Clearing the Decks
QBE Insurance (ASX:QBE) announced another profit warning last week, citing an expected US$1.2 billion loss for FY17. The stock was weak in trading immediately following the announcement, but has since traded modestly higher. With a new CEO at the helm of the insurer, it appears investors are taking the view that this ‘clearing of the decks’ likely represents a loss that is about as bad as it will get for the company; paving the way for a recovery in the share price. In addition, we believe there are some potential positive re-rating catalysts on the horizon.
As discussed in our earlier coverage of QBE, given the string of tragic catastrophes such as Cyclone Debbie in Australia, and Hurricanes Harvey, Irma and Maria which impacted the Gulf of Mexico, the Caribbean and Florida, among other events globally in 2017, the insurance industry’s profitability last year and QBE’s specifically, was always going to be heavily impacted.
Market update
Towards the end of 2017, QBE (ASX:QBE) provided a couple of updates lowering earnings expectations, but more significant catastrophe activity seen in 4Q17 resulted in the company providing yet another update in January 2018, saying it expects to make an after-tax loss of about US$1.2 billion for fiscal 2017. The Group now anticipates its combined operating ratio (COR) for the year will be around 104%, marking an increase from the target COR range of 100 – 102% provided in its early October 2017 ASX release. The COR is a measure of underwriting profitability, with a figure of less than 100% representing profitable underwriting.
It is likely that QBE’s Group CEO Mr Pat Regan, whom took over the role in September 2017, wants to err on the side of caution. New CEO’s are often given some leeway in their early tenure in the role and therefore like to rebase earnings expectations as they establish their own strategy of how best to move the business forward. Mr Regan stated of the company’s update, “This has been a challenging year for QBE, reflecting an unprecedented cost of catastrophes as well as the particularly disappointing deterioration in our emerging markets businesses.”
In its ASX release, the Group cited “significant” 4Q17 catastrophe events adding around US$130 million to the net cost of catastrophes, increasing the Group’s COR by a little more than 1% from earlier expectations. This included the California wildfires, December storms in Australia and Hurricane Maria.
QBE (ASX:QBE) also strengthened claims provisions by around US$110 million, mostly in North America and Asia Pacific. That compared to the prior expectation of a “modest” 2H17 release. This also negatively impacts the company’s expected COR by 1% or so. Other smaller items are expected to be another 0.5% drag on the COR.
In addition to the above, two large non-cash items are key factors in the expected US$1.2 billion loss for the year. The first is an impairment charge of US$700 million, after revising the assumptions used to support the carrying value of goodwill for the North America business. The second is the reduction in the US corporate tax rate has resulted in a US$230 million write down of the carrying value of deferred tax assets in the group’s North American operations.
QBE (ASX:QBE) noted that significant catastrophe claims in the Equator Re and North American operations have “distorted” the group’s effective tax rate, such that it will recognise a significant tax expense in FY17, despite incurring the large pre-tax loss.
QBE provided some colour of the expected divisional CORs for FY17 and they ranged from a low of 92% for the Australian & New Zealand business to 141% at Equator Re.
Besides Australia & New Zealand, only the European operations are expected to have a COR below 100% in FY17.
QBE (ASX:QBE) is adequately capitalised and its preliminary assessment of the capital position at the end of 2017 indicates a PCA (prescribed capital amount) multiple of approximately 1.6 times. At the end of 2016, it was around 1.8 times.
Next year, the group COR is expected to fall back to a profitable 95 – 97.5% level. We expect the outlook for underwriting profitability to improve as premiums move higher, with the abnormal amount of catastrophe losses sucking a lot of insurance capacity out of the system.
There are a couple of other potential positive re-rating catalysts we see on the horizon.
Higher bond yields over time will support investment income, after this being a drag on earnings since the GFC. QBE has guided for investment returns of 2.5 – 3% in FY18.
In addition, commentary from Mr Regan hint at potential divestments on the way and he will likely be wanting to put his own mark on the turnaround at QBE.
Mr Regan stated, “Over the last few months, I have been conducting a detailed review of our operations. We have some businesses with strong market positions that are performing well but we also have businesses that are underperforming. We have commenced a comprehensive program of work to improve both the level and consistency of performance. At the same time, we are conducting a strategic review of our Latin American Operations as we look to simplify the Group and reduce risk. I will give you more detail on these plans in conjunction with the release of our FY17 result detail on 26 February 2018”.
There has been significant speculation about what assets could be up for sale, but we don’t see the company likely to undertake fire sales. Getting a decent price will be essential for any sales to be a positive catalyst. However, with QBE stock trading around current levels we see more upside than downside.
Turning to the daily chart, near term overhead resistance is sighted at the mid-November 2017 high of $11.23 as marked by the horizontal thin-red line. A sustained break above this level would likely send prices north towards structural resistance situated between $11.43 and $11.48. This is made up of the June 2017 low (horizontal dashed-red line) and the August 2017 low (horizontal solid-red line) respectively. A definitive clearance of this price range would shift medium-term momentum upwards, and consequently steer the prevailing direction of QBE Insurance.
With reference to the monthly chart, our previously identified support zone evident between $9.23 and the psychologically significant $10.00 round number was respected in October. This price range has been tested on a number of occasions since 2012, and moving forward, this is a positive development from a technical angle. Should upward momentum gather over the medium-term, then the pendulum would swing towards an eventual retest of resistance sighted at the 50% Fibonacci retracement of $13.14 over the broader horizon.
Summary
QBE Insurance (ASX:QBE) shares have once again proven resilient to the most recent profit warning, rising modestly since the announcement. At current levels, we believe downside is much more limited than the upside potential. Sentiment towards the stock is already at a low ebb; providing a low hurdle to see sentiment improve in future periods. A wildcard is the company being a prospective takeover target given its significant discount to international peers.
The incoming CEO Pat Regan could bring some positivity to the investment story, especially as it seems much ‘kitchen sinking’ has already been done. The first half FY17 results were decent enough given the headwinds, with a 30% rise in interim cash profit to US$374 million.
Source: QBE (ASX:QBE)
Premiums will likely see significant upward pressure due to 2017’s extreme catastrophe experience, and we expect investment income to continue following suit over the medium-term, due to our expectation for a rising yield curve. This should help support the share buyback program that has faced some doubt after the tumultuous year in 2017.
We therefore retain our conviction buy on QBE (ASX:QBE) for Members without exposure. A medium to long-term investment horizon is necessary in our view.
Disclosure: QBE Insurance (ASX:QBE) is held in the Fat Prophets Global Contrarian Fund, the Global Opportunities and Australian Concentrated Share portfolios.
