Tailwind ahead for earnings. IAG still looks cheap vs history.
The last few years have been tough for IAG – a combination of self-inflicted earnings wounds and a difficult claims environment has weighed on earnings. Since 2018, IAG’s earnings have shrunk by half.
Looking forward, we believe headwinds can become tailwinds. The insurance pricing cycle in motor and home is likely to remain firm over FY24, whilst claims costs inflation should slow (as supply chains heal) and legacy legal issues are gradually being solved. IAG’s insurance margin has the potential to move from 10% in 1H23 to > 15% in FY24/25.
Weather could drive a material earnings beat in FY24/FY25
After two horrible years of natural perils/CAT costs, the prospect of a more normal year is increasing with gradual drying out of the weather along on the east coast of Australia. Consensus forecasts attribute little benefit from drier period, with insurance margins of 15-15.5% across FY24-25E. There is potential upside to 16-17% margins (consistently achieved in 2017/18).
IAG still need several things to go right, some outside of IAG’s control
To be sure IAG still needs several items outside of its direct control to go right to meet is new margin of target of 15% (vs 15-17% prior). These include favourable reinsurance renewals for 2024 (expect another period of strong price increases); a more normal year to natural perils costs, and continuation of falling claims cost inflation.
Balance sheet has room for further capital management
IAG’s balance sheet remains well within management liquidity and leverage thresholds. The Covid-19 Business Interruption provision of A$606m remains down from A$975m. IAG has flagged a further release at August 2023 results. We expect the current on-market share buyback of A$350m to upsized by a further A$150-200m.
Investment View
Upgrade to Buy. The early signs of business improvement are underway, assisted by the strongest environment for premium pricing in decades. Earnings growth can be supported by positive jaws in FY24/25 as insurance claim costs inflation shows further evidence of slowing.
After 2-3 years of elevated natural claims costs, the prospects for a more normal period remain, which could see IAG deliver an insurance margin well ahead of guidance and market expectations.
IAG is two-thirds through its $350m share buyback. We expect a further release of Covid-19 provisions in August 2023, topping up the buyback program.
IAG trades at early teens PER discount to its long-term average, which in our view can be closed if earnings recovery continues into FY24/25. With a forward dividend yield of 5% and likely ongoing share buyback into 2024, we see prospects of mid-teens total return from IAG.
Risks to Investment View
The business of providing insurance inherently involves the pricing of risk. A wide range of variables including factors outside of the company’s control can have a material influence on both the earnings and capital base of company.
Lower than expected insurance premium increases or high claims inflation could eat into the current expectations for improved earnings. Higher than expected reinsurance allowances / costs could also impact earnings.
Volatility in investment markets, including equities and credit spreads could have a negative impact on the investment earnings.
Evidence of margin expansion would increase the confidence of investors around an earnings recovery story for IAG which would present upside risks to the share price.
Figure 1: La Nina has ended. BOM forecasts suggest the likelihood of dryer weather across 2023/24
Figure 2: IAG is guiding to its insurance margin improving to 15%. Lower natural perils cost pose upside risks to this margin forecast, which is possible given rising likelihood of El Nino weather pattern for Australia
Figure 3: Natural perils allowance vs perils cost. Costs have almost doubled since 2018/19
Figure 4: IAG PER -1SD cheap relative to history
Figure 5: IAG trades in line with its long term PER rel to market
Figure 6: IAG NTM dividend yield
Figure 7: Target ROE upgraded to 13-14% (vs 12-13%), driven be improved earnings from higher bond yields
