EUR 850.00 For Business Accounts Only

Morningstar | Underlying Momentum Underpins IAG's FY18 Result. Capital Returns Continue. FVE Increased to AUD 7.50

No-moat Insurance Australia Group's fiscal 2018 cash NPAT of AUD 1.03 billion fell just short of our forecast and consensus but was up a solid 4.4% on fiscal 2017. Gross written premium, or GWP, growth of just 1.8% was in line with guidance of "low-single digits," but on an underlying basis increased 4% year on year due primarily to broad based rate increases. Reported insurance margins of 18.3% surged from 14.5% in fiscal 2017 and modestly exceeded guidance of 16%-18%. The underlying insurance margin of 14.1% improved on 12.4% a year ago.

We increase our fair value estimate 3% to AUD 7.50 after rolling our financial model. At current prices, the stock is fairly valued. Strong profitability, a robust capital position and a positive outlook enabled the board to declare a fully franked final dividend of AUD 20 cents per share, or cps, taking total dividends to AUD 34 cps, based on a 78% payout. Despite the solid year-on-year performance, a much softer second half was concerning.

We applaud the previously announced sale of the Thailand, Indonesia and Vietnam businesses, and support the capital management initiatives valued at AUD 592 million. Subject to shareholder approval, Insurance Australia Group is planning a AUD 19.5 cps capital return, a AUD 5.5 cps fully franked special dividend and a share consolidation to reduce ordinary shares on issue by around 2.4% to preserve consistency of the EPS calculation. The AUD 25.0 cps total is scheduled to be paid to shareholders on or about Nov. 26, 2018. 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.

A negative was confirmation 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.

Statutory NPAT of AUD 923 million for fiscal 2018 was broadly flat on fiscal 2017, with a higher tax rate, lower investment income and loss on discontinued operations detracting from the 11% increase in insurance profit. While claims cost inflation remains a concern, premium rate increases and higher-than-expected reserve releases supported a good insurance margin outcome. Natural peril costs of AUD 541 million came in AUD 84 million below the AUD 625 million allowance due to a more benign natural peril outcome and protection provided aggregate reinsurance.

We expect further underlying improvement in earnings in fiscal 2019 with management guiding for GWP growth of 2%-4% and a reported insurance margin in the 16%-18% range. Despite the margin guidance range below the 18.3% achieved in fiscal 2018, we think a margin around 18% in fiscal 2018 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.

The solid fiscal 2018 performance provides encouragement the firm's ambitious medium-term financial targets can be achieved. 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. We had previously incorporated these savings in our forecast and consequently our fiscal 2019 cash NPAT forecast of AUD 1.14 billion is broadly unchanged.

We are impressed with the implementation of the firm's growth strategy, supported by the commercial insurance pricing cycle fortuitously continuing in the insurer's favour. Expanded reinsurance and quota share arrangements are working to reduce natural disaster claims volatility and we expect further moderation going forward. Insurance margins benefited from favourable natural event outcomes, reserve releases, credit spreads, rate increases, and more normal commercial large losses.

Australian operations continue to improve with the underlying insurance margin increasing to 12.9% due to increased premium rates in both consumer and business, offset by a reduction in CTP GWP flowing from NSW government reforms. New Zealand reported a strong performance with the insurance profit up 74% to AUD 218 million due to good volume growth, rate increases, and lower claims costs. Underlying margins in New Zealand increased to 17.6% in fiscal 2018 from 14.8% in fiscal 2017.

Management's three to five year through-the-cycle targets are unchanged with a return on equity, or ROE, of 15%, sustainable and attractive dividends, top quartile total shareholder returns, and compound EPS growth around 10%. We were originally sceptical these targets could be achieved, but following solid fiscal 2018 results, we are increasingly confident. A key plank of the ambitious EPS target is a major uplift in operational efficiency. We are confident the insurer can make good progress on its ambitious business optimisation targets, and we are increasingly confident it can achieve the pretax AUD 250 million per year or 10% of the fiscal 2016 total cost base target from fiscal 2020 onwards.

A key risk is how much of the AUD 250 million in pretax targeted gains will be competed away over time given the company sells commoditised products and has no sustainable competitive advantages, hence our no-moat rating. We cannot ignore the potential for strategy execution setbacks that could put expected cost savings at risk. Our long-term tax rate of 28% is unchanged.