Aviva PLC (NYSE:AV) is up about 85% since management first laid out a comprehensive restructuring plan in July of 2012. While that sounds like an impressive return, it's not quite as remarkable when compared to the 70%-plus gains for Prudential PLC (NYSE:PUK) and Legal & General (OTCPK:LGGNY), and the 50%-plus gains for Allianz (OTCPK:AZSEY) and AXA (OTCQX:AXAHY). Aviva management has done a good job of turning over its senior management and progressing with cost-cutting, shedding non-core businesses, and reducing leverage. Evaluating Aviva's fair value is a little more challenging, but even with the challenges presented by a change in the key U.K. annuities market, Aviva looks about 10% undervalued today.
Sizable Life Operations
Aviva PLC is the world's sixth-largest insurance company, and it operates a global business. Roughly two-thirds of the business is in life insurance, 30% is non-life insurance products like P&C, and the undersized asset management makes up for the remaining few percentage points. The U.K. generates about half of the company's profits, while France generates about 15% and Canada generates about 10%.
In the U.K., Aviva's life insurance business is the leading seller of annuity products, with around 20% share. Prudential PLC is a fairly close second, while Legal & General is third, with around half of Aviva's share. The U.K. annuity business was worth about GBP 12 billion a year, as the government required most retirees to convert their pension savings to an annuity (leading to about 85% of pension savers eventually buying an annuity). This was a widely unpopular requirement, and it was done away with early this year. The initial response in the first quarter of this year was a 20% to 50% decline in annuity sales at various providers, with Aviva reporting a 21% decline.
Outside of the U.K., Aviva sells a range of saving and protection products through its life insurance businesses. While some of the savings products do have guarantees, Aviva is much less exposed to guaranteed returns than Allianz or AXA. France generates about 20% of Aviva's life earnings, while Spain, Poland, and Italy all contribute high single-digit percentages (and Aviva is 4th in Poland, with 10% share). Aviva's Asian life businesses don't generate a sizable percentage of earnings (around 5% of overall life profits), but the company does have good share in markets like Singapore, Hong Kong, and China that are starting to grow off of small bases.
Non-Life Needs Work
Aviva's life insurance operations generate a mid-teens return, but the non-life insurance operations are not as profitable - non-life accounts for close to 40% of gross capital employed, but about 30% of profits. Aviva's reserve/premium ratio isn't bad compared to Allianz (127%), and the company has been building reserves (seen in a steadily increasing "incurred but not reported" number), but the company's underwriting has not been top-notch; the combined ratio has generally bounced around between 97 and 99 over the last five years, which isn't terrible compared to AXA or Generali, but is definitely below Allianz.
The U.K. accounts for more than half of Aviva's non-life business (around 55%), split between personal (60%) and commercial (40%). Aviva holds about 11% share in the markets where it competes (good for #2), with companies like Direct Line Group, Lloyds (NYSE:LYG), and AXA in personal and AXA, Allianz, and ACE Ltd. (NYSE:ACE) in commercial.
While the U.K. P&C business has had its issues with risk selection and underwriting, the Canadian business (about 30% of non-life profits) has generally been stronger. Aviva has about 8% share of the Canadian market, and management has been trying to transfer some of the practices here to other lines. Outside of Canada, Aviva is also active in France (10% of the business), Spain, Italy, and Poland.
Asset Management Is A Long-Term Project
Relative to Allianz or AXA, Aviva has a very weak asset management business. Historically neglected by management, third-party assets account for only about 20% of AUM, and its profit contributions are negligible. Turning this business around is going to be a long-term project. Selling it doesn't make much sense when the company still needs asset management capabilities to invest its float, but it's going to be hard to attract talent.
Work To Do, But A Valuable Core
Prior management at Aviva went overboard with leverage, and let costs and global expansion get out of hand. Current management is now cleaning up that mess.
In addition to a new, simpler corporate structure, management targeted and has largely achieved GBP 0.4B in cost cuts. Management has also made progress with exiting non-core businesses in the U.S., Malaysia, and South Korea, with Turkey likely still to be sold.
Reducing leverage is still a sizable work in progress; the company had to make a GBP 5.1 billion loan from its U.K. general insurance business to the holding company (30% of the capital employed). Management had repaid about GBP 1 billion of that by the end of 2013, but the external leverage ratio of 48% is still very high. Improving the leverage is going to be a process, in part, of remitting more of the cash generated in the subs up into the holding company, and that will take time.
The good news is that Aviva still has good businesses to rebuild and restructure around. The company has strong positions in emerging markets like Poland, China, and Southeast Asia, and it is looking to benefit as personal income growth leads to higher insurance penetration. Management is also looking to reorient its U.K. annuity business in the wake of this policy change (focusing more on the mid-size bulk annuity market, for instance), and that is likely to be a major topic at the upcoming July 9 Investor Day.
The Bottom Line
Aviva's unsustainably high leverage distorts the underlying ROE. Adjusting for the leverage, I believe Aviva will see normalized/sustainable returns on equity around 11% for the long term. That works back to a fair value of almost $19 today. If management can improve its loss ratios in its P&C businesses, leverage growth potential in emerging markets, and transition away from annuities to other savings/protection products in the U.K. life business, there's upside beyond that level over time.
In terms of European insurance stock selection, I like AXA and Allianz better than Aviva, as I think investors have given a lot of benefit of the doubt to Aviva's restructuring plans. Even with those preferences, though, there seems to be upside remaining for Aviva shareholders.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.