Investors clearly don’t like what’s going on with Aviva (OTCPK:AVVIY, AV.L), as these shares have been pounded down 25% over the past year, with most of that damage coming in the last six months. The similarly weak results from Prudential plc (PUK) and Legal & General Group (OTCPK:LGGNY), particularly when compared to Allianz (OTCPK:AZSEY), Ageas (OTCPK:AGESY), and other non-UK insurers, would certainly argue for a strong Brexit uncertainty/risk component, but I believe Aviva shares are also suffering from a lack of confidence tied to the recent departure of the CEO and uncertainty over the future direction of the business.
Whoever takes the top job at Aviva, he or she will have some difficult decisions to make. The company’s leverage is higher than that of its peers (and higher than it may appear on casual observation), and its hodgepodge of businesses outside of the U.K., France, Canada, and (maybe) Poland don’t necessarily make sense for the long term. While I understand that Aviva may well be untouchable until the Brexit situation is resolved and there’s a new CEO in place, today’s valuation assumes a very weak run of financial results that I think are unlikely to materialize.
A Surprising Departure Intensifies The Uncertainties
Aviva surprised investors early in October when it announced that the CEO Mark Wilson had decided to resign with immediate effect. Wilson had overseen a significant restructuring of the company’s operations and a meaningful turnaround in the business, but the stock and the CEO never seemed to get all that much credit for it, and particularly since the Friends Life deal - a deal that has remained a point of serious disagreement between those who believe it helped shore up Aviva’s capital and gave the company invaluable back book management capabilities and those who believe the capital improvement could have been organically and that it was a diversion of capital into a low-growth/low-return business that could have gone back to shareholders.
Wilson offered little explanation for his departure beyond basically saying that he’d accomplished what he set out to do and wanted to move on to new challenges. From where I sit, it wouldn’t surprise me if the real reason was a more Cartman-esque “screw you guys, I’m going home...” reaction to years of criticism from investors who’ve never been on board with his vision and strategic plan for the company and weak relative share price performance.
Whatever the reason, Aviva needs a new CEO and a new CEO will almost certainly bring new priorities and a new plan. In the near term, that likely means no meaningful increases in capital returns to shareholders, though I don’t think an incoming CEO will need to do what the last three incoming CEOs of Aviva did and cut the dividend. What’s more, given the ample uncertainties around Brexit (including whether it will happen at all), and a sub-optimal corporate structure, there is a lot of uncertainty now as to what Aviva will look like in 2020 and what it’s operating environment will look like.
Time To Restructure And Refocus?
I’ve said in the past that I wasn’t a big fan of Aviva’s ongoing strategy in Asia, as the company lacks any meaningful market presence outside of Singapore. While Asia is an attractive market for companies like Prudential and AXA (OTCQX:AXAHY), I don’t believe Aviva is likely to be able to organically build those businesses fast enough to really leverage the opportunities, and I don’t believe the company has particularly attractive M&A options (nor would M&A in Asia likely be well-received).
Along similar lines, the company’s non-U.K. European business is a blend of relatively strong and meaningful units (France life and P&C, Poland life and kinda-sorta P&C) and mostly less-attractive operations elsewhere. While the growth potential of Poland and Turkey might argue for keeping them, and the solid contributions from France would likewise argue for keeping the business, the smaller and less strategic businesses could be good candidates for sale. While the Canadian business is more of a toss-up from a strategic perspective, I believe the board would be loath to part with this asset barring a compelling offer.
Part of the reason I advocate selling the subscale operations is that Aviva’s leverage situation has remained a point of contention with bears. The company’s debt ratios are elevated compared to St. James Place, Legal & General, and Prudential, and while the now-former CEO was comfortable with them, many investors are not. Likewise, while the company’s reported Solvency II ratio is fine, there are some subjective elements in the calculation that boost the ratio, and you could argue the actual solvency situation is not as strong as it appears (which would restrict future capital returns to shareholders).
In lieu of operating sub-scale businesses in Europe and Asia, the company may want to reconsider refocusing on the U.K. Although the U.K. life market is not considered particularly attractive (Pru is getting out), there are profitable opportunities for Aviva to grow its bulk annuity business and leverage opportunities in the pension business. The company could also leverage that experience it acquired from Friends Life in running back books to acquire more back books in the U.K. market - an area where there’s not much competition and where European insurance companies will probably be looking to sell if Brexit happens, and where banks may look to sell (because of Solvency II requirements) irrespective of Brexit.
Between Brexit uncertainty and a new CEO coming in, clearly there are a lot of unknowns for Aviva and that make modeling even more challenging. My base case of 4% long-term earnings growth (which incorporated the assumptions of exiting the Asian businesses eventually and increasing bulk annuity, pension, and back book commitments) still seems attainable to me, but a 2-3% growth rate would still offer upside from here, so the company can afford to shore up its leverage situation if need be.
Right now, the market seems to be pricing in actual long-term earnings decline. It could also be argued that the market may be discounting Aviva’s future earnings stream at a higher discount rate due to the uncertainties, or some combination of the two. Whatever the case, I believe the current valuation is extreme, as you could apply a 20% haircut to today’s tangible book and project forward ROEs in the high-single digits and the shares would still be slightly undervalued relative to the normal BV premiums for those levels of ROE.
The Bottom Line
My fair value for Aviva is now more than 40% above today’s price, and I really don’t think my assumptions are as aggressive as that might otherwise suggest. Clearly the market disagrees, and I think the sharp decline at Prudential (which doesn’t have quite the same bull/bear debate as Aviva regarding the quality of the business) suggests the market has opted to just bail out of U.K. insurance companies during this Brexit uncertainty. I can’t, and won’t, recommend Aviva for anybody who can’t accept above-average risks and losses, but it looks like a very dire scenario is being priced into a company that is at worst an okay operator.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.