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Morningstar | Suncorp's Business Improvement Program Gains Momentum in FY18. FVE Increased to AUD 14.50

Surprisingly, no moat rated Suncorp Group delivered on the early stages of its ambitious business improvement program, or BIP, with a better than expected fiscal 2018 cash NPAT of AUD 1.098 billion. Profit was modestly higher than our AUD 1.066 billion forecast and well above consensus of AUD 1.042 billion, though 5% lower than fiscal 2017. We have been too negative on the outlook for the BIP and have increased expected benefits in fiscal 2019 and beyond. Following stronger than previously expected earnings uplift,  our fiscal 2019 cash NPAT forecast increases to AUD 1.25 billion from our previous forecast of AUD 1.15 billion, with higher increases in later forecast years. Longer term, we forecast improved revenue growth, increased cost outs, higher interest rates boosting future investment returns and capital returns with our our fair value estimate increasing by 12% to AUD 14.50 per share due to the strong earnings outlook and the financial roll forward. At current prices, the stock is overvalued, trading 9% above our valuation.

Fiscal 2018 highlights were a strong second half in the Australian and New Zealand general insurance businesses, impressive balance sheet settings, surplus capital and the AUD 8 cents per share, or cps, special dividend. The final ordinary dividend of AUD 40 cps took total ordinary fully franked dividends to AUD 73 cps, based on an 86% payout, well above the 60%-80% target range. The total payout for fiscal 2018 was a high 95.2% and collectively, ordinary and special dividends were 11% higher than fiscal 2017 dividends.

Improved underlying claims performance and natural hazards below allowance by AUD 36 million in Australia impressed. Reserve releases of AUD 319 million represented 3.8% of NEP, well above the 1.5% long-term trend. Net benefits from the business improvement program delivered net benefits of AUD 40 million in fiscal 2018, exceeding plan by AUD 30 million. Top line revenue growth was a soft 2.4%.

Disappointments included a modest decline in the year on year Australian general insurance profit to AUD 681 million, a 190 basis point decline in the group general underlying insurance margin to 10.6%, a 5% decline in the banking profit to AUD 389 million, a weak wealth result and a 40 basis point fall in the cash return on equity to 8%, below our cost of equity of 9%.

Guidance for fiscal 2019 was maintained with an underlying insurance margin of at least 12% and cash ROE of 10%. Gross benefits of the BIP of AUD 187 million are already locked in with net benefits in fiscal 2019 expected to exceed the original target of AUD 195 million. Management's target for fiscal 2020 net benefits of AUD 329 million were confirmed. Strong second half fiscal 2018 momentum gives us more confidence the fiscal 2019 targets will be achieved. Suncorp is guiding for group top line revenue growth of 3.5%; a stable expense base of AUD 2.7 billion; an underlying insurance margin at least 12%; an approximate 50% cost to income ratio and a net interest margin at the low end of the 1.80-1.90% range in the bank; a cash ROE of 10% and the ordinary dividend in the 60%-80% range.

Suncorp announced a non-binding agreement for the sale of the life business to TAL Dai-Ichi, or TAL, for AUD 725 million, generating an estimated non-cash write down of AUD 880 million. The sale is expected to complete before the end of 2018 with approximately AUD 600 million of the net sale proceeds to be returned to shareholders in fiscal 2019. We estimate the AUD 600 million represents approximately AUD 46 cents per share. Suncorp will enter into a 20-year distribution agreement with TAL. Management expects the transaction to be marginally accretive to cash ROE in fiscal 2019. The life business reported a AUD 58 million NPAT for fiscal 2018 and we assume completion midway through fiscal 2019 with an estimated reduction in group NPAT of approximately AUD 30 million.

The life business is completely excluded from our forecasts from fiscal 2020 and beyond. Balance sheet strength impressed, with all business holding common equity tier one capital above targets. After adjusting for the final dividend, the group holds AUD 448 million in surplus capital.

CEO Michael Cameron has started delivering on promises, and we are now confident the finical 2019 targets will be achieved underpinning our forecast 12% uplift in cash NPAT. If achieved, the business improvement program benefits will be a great outcome for shareholders, and our previous scepticism was not warranted as the group is moving ahead with limited business disruption. Suncorp is making good progress on the execution of the business and marketplace acceleration strategies.

We forecast an underlying insurance margin of 12.3% in fiscal 2019 increasing to 14.2% in fiscal 2023. Improvement in the underlying insurance margin is likely but any improvement is both necessary and coming off a low base, with 10.6% reported for fiscal 2018. We do like the commitment to return surplus capital to shareholders and the high dividend payout. We forecast an ROE of approximately 9% in fiscal 2019 increasing to 11.3% in fiscal 2023. We forecast healthy EPS growth from fiscal 2019 onwards. We forecast average EPS growth of about 10% to end fiscal 2023.

Over time, we expect improvements in underlying profitability and dividend to boost shareholder returns. The expected uplift in performance is coming from improved customer experience, operational efficiencies and broader customer relationships. An overarching goal is to embed a culture of continuous improvement across the organisation. Strategy execution is the key risk to delivering good business momentum and any missteps will detract from our forecast earnings growth.