote in favour of the proposed capital management initiative announced with fiscal 2018 results on Aug. 15, as long as the decision aligns with individual investment goals. The vote will take place at the annual general meeting on Oct. 26. Surplus capital, strong profitability, and a positive business outlook enabled the board to propose the payment of AUD 25 cents per share, or cps. Equity capital is well above internal targets and regulatory requirements with limited operational demand for the surplus capital. We support the capital management initiative, valued at approximately AUD 592 million. Subject to shareholder approval, Insurance Australia Group intends to pay a capital return of AUD 19.5 cps and a fully franked special dividend of AUD 5.5 cps, and to undertake an equal and proportionate share consolidation to reduce ordinary shares on issue by approximately 2.4% to preserve consistency of the EPS calculation. To achieve the share consolidation, each ordinary share will convert into 0.9760 ordinary shares. The proposed share consolidation will enable a consistent EPS calculation, not distorted by the capital return.

The AUD 25 cps total is to be paid to shareholders on Nov. 26. We retain our AUD 7.50 fair value estimate; at current prices, the stock is fairly valued. Our forecast dividend for fiscal 2019 of AUD 40.5 cps includes the yet-to-be-approved AUD 5.5 cps fully franked special dividend. The dividend reinvestment plan will apply to the AUD 5.5 cps special dividend but not the AUD 19.5 cps capital return. Tax implications for shareholders will depend on individual circumstances. We recommend shareholders seek their own professional advice in relation to their tax position. Insurance Australia Group confirmed it has applied to the Australian Taxation Office for a class ruling to confirm the Australian tax consequences for shareholders who hold shares on capital account for tax purposes.

Insurance Australia Group's statement of Sept. 10 noted: “It is anticipated that, in broad terms: the special dividend will be a frankable distribution and treated as a normal dividend for shareholders; there should be no immediate tax liability for most shareholders relating to the capital return as the tax cost base of shares is instead reduced, thereby deferring any tax payable by shareholders until they dispose of the shares; and no capital gains tax event should occur as a result of the share consolidation”. Insurance Australia Group expects the tax treatment issues will be confirmed in the class ruling to be issued by the Australian Taxation Office, or ATO, after payment of the capital return and special dividend, assuming shareholder approval is provided.

If the capital management initiative is approved, the total number of ordinary shares on issue will be reduced to approximately 2,311 million from around 2,368 million, a reduction of 57 million shares. Each shareholder will own the same proportionate interest in the company after the consolidation as they did before the consolidation.

Despite the proposed AUD 592 million worth of capital management initiatives to be voted on by shareholders in October, the insurer is expected to benefit from future initiatives and transactions that will likely maintain key capital measures, the common equity Tier 1 ratio, and the prescribed capital amount, above management target levels and regulatory requirements. Retained earnings will continue to grow due to the dividend payout policy of 60%-80% of cash earnings, with only modest organic or acquisitive growth expected. Future quota share benefits amount to about AUD 200 million, and approximately AUD 400 million from the unwind of New Zealand tax losses will boost capital levels.

A negative in the fiscal 2018 result announcement was confirmation that surplus franking credits continue to decline, with guidance for a reduction in the franking rate from the second half of calendar 2019 onwards, with franking expected to be in the 70%-100% range. We estimate a franking rate of 85% for the final fiscal 2019 dividend declared in August 2019 and subsequent dividends.

The outlook is positive for Insurance Australia Group, and we expect further underlying improvement in earnings in fiscal 2019, with management guiding for gross written premium growth of 2%-4% and a reported insurance margin in the 16%-18% range. Despite margin guidance being below the 18.3% achieved in fiscal 2018, we think a margin around 18% in fiscal 2019 would be a good outcome and is in line with our forecasts. Insurance margin guidance for fiscal 2019 is based on the full-year impact of the quota share and underlying business improvements, offset by lower reserve releases of around 2%, natural perils in line with an increased allowance, and unchanged investment market conditions.

We remain confident that the firm can deliver on its ambitious medium-term financial targets. The business optimisation project is progressing well and is on track to deliver net benefits of approximately AUD 100 million in fiscal 2019. Exiting fiscal 2019, management guides to net run rate benefits of AUD 250 million. Our fiscal 2019 cash net profit after tax forecast of AUD 1.14 billion is unchanged. Management’s three- to five-year through-the-cycle targets are unchanged with a return on equity of 15%, sustainable and attractive dividends, top-quartile total shareholder returns, and compound EPS growth around 10%. We are increasingly confident that these targets can be achieved following solid fiscal 2018 results. A key plank of the ambitious EPS target is a major uplift in operational efficiency.