Generali: An Undervalued Insurance Company Offering Restructuring And Growth

| About: Assicurazioni Generali (ARZGY)

Summary

Generali has underperformed the sector for many years.

The recent restructuring coupled with future strategic initiatives should stop the historical underperformance.

Discounted valuations support the investment case.

Business overview

Assicurazioni Generali (OTCPK:ARZGF)(OTCPK:ARZGY) is a leading European insurer providing life and non-life insurance products in more than 60 countries, with a $19 B market capitalization. Life insurance and non-life insurance account for 75% and 25% of revenue, respectively. The operating income is geographically well diversified, with some exposure to emerging markets.

The group enjoys a strong position in Italy (with an overall market share of more than 15%), Germany, France and Eastern Europe. Its direct peers are Axa (OTCQX:AXAHF), Allianz (OTCQX:ALIZF) and Zurich (OTCQX:ZURVY).

Generali has restructured its activities over the last few years under the mandate of its previous CEO Mario Greco in order to strengthen its business and to improve its profitability. The new management has reaffirmed the previous guidance and kept the same strategy (more about that later).

Is the strong underperformance justified?

Generali has strongly underperformed its main competitors (and the sector) since 2010. The underperformance has been mainly realized during 2012/2013 and during 2015/2016.

The following table shows different operating indicators since 2010 and analyzes the trend over the period 2010/2015 and over the period 2012/2015.

Looking at the first period 2010/2015, Generali has lagged its peers in terms of business and earnings growth despite a strong improvement in its business efficiency, measured by the combined ratio. Generali had the weakest balance sheet but managed to build reserves very carefully and in a prudential way. The dividend growth was in line with peers. To sum up, operating performance has been weakest than peers', therefore part of the underperformance is deserved. If we combine this conclusion with the high valuation, measured by the price to book ratio, the underperformance seems justified.

The European sovereign debt crisis (2011-2012) had very dire consequences on European insurance companies, and even more so on Generali with its large exposure to Italy and its weakest balance sheet.

However, even though Generali was still more expensive than peers, its operating performance over the period 2012/2015 was also far superior to them, thus we are a bit surprised to see the stock underperforming in 2013 and again in 2015 and since the beginning of 2016, especially in light of the strong derating of the stock.

To sum up, the operating performance of Generali has been worse than peers' due to the effect of the European sovereign debt crisis but has strongly recovered after 2012. However, the stock price has lagged the sector despite the strong boost in operating performance witnessed in the past 3 years.

According to us, this recent underperformance is not connected with its operating performance, which continues to be good, but stems from the macroeconomic risks in Italy. Indeed, investors are afraid that the government won't find a solution to the banking crisis (banks are saddled with a large exposure to non-performing loans). More recently, investors are also worried about a potential NO in the referendum, which will take place on the 4th of December.

The strategic plan in details

Generali held an investor day in which management has detailed its strategic plan and confirmed its 2018 targets announced in May 2015.

The company guides for a cumulative cash flow generation of more than €7B between 2015 and 2018. Over the same period, it wants to distribute more than €5B in dividends and generate an average operating ROE superior to 13%. Moreover, management has added a new target during its investor day concerning a net reduction in costs of €200M by 2019.

In order to reach its guidance, the company has already implemented several measures (cost cutting, divestitures…) but still wants to implement further measures (new cost reductions…) in order to improve operating performance and create long-term shareholder value.

First of all, the company wants to optimize its international footprint by focusing on core markets where the group has relevant size, profitability and good prospects. The group expects to generate at least €1B from disposals. Businesses are candidates to be disposed if they generate a ROE below 5%, account for roughly 1% of operating result or less than 5% of gross written premiums.

The company wants also to reduce its cost structure through the net €200M cost reduction but also improve its combined ratio through the use of data analytics and the leverage of its technical capabilities in claims management.

Moreover, the group focuses on the shift of its life portfolio towards capital light products, such as protection and unit-linked products, away from traditional products. Moreover, it keeps optimizing the back-book (old insurance policies previously sold) in order to reduce the average guarantee (minimum guarantee offered by the insurance company on the insurance policy). The management guides for a 30 bps reduction of average portfolio guarantee by 2018.

Lastly, the company wants to improve its brand and increase the client retention rate. In order to reach these objectives, the company has implemented new offerings (connected insurance products, hybrid life products…) and leverages its distribution network (digital apps, new dynamic pricing approach…).

The strategic plan gives us confidence in the operational improvement. The focus on customer coupled with new distribution solutions should allow Generali to maintain its client base (with cross-selling opportunities) and to attract new customers. The different cost cutting and operating initiatives should improve the efficacy and the profitability of the company. Finally, the divestiture of non-attractive assets will improve the overall profitability and increase the cash available for dividends (if not reinvested in attractive markets for growth). However, reaching these objectives depends also strongly on the investments results, which are pressured in this low interest rate environment.

Investment income

The investment portfolio of insurance companies is mainly comprised of fixed income securities (roughly 82% of total portfolio). In general, they keep the bonds until maturity and reinvest them at current market rate, thus the low interest rate environment is a headwind for investment income due to the portfolio rollover over time. To face this headwind, the group has the possibility to increase the risk of the portfolio by shifting the allocation towards riskier asset classes and extending the duration and credit risk. With solvency II, increasing exposure to riskier asset classes is not a solution because it requires too much capital. Increasing the duration and/or the credit risk are solutions of choice for partially offsetting the pressure on investment income (even though it increases the overall risk taken by the company).

The following chart shows clearly the downward trend of interest rates since the end of 2010.

As a consequence, Generali has increased the portfolio duration and the risk of its portfolio.

Of course, part of the higher exposure to credit risk comes from the downgrade of the Italian sovereign debt (in 2011 and 2012) but the management has also chosen to increase the risk as highlighted by the constant increase in the below investment grade category and the latest increase of BBB category in 2015. Keep in mind that all insurance companies have implemented the same strategy and that the portfolio of Generali (duration and credit risk) is not significantly riskier than direct peers' (adjusted for the exposure to the sovereign Italian debt).

The following table shows the average yield from different fixed income securities over 2015 (from 31/12/2014 to 31/12/2015) and 2016 (from 31/12/2015 to 30/11/2016) in order to quantify the fall in European interest rates.

European interest rates have kept going down during 2016 by roughly 40 bps in average, thus investment income will be a drag to the company's growth.

The following table shows the current portfolio yield with the minimum guarantee between 2012/2015 and our forecasts for 2015/2018. Although the return on investments will be under pressure if reinvestment yield stays below the current yield (3.40% at the end of 2015), the impact on the overall portfolio will be gradual, since only a fraction of the assets matures each year. We estimate a fall in investment income (excluding realized and unrealized capital gain) of roughly 4-5% per year.

Finally, Generali has the lowest guarantee as highlighted by the following chart from Société Générale (Societe Generale) (OTCPK:SCGLF).

On the positive side, the company has given its guidance based on constant yield, measured at the end of the third quarter 2016 and since the end of the quarter; rates have increased by roughly 50 bps, diminishing the risk of not meeting the guidance of 5% operating income growth between 2016 and 2018.

Balance sheet

Generali has one of the weakest financial positions but still shows a sustainable level of indebtedness because a large part of its debt will mature only after 2040 (roughly €8B over a total of €13B)

Valuations

Generali trades with a lower P/B and P/TB ratio than the group average (and median) despite a higher profitability. The company trades also at a forward P/E inferior to the sector and offers a dividend yield substantially above the sector.

Looking at historical valuation, Generali trades near its lowest level which was reached during the European sovereign debt crisis.

Generali used to trade at a premium to the European insurance sector but years of underperformance gives the opportunity to buy the stock at a 29% discount.

Italian referendum

A constitutional referendum will be held in Italy on 4th of December 2016. The referendum will ask Italians if they want to amend a part of the constitution in order to reduce the power of Parliament. If the result is YES, it means that Italians agree with the reforms and the market should react positively. If the result is NO, it means that Italians do not want to reform the current system and there is a risk that Prime Minister Matteo Renzi resigns. In this case, it will lead to a period of political instability which is not good for financial markets (in general) and could lead extreme political parties to rule after new election.

If the YES wins, the Italian spread will tighten which is good for solvency ratio. Moreover, the spread increase ahead of the election has probably given Generali an opportunity to improve its reinvestment yield. Finally, a market rebound will be also positive for future bank's capital increases (Unicredit, BMPS) because it makes them less dilutive and reduce the uncertainty weighting on the Italian market.

If the NO wins, the market could drop but the YTD correction of 22% might have already anticipated such an outcome and Italian spreads could increase. It would be negative from an operating standpoint for Generali (more difficult to sell unit-linked products, decrease in the solvency II ratio due to lower financial market level, higher spread, lower interest rate if the ECB has to intervene…).

Conclusion

Generali has underperformed the sector over many years. Part of this underperformance was justified by a higher valuation, lower business growth and weakest balance sheet but we assume that the underperformance has gone too far, especially after the successful restructurings efforts. The company has initiated a restructuring in 2015 that they will pursue until 2018 with clear goals and targets. These targets seem realistic and the company has recently gained the benefit of the doubt about implementing such strategic initiatives. Lastly, the company trades at a discount despite a higher estimated growth. However, all is not perfect because the company remains riskier (leverage, Italian exposure…) than direct peers.

Risks

- Italian referendum: A negative result could lead to a financial market correction, probably led by the financial sector.

- The government could require a new contribution for the Atlante fund, which is dedicated to recapitalize the Italian banks.

- Due to its large exposure to the Italian sovereign debt, a spread widening will negatively impact Generali.

- Insurance companies have large investment portfolio, thus any market correction and economic downturn will impact them negatively.

- Dividends are paid by foreign subsidiary to the group central entity before being distributed to shareholders. A local regulatory change or a local capital shortfall could result in a non-payment from the subsidiary to the group, leading to a decrease in the dividend paid to investors.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ARZGY over the next 72 hours.

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.

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.

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