AIA - A Buffett Style Compounder In The Far East

| About: AIA Group, (AAGIY)

Summary

High-quality exposure to fast-growing Asian middle-income consumers.

Durable competitive advantage with sustainable growth (>20% CAGR) and strong returns (>20% IRR).

Undemanding valuation based on appropriate embedded value metrics.

Share price catalysts include gradual dissipation of Hong Kong regulatory concerns, sustained delivery of growth, geographical expansion in China, and favorable shift in capital adequacy regime.

High conviction buy-hold for multi-decade growth at significant margin of safety (61-102%).

Brief History

AIA Group Limited (OTCPK:AAGIY) (OTCPK:AAIGF) [1299:HK] traced its roots back to Shanghai, where it was founded in 1919 by an American, Cornelius Vander Starr. It was part of the American International Group (NYSE:AIG) for most of the history. As a result of the 2008 financial crisis, AIG was forced to spin off AIA as part of its rescue plan. In 2010, it successfully listed on the Hong Kong stock exchange, the third-largest IPO ever globally at the time. Today, it operates across 18 markets in Asia Pacific, and is the second-largest life insurance company in the world, ranked by market capitalization.

Investment thesis

1. Bright Sector Outlook

The Asian life insurance sector is vibrant. Over the past decade, the Asia ex-Japan markets registered a life premium CAGR of 11.5%. The strong growth rate is expected to sustain or accelerate moving forward, driven by the following factors:

Fast-growing middle class

The Asian economy is projected to sustain a real GDP growth rate of above 5% in the medium term. This is accompanied by an exponential growth in middle-income consumers. New spending power created each year is eight times of what is created by the G7 economies combined.

High savings rate

Asian consumers have an unusually high savings rate of 44% GDP compared to 18% in US and 13% in UK. More than 50% of the savings are in the form of cash. This represents a huge opportunity for asset diversification. Life insurance being a low-beta product has particularly strong appeal since the financial crisis.

Low insurance penetration

Life insurance premiums penetration in Asia ex-Japan markets is at 2.4% of GDP. This is significantly lower than the developed economies such as US (3.5%), Italy (6%), UK (8%) and Japan (8%). In terms of fundamentals, the penetration rate should be rightfully above the ratio of the developed economies, given the relatively low amount of social spending and high savings rate.

Significant protection gap

The cumulative result of the structural drivers is a fast-increasing mortality protection gap, estimated at US$58tn in 2014, up from US$21tn in 2004. This shows that in spite of the double-digit CAGR over the past decade, the industry has yet to catch up with the social needs. It is also worth noting that not all life insurance products are equal - only those with protection elements count in this respect. Among all insurers, AIA has an exceptionally high mix of protection products.

Sources of estimates: Swiss Re, IMF, Credit Suisse, BCG, AIA, Prudential

2. Durable Competitive Advantages

I believe that both AIA and the Asian arm of Prudential (NYSE:PUK) possess long-term economic moats in this industry. They are well ahead of the pack in terms of building up Pan-Asian platforms with geographical breadth and depth.

Life insurers compete on four main elements: (1) distribution capabilities (2) product manufacturing capabilities (3) brand and (4) asset-liability management. All these elements take many years to build and benefit tremendously from economies of scale as well as scope. M&A used to be effective in accelerating the process, but with the intense bidding wars in the recent years, this avenue can hardly be value accretive.

On agency recruitment, AIA uses a premium agency model, which selectively targets highly-educated quality recruits. These hires are then being exposed to comprehensive training programs to help them achieve best-in-industry productivity, bringing them higher-than-average income in the industry. This virtuous cycle allows AIA to retain the most productive agents in the long run.

Between AIA and Prudential Asia, competition should be relatively benign, due to (1) strong industry growth rate (2) both having track records of being rational competitors and (3) competition is mostly around non-price factors.

3. Consistent Execution

AIA has an excellent team of management led by Mark E. Tucker (ex-Prudential CEO) with a strong execution track record and shareholder value alignment. Since the IPO, CAGRs of key operating metrics - Value of New Business (VONB), Embedded Value Operating Profit and EV Equity are 27%, 17% and 10%, respectively (Table 1). It is delivered consistently through market cycles, interest rate, and equities market volatility.

The management has also repeatedly iterated that the business is managed for overall value rather than for market share. For instance, we have seen the VONB margin increasing from 32.6% in 2010 to 55.1% in 2015 as well as an improving capital efficiency (IRR consistently >20%). This allows AIA to achieve three objectives - funding growth internally, increasing free surplus, and hiking dividend payments, all at the same time.

Another key strength of AIA is its geographical diversity (Table 3). This provides AIA with a relatively stable growth profile and allows AIA to participate selectively in markets or products based on underlying economics. Do note that the new business franchise of AIA China is now over six times of the size of year 2010. Given the large addressable market and relatively low market share currently (1-2%), the strong growth momentum should sustain for quite a long time.

2010

2011

2012

2013

2014

2015

CAGR

2015 / 2010 multiple

Annualized new premium (ANP)

2,025

2,472

2,696

3,341

3,700

3,991

15%

2.0

Value of new business (VONB)

667

932

1,188

1,490

1,845

2,198

27%

3.3

VONB margin (%)

32.9%

37.7%

44.1%

44.6%

49.9%

55.1%

EV operating profit

2,412

2,800

3,491

3,975

4,535

5,400

17%

2.2

Embedded value equity

24,748

27,464

31,657

34,871

39,042

39,818

10%

1.6

ROEV

9.7%

10.2%

11.0%

11.4%

11.6%

13.6%

Free surplus

4,992

5,930

6,643

6,727

7,794

7,528

9%

1.5

Click to enlarge

Table 1. Key operating metrics since IPO (US$M) (data from AIA IR)

1H15

1H16

Y-o-y

Annualized new premium (ANP)

1,878

2,355

25%

Value of new business (VONB)

959

1,260

31%

VONB margin (%)

51.1%

53.5%

EV operating profit

2,352

2,896

23%

Embedded value equity

39,818

41,657

5%

Annualized ROEV

11.8%

13.9%

Free surplus

7,528

8,249

10%

Click to enlarge

Table 2. Operating results 1H16 (US$M) (data from AIA IR)

VONB

2010

2011

2012

2013

2014

2015

CAGR

2015 / 2010 multiple

Hong Kong

210

305

366

468

619

820

31%

3.9

China

68

102

124

166

366

438

45%

6.4

Thailand

174

227

287

319

361

395

18%

2.3

Singapore

104

164

226

269

299

341

27%

3.3

Malaysia

39

58

68

120

161

172

35%

4.4

Other markets

99

112

162

220

212

250

20%

2.5

Korea

64

74

68

91

82

46

(6%)

0.7

Click to enlarge

Table 3. Geographical contributions in VONB since IPO (US$M) (data from AIA IR)

Addressing Bearish Views

1. "AIA is an Expensive Stock"

AIA is often incorrectly being labeled as an expensive stock. Firstly, many people use the IFRS book value as a measurement of intrinsic value, which is not appropriate for AIA and many other life insurers. A better, if not perfect, measurement is based on embedded value. Secondly, conducting relative valuation against its fellow Asian life insurers is largely a fruitless exercise, given the significant difference in quality of business models as well as risk discount rates used. To provide a better framework to value AIA, I took other two approaches, one based on historical averages, and the other based on discounted-cash-flow analysis. Both approaches show that AIA's current valuation is quite undemanding.

Embedded value accounting is more appropriate for valuation

The two main bases to value life insurers are: (1) book value and accounting earnings and (2) embedded value metrics. The former relies on either statutory or GAAP/IFRS accounting book value. This is, however, often a poor measurement of the intrinsic value of an insurer. It is especially the case for AIA due to the following:

- IFRS accounting does not accurately capture the long-term nature of the insurance business, especially for regular premium protection business which AIA focuses on.
- AIA has grown its new business franchise significantly with increasing capital efficiency since its separation with AIG: IFRS book value is a lagging indicator of the intrinsic value in such case.
- IFRS balance sheet does not reflect the conservative nature of AIA's capital management in the form of high, free surplus stock

Embedded value metrics, on the other hand, have solid theoretical foundation, but rely heavily on the various actuarial assumptions made by the insurer. Hence, caution needs to be exercised when conducting relative valuation (see below).

No relevant comparables in the stock market

It is important to recognize that there are some fundamental differences in quality among the group that AIA is frequently being compared to.

The superior quality of AIA's business franchise against the Chinese players (China Life (NYSE:LFC), Ping An (OTCPK:PNGAY), CPI (OTC:CHPXF)) is clear. AIA focuses on selling protection products, which means that it derives more than 60% of its profit from insurance and fee-based sources. It has low sensitivity towards interest rate - a 50 basis point decrease in interest rate will only reduce the embedded value by 0.3%. On the other hand, all the Chinese players derive a majority of their profit from interest rate spread. As China continues to lower interest rate to stimulate economy, those companies may struggle to look for returns to cover their interest rate guarantee to policyholders. This is in a way similar to the pension deficit issues in UK.

On the other hand, unlike AIA, Prudential is not an Asian pure play. Its European and American businesses are facing significant headwind from Brexit, regulatory changes, and lower-for-longer interest rates. Also, AIA's weighted average risk discount rate of 8.28% for EV computation is materially more conservative than Prudential's 4.7%, although part of it is the difference in geography and product mix. Both are worth investing in my opinion, but AIA represents a more clear-cut exposure to the Asian insurance sector.

AIA

China Life - H

Ping An - H

China Pacific - H

Prudential

Price (local currency)

47.2

19.8

40.75

27.9

15.15

P/EV

1.9

0.9

1.1

1.3

1.2

VONB Multiple

15.7

-2.5

2.0

3.8

2.5

Dividend yield

1.42%

2.51%

1.58%

4.15%

2.82%

Click to enlarge

Table 4. Valuation comps based on share price as of 15 Nov. '16 and 2015 financial results

Trades in line with historical valuation with improving ROEV

AIA currently trades at 1.8X P/EV ratio, which is slightly higher than its historical average of 1.6X. However, its Return-on-Embedded Value (ROEV) has been trending higher from 10% initially to 15% today, driven by consistent growth in new business. As a result, in terms of P/E ratio, "E" being the embedded value operating profit, it trades at 11 times, which is below historical average.

2010

2011

2012

2013

2014

2015

15-Nov-'16

Historical average

Closing share price (HKD)

22.1

24.6

30.5

39.2

43.6

46.2

47.2

Market cap (US$b)

34.6

38.5

47.8

61.4

68.3

72.4

73.9

Share price gain (%)

+11%

+24%

+29%

+11%

+6%

+2%

+16%

Excess return (%)

+30%

+2%

+26%

+10%

+14%

+0%

+17%

P/EV

1.4

1.4

1.5

1.8

1.7

1.8

1.8

1.6

ROEV

10%

10%

11%

11%

12%

14%

15%

11%

P/E*

14.4

13.8

13.7

15.4

15.1

13.4

11.1

14.3

New business growth (%)

+35%

+27%

+25%

+27%

+26%

+29%

+28%

Click to enlarge

Table 5. Historical averages of AIA's share price and valuation. Excess return against the Hang Seng Index
*Based on embedded value operating profit

Undervalued based on discounted cash flow

Based on discounted cash flow model, AIA looks fairly undervalued. I estimate that based on its current market capitalization, the implied terminal value growth rate (year 2020 onwards) is -12.0% after taking into account the market consensus VONB projection between year 2016 and 2019, which is supported by free surplus generation (Table 6-7). This is quite depressed, especially in the context of the bright sector outlook and AIA's competitive advantages.

If I take a terminal value growth rate of 2-4% instead, based on long-term GDP trend, which is still fairly conservative, there is a highly attractive 61% to 102% upside to the share price (Table 8). While I do not expect this to crystallize immediately, this can serve as our "margin of safety" to ride the long-term growth in this highly attractive business.

2015

2016e

2017e

2018e

2019e

VONB (US$M)

2,198

2,762

3,358

4,077

4,852

Y-o-y growth

26%

22%

21%

19%

Free surplus before dividend (US$b)

9.3

11.1

13.0

15.0

17.2

Click to enlarge

Market cap (US$b)

74.3

EV Equity (US$b)

41.7

Implied NB Goodwill (US$b)

32.6

Discount Rate*

8.3%

Implied Terminal Value growth rate (2020 onwards)

-12.0%

Click to enlarge

Table 6. Market consensus VONB projection for 2016-2019
Table 7. Implied Terminal Value growth rate
* Discount rate based on AIA's internal metrics and counter-checked with CAPM model

Terminal value growth rate (2020 onwards)

Fair value (US$b)

Fair value per share (HK$)

Implied P/EV multiple

Margin-of-safety

-2%

94.0

59.71

2.3

27%

0%

103.7

65.87

2.5

40%

2%

119.6

75.96

2.9

61%

4%

150.3

95.48

3.6

102%

Click to enlarge

Table 8. Fair value based on terminal value growth rate sensitivity

2. "Capital Control Measures Will Hurt its Hong Kong Business"

Since early this year, there has been a series of measures from the Chinese government to restrict insurance purchases in Hong Kong by Mainland Chinese visitors ("offshore business"). This includes capping UnionPay transactions to HK$5,000 per swipe and restricting the use of third-party payment providers. Ironically, this actually accelerated business inflows from China, which more than doubled in 1H 2016 (Figure 1). AIA was particularly successful in capturing the inflows - new premium from Mainland Chinese visitors went up 3.7 times year on year.

In spite of the windfall, AIA's share price has been negatively hit by the news earlier this year, and after recovering to its Apr 15 high, it fell again recently due to a new restriction from UnionPay. Ultimately, the market is concerned about whether this offshore business is sustainable. I have spoken to an investor relations representative on this concern, and am reassured with the following:

- The intention of the policies is to clamp down on illicit selling and capital outflows, rather than shutting down this business altogether. AIA believes that its internal processes are adequate to comply with all the regulations.
- Given Hong Kong's "one country two system" status and the attraction of Hong Kong insurance products, the trend of PRC visitors buying insurance in Hong Kong should continue. To put in context, before the current surge, the market has already been growing at ~50% CAGR (Figure 1). Even today, the policy buyers from PRC remain less than 1% of the total PRC visitors in Hong Kong. Hence, the business outlook of this segment remains strong.
- AIA managed to capture a larger share of the inflows by expanding on its distribution reach. Moving forward, the expectation is for the business to continue growing from this high base, albeit at a more normal growth rate

To check the sensitivity of the HK offshore business towards AIA's valuation, I created two alternative scenarios based off my base-case valuation. The two scenarios are (1) a bullish case where the offshore business continues to grow strongly to make up two-thirds of the HK market and (2) a bearish case or "total clamp-down" scenario where this business is totally halted from 2017 onwards.

The results are presented in Table 9-12. It is assuring that while a bullish scenario could increase the fair values by double-digit percentages, the existing share price is justifiable even in the unlikely scenario of a total clampdown.

Click to enlarge

Figure 1. Mainland Chinese spending on insurance in Hong Kong (Bloomberg)

2015

2016e

2017e

2018e

2019e

VONB (US$M)

2,198

2,810

3,603

4,553

5,710

Y-o-y growth

28%

28%

26%

19%

Click to enlarge

TV growth rate (2020 onwards)

Fair value (US$b)

Fair value per share (HK$)

Implied P/EV

Margin-of-safety

-2%

105.8

68.07

2.5

42%

0%

118.0

75.92

2.8

59%

2%

138.1

88.86

3.3

86%

4%

176.8

113.77

4.2

138%

Click to enlarge

Table 9-10. Fair value based on bullish scenario of HK offshore business

2015

2016e

2017e

2018e

2019e

VONB (US$M)

2,198

2,762

2,720

3,229

3,723

Y-o-y growth

26%

-2%

19%

19%

Click to enlarge

TV growth rate (2020 onwards)

Fair value (US$b)

Fair value per share (HK$)

Implied P/EV

Margin of safety

-2%

81.4

52.36

2.0

9%

0%

88.5

56.93

2.1

19%

2%

100.2

64.47

2.4

35%

4%

122.8

79.01

2.9

65%

Click to enlarge

Table 11-12. Fair value based on bearish "clamp-down" scenario of HK offshore business

Catalysts

1. Business results continue to beat expectations

Since the IPO, AIA has repeatedly beaten Street expectations by delivering strong VONB growth every single quarter. The Street seems to have a systematic tendency to underestimate its growth rate. I believe that AIA can maintain a VONB growth rate of above 20% over the next few years. This could be driven by stronger-than-expected performance from Hong Kong (as explained above), improved performance from Thailand and other markets (cyclical recovery plus operational improvement), as well as increased contribution from bank partnerships (exclusive Citibank (NYSE:C) deal and other local banks).

2. China geographical expansion

The Chinese insurance market is highly regulated. AIA is the sole wholly-owned foreign life insurance company in China and has the licenses to sell in two provinces (Guangdong and Jiangsu) and three cities (Shanghai, Beijing, Shanghai). The regions account for a third of the overall China insurance market and AIA has been increasing its market share from a relatively low base of 1-2%. Hence, there is still plenty of room to grow even with this existing coverage.

That said, it is no secret that AIA has been eying geographical expansion opportunities in China, in particular to free trade zones such as Tianjin and Fujian. The materialization of such plans or the grant of a national license would serve as a strong catalyst for AIA's share price.

3. Favorable shift in capital adequacy regime

Hong Kong is expected to transit from a rule-based regulatory framework to a risk-based regulatory framework, in line with international standards and practices. For AIA, this potentially releases a few billion dollars of regulatory capital requirement, which will open up the possibility for increased dividend payment, buybacks, organic and inorganic expansion.

Conclusion

To sum it all up, AIA is a high-quality company with strong growth prospect, trading at a reasonable valuation. To use an analogy, this is akin to investing in American Express (NYSE:AXP) or Wal-Mart (NYSE:WMT) decades ago - a steady compounder with runway for growth.

Disclosure: I am/we are long 1299:HK.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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