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Morningstar | Suncorp’s Natural Hazard Costs Blow Out. FVE AUD 14.50 Unchanged

No-moat-rated Suncorp Group’s natural hazard update for the six months ended Dec. 31, 2018 again highlights earnings volatility in the general insurance sector in Australia and New Zealand. The estimated cost of individual natural hazard events over AUD 10 million total AUD 415 million pretax. Including an estimated AUD 185-195 million in natural hazard attritional claims, costing less than AUD 10 million, total natural hazard costs are a significant AUD 600-610 million for first-half fiscal 2019. The natural hazard allowance for the first half was AUD 360 million, therefore Suncorp will incur an additional AUD 240-250 million pretax in natural hazard claims costs for first-half fiscal 2019.

Management estimates cost of the very expensive hailstorms that hit Sydney, Central Coast, and South Eastern Queensland regions in late December exceeded the firm’s maximum first event retention of AUD 250 million, within Suncorp’s reinsurance program. The majority of the more than 24,800 claims relate to home and motor vehicle damage. Suncorp has a disappointing track record of underestimating natural hazard costs, with fiscal 2014 and 2018 the only years in the past 10 where natural hazard costs came in below management’s annual allowance.

Despite the first-half over-run, Suncorp’s fiscal 2019 natural hazard allowance of AUD 720 million is unchanged, with approximately only AUD 115 million allowed for second-half fiscal 2019. But Suncorp is reasonably well protected against a blow out in natural hazard costs in second-half fiscal 2019, with AUD 300 million in cover available once the retained portion of natural hazard events greater than AUD 10 million exceeds a total of AUD 504 million. As at Dec. 31, 2018, approximately AUD 415 million of the deductible amount has been eroded or used. Financial results for first-half fiscal 2019 are due Feb. 14, 2019 and we expect a cash profit around AUD 525 million and an interim fully franked dividend around AUD 33 cents per share.

Our full-year fiscal 2019 cash profit forecast declines to AUD 1.1 billion from our previous forecast of AUD 1.25 billion reflecting the higher-than-expected first-half natural hazard cost. Despite minor changes to earnings forecasts, our DCF-derived AUD 14.50 fair value estimate is unchanged, and at current prices, the stock is undervalued trading around 15% below our valuation.

A key attraction is the fully franked dividend yield and potential returns of surplus capital to shareholders. We forecast returns on equity to achieve management’s 10% target by end fiscal 2020 based on an insurance margin of at 13%. Even though Suncorp has made good progress over the past 18 months on strategy and operating model changes, additional work is scheduled for the next two financial years. Major changes in a complex financial services conglomerate like Suncorp increases operational risk, particularly in a fast-moving digitally disruptive world. Despite the risks we are increasingly comfortable with management’s ability to deliver on the estimated three-year cumulative net AUD 329 million in targeted cost-out savings by end fiscal 2020.