EUR 850.00 For Business Accounts Only

Morningstar | QBE's 1H18 Result in Line. No Bad News is Good News. FVE Upgraded to AUD 12.50. See Updated Analyst Note from 16 Aug 2018

There is finally light at the end of the tunnel for long-suffering QBE Insurance shareholders with the no-moat insurer delivering a steady, no frills result for first-half 2018. Importantly, there were no negative surprises with clear evidence remedial work initiated by new CEO Pat Regan is on track to deliver consistently higher quality results going forward. Fortuitously, in addition to internal operational improvements, the group is benefiting from an improving external environment, with increasing premium rates, higher interest rates and improving global economic conditions. The group continues to slim down, simplify and focus on risk-adjusted returns with underperforming business lines in Latin America, Thailand, Hong Kong, North America and Australia sold or exited. Our USD earnings forecasts from 2019 are broadly unchanged, but our fair value estimate increases 4% to AUD 12.50 due to lower Australian dollar/U.S. dollar exchange rate applied to our AUD valuation. At current prices, the stock is undervalued, trading 12% below our valuation. Since mid-June, the stock has increased 15% on the back of increasing confidence the new strategy will deliver a sustainable improvement in future earnings.

The long-awaited earnings recovery has started with first-half 2018 cash profits in line with expectations, up a modest 3% to USD 385 million. We like the result, especially the absence of negative surprises and no deterioration in outlook. Underlying fundamentals continue to improve, and we expect further good progress with legacy issues during the next 12 months. The 8% tax rate for the half was below our full-year 2018 forecast of 18%. Management expects full-year 2018 tax rate in the low to mid-teens range and high teens for the next couple of years. We increase our adjusted cash NPAT forecast for 2018 to USD 775 million from USD 743 million due to a lower tax rate of 14%. Longer term our tax rate forecast is in line with management guidance of the low 20% range.

The unchanged interim dividend of AUD 22 cents per share, or cps, 30% franked, was in line with expectations. The 59% interim dividend payout was broadly in line with a year ago and within the firm's target of up to 65% of cash profit. We make a minor change to our full-year 2018 dividend forecast increasing it to AUD 46 cps from AUD 45 cps previously. Our longer-term payout forecast averages 60%.

Business improvement is slow but it is moving in the right direction with the adjusted combined operating ratio, or COR, of 95.8% within the full-year 2018 guidance range. Despite reporting a decline in first-half insurance margin to 8.2% from 10.1% a year ago, the fall was due to lower investment returns and a decline in prior-year reserve releases, not underlying business shortcomings. In February 2018, QBE Insurance reported a disappointing adjusted COR of 103.6% and an insurance margin of negative 0.8% for 2017. The sold and/or exited businesses incurred about USD 200 million in underwriting losses in 2017 which will not repeat in 2018.

The COR is a key measure of insurance performance and is calculated by dividing total insurance costs (claims cost, acquisition and underwriting expenses) by net earned premium. COR guidance for 2018 was modestly upgraded to a range of 95%-97% from previous guidance of 95%-97.5%. Investment return guidance was softened to 2.25%-2.75% from 2.5%-3.0% previously. Statutory NPAT for the half of USD 358 million was 4% higher than first-half 2017.

Positives from the result include further increases in insurance premium rates with an average 4.6% uplift during the half compared with only 1% in the previous corresponding period, or pcp, with the rate of increase accelerating with all divisions benefiting. The key North American operations reported a 3.1% uplift, Europe 4.8% increase, and Australia and New Zealand 6.8%. Customer retention remains high despite the premium price increases. The modest increases in cash profit was achieved despite prior period reserve releases declining to USD 51 million in the half, representing 0.9% of net earned premium, compared with USD 147 million, or 2.6% of net earned premium a year ago. The increase in risk-free interest rates resulted in a net USD 40 million underwriting benefit in the half compared with USD 30 million benefit in pcp.

Balance sheet settings improved with key capital ratios increasing following a tough natural peril experience in 2017. The PCA multiple of 1.74 times is mid range of the insurer's target of 1.6 to 1.8 times. Gearing improved with the debt/equity ratio easing to 36.9% from 40.8% at Dec. 31, 2017 with the repayment of USD 391 million in debt, but still is above the firm's medium-term target of 25%-35%. Return on equity, or ROE, improved to 8.2% on cash NPAT from 6.6% in pcp, but remains subpar and below our 9% cost of equity assumption.

Approximately AUD 100 million of shares were bought back in the half with the firm's yearly buyback target of up to AUD 333 million unchanged. The three-year AUD 1.0 billion buyback program was announced in February 2017 and to date, AUD 239 million of QBE Insurance shares have been acquired and 23.3 million shares or 1.7% of issued capital cancelled.

Investment income declined to USD 287 million in the half from USD 424 million in the pcp with the annualised investment return easing to 2.1% from 3.6% a year ago. Returns were impacted by rising bond yield mark to market, widening credit spreads, foreign exchange movements, lower returns from growth assets, as well as asset sales and debt and equity buybacks reducing investment funds. The investment portfolio declined to USD 23.3 billion at June 30, 2018 from USD 26.1 billion at Dec. 31, 2017.

Despite struggling to generate acceptable returns for several years in the key North American business, the outlook is finally improving with a 46% uplift in insurance profit to USD 132 million in the half from just USD 71 million in the pcp. The COR of 95.4% improved from 98.3% a year ago. QBE Insurance's profitable European and Australian & New Zealand business underpin group returns with first-half insurance profits of USD 213 million and USD 169 million, respectively. We think the remedial action to improve the Asia Pacific business should work and the disposal of underperforming Latin American businesses was long overdue. The Latin America division's first-half insurance loss of USD 18 million eased from a loss of USD 25 million in the pcp.

We are confident new management will succeed in delivering improved shareholder returns on the back of organisational restructuring, more focused growth options, disciplined underwriting standards, improved productivity and increased cash flow. We expect to further progress when the firm reports 2018 results in mid-February 2019. Turning the business around requires changes in the insurance portfolio, cost-cutting, tightened underwriting standards, and greater accountability.

Changes in senior executive ranks are welcome with the new way of business based on achieving rigorous financial hurdles, high levels of management accountability, and aggressively improving underwriting discipline at the expense of top line growth. Despite the progress, we believe QBE Insurance's competitive advantage in underwriting has weakened to such an extent the firm no longer warrants a narrow economic moat rating. Consequently, we downgraded the global insurer's moat rating to no-moat in early July.