The Wrap: Insurers, Utilities And Telcos

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Weekly Broker Wrap: Insurers; utilities; telcos; and Capitol Health.

-Youi seen sacrificing GWP growth for profitability
-Competition for the major insurers shifts in home & motor products
-Uncertainty causing lack of liquidity in electricity futures, depressing prices
-Heightened difficulty in generating targeted returns on spectrum costs for telcos
 

By Eva Brocklehurst

Insurers

Citi considers domestic general insurance the most attractive insurance sub-sector and retains both Suncorp ((SUN)) and Insurance Australia Group ((IAG)) in its top three picks. Moreover, the portfolio review at AMP ltd ((AMP)) could be a key to future stock performance.

The broker expects Suncorp to enjoy tailwinds from premium rates that are rising more than claims inflation, particularly in commercial lines and personal motor insurance. While not yet fully backing the company to deliver its 10% cash return target for FY19, the broker is closer to this point in its estimates than consensus and maintains a Buy rating.

AMP is ranked second and heads the remainder of the Neutral-rated insurer stocks. The broker envisages potential upside at QBE Insurance ((QBE)) if management can turn the business around but this is likely to take time.

While baulking at the price at which IAG trades, Citi also acknowledges a risk it will continue to screen expensively. Hence, while retaining a Neutral call, the broker ranks the stock highly in its pecking order.

Youi's expansion into NSW CTP distribution – partnering with QBE as underwriter – online sales, and business pack products is proving to be a long-dated proposition. Macquarie deems the company is no longer the face of competition to the majors such as IAG and Suncorp.

The broker believes IAG, Commonwealth Bank ((CBA)) and Westpac ((WBC)) are taking market share in the profitable home & motor products and should be seen as primary competition going forward. Youi improved its net profit in the first half by 38%, which leads Macquarie to suspect that the company is implementing a deliberate strategy to hold growth and retain the best risks.

The broker notes automotive clubs continue to take market share in Western Australia and South Australia, with price rises comfortably lower than the listed insurers. Hollard has purchased Progressive and Calibre, which will open up new channels and products to grow its market share. The broker suspects this could allow scale to be achieved quickly by diversifying the insurance book.

Meanwhile, IAG has now officially launched a mass-market home & motor product in Australia and by plugging into broker platforms it could access volumes quickly to achieve scale. Macquarie maintains a Neutral rating for IAG and Underperform for Suncorp.

UBS agrees Youi appears to be sacrificing growth for profitability, with gross written premium reducing by -1.7% in the first half, and these trends remain at odds with the broader domestic motor insurance market, where gross written premium rose 5.9%, albeit margins were crunched. Youi's response will be an important determinant in any margin recovery in motor insurance, the broker suggests.

Utilities

Citi has reviewed three years of electricity price data and compared spot prices to derivative prices, finding no correlation. The broker flags a lack of liquidity in futures markets because of ongoing political uncertainty and suspects this may act to artificially depress prices in the futures market.

The broker believes the risk for futures prices on electricity is to the upside, given the liquidity issue and the ongoing reliance on gas-fired generation, as gas prices are unlikely to fall. Citi calculates earnings growth rates for AGL Energy ((AGL)) from FY17-21 would rise to 9.4% from 6.5% if electricity prices are forecast at the futures curve plus $10 per megawatt hour.

The broker notes AGL Energy has now matched Alinta's headline discount of -28% in Queensland for retail pricing. Citi believes this is further evidence AGL is willing to compete on price to protect market share. The broker forecasts retail gross margins to decline by 300 basis points to around 10% by the second half of FY19.

Telcos

The government has confirmed that 125 MHz of 3.6 GHz band will be sold at auction. The process will commence from October. UBS suspects some parties will be disappointed the auction was not pulled forward. Competition limits aside, the broker suspects Telstra ((TLS)) and Optus have the most balance sheet capacity to bid for spectrum, estimating TPG Telecom ((TPM)) could only bid around $550m before potentially testing its debt covenant.

Ideally, spectrum expenditure should generate a return above Telstra's underlying return on invested capital of around 14%. However, industry earnings are plateauing, even before the entry of TPG, and with a swathe of other auctions on top of the 3.6 GHz UBS suggests achieving this will be difficult.

Taking a more pragmatic approach to hurdles, the broker envisages investors are now primarily looking at Telstra's long-term earnings per share and the sustainability of its dividend. UBS calculates every $1bn in spectrum expenditure creates a -0.7c per share drag on long-term earnings.

Capitol Health

As Capitol Health ((CAJ)) does not intend to increase its hostile bid for Integral Diagnostics ((IDX)), nor waive conditions, Shaw and Partners considers it unlikely the bid will proceed.

The broker suggests the company could undertake further industry consolidation, perhaps through number of smaller operations and the larger clinic groups that are available. Shaw and Partners does not assume any acquisition uplift at this point in time.

The broker also understands that the majority of costs under the takeover offer were payable on the success of the bid going ahead. No changes are made to earnings estimates and valuation and, while disappointed that the merger with IDX will not proceed, Shaw and Partners envisages Capitol Health having material upside.

The business is currently supported by the stock trading at a -20% discount to ASX-listed medical peers on a capital structure neutral basis. Moreover supportive industry tailwinds have returned with referrals and fee growth ahead of guidance. The broker reiterates a Buy rating and $0.35 target.

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