Admiral: 6% Fall After Citi Downgrade is Another Opportunity

Company Update (ADM LN) (Buy)

Highlights

• Shares are at 14.8x 2019 EPS and 40% down from peak

• 2022 inflation may hit near-term profitability, likely moderately

• Price hikes since 2022 mean long-term margins are secure

• 2023 year-to-date datapoints show positive sector trends

• At 2,189p, we see 54% upside (20.7% p.a.) by end of 2025. Buy

Introduction

We review our Admiral investment case after a Citi downgrade this morning (June 13) caused the share price to fall significantly. As of 12:50 in London, shares are down 6% for the day, having reached a new 52-week high last week (June 6) as part of a sustained recovery since troughing in July 2022. The share price remains around 40% lower than its all-time high in August 2021.

We believe Admiral shares are highly attractive. They are at 17.7x 2022 EPS, though the year was impacted by elevated inflation and U.K. Motor policies written last year are currently around breakeven. More meaningfully, shares are at 14.8x 2019 EPS, despite the company now insuring 13% more vehicles in the U.K. We see the industry’s long-term fundamentals as undiminished, with the FCA ban on “price walking” at the start of 2022 being positive for profit margins, and expect Admiral to still see a high-single-digit EPS growth over time.

While near-term financials can be volatile due to the lagging impact of elevated inflation in 2022, we believe the impact will be moderate, and policies written since H2 2022 are on decisively higher prices and likely to be solidly profitable. Recent datapoints show that industry prices have continued to rise, supporting sector profitability. Our forecasts show a total return of 54% (20.7% annualized) by 2025 year-end. The Dividend Yield is currently around 5%. Buy.

Admiral has typically reported H1 results in mid-August, though peers Direct Line and Sabre Insurance both issued profit warnings in July last year (on July 18 and 14 respectively).

As this is our first Admiral article on Substack, we start with a longer recap of its investment case. Readers familiar with our research can jump one section ahead to “Citi Downgrades Admiral to Sell”.

Admiral Investment Case Recap

Admiral is a U.K. insurer with a market capitalization of £6.6bn ($8.3bn). It generates most of its Profit Before Tax ("PBT") in U.K. motor insurance, where it is the market leader. It also offers household, travel and other types of insurance, as well as personal loans, and has small presences in Italy, France, Spain and the U.S.

Admiral PBT By Business (2014-22)

Source: Admiral company filings.

Our investment case centres around the U.K. Motor business, where we see Admiral as the U.K. version of GEICO (or, more recently, Progressive Insurance).

The first component of our investment case is continuing growth in the underlying market. The number of cars will continue to rise – the average annual growth of registered cars in Great Britain was around 1% annually in 2017-19, fell to around 0.3% annually since COVID-19 due to supply chain issues at automakers, and should rise again. The cost of dealing with each accident is constantly rising, as labour, car parts and medical treatment all become more expensive over time (the latter two accelerated by technological advances). The frequency of accidents is less consistent, due to the number of fraudulent “whiplash” claims and repeated government attempts to reduce them. Overall, the total pool of U.K. motor premiums had been growing at around 4% annually before the pandemic.

The second component of our investment case is that U.K. motor insurance will at least breakeven as an industry. The sector remains relatively fragmented, with a long tail of smaller providers that make low margins. In aggregate, before COVID, the industry was just breakeven in 2019 but with a diverse range of profitability among participants:

U.K. Motor Net Earned Premium & Combined Ratio (2019)

NB. Includes Sabre management estimates (before actual results).

Source: Sabre Insurance results presentation (H1 2020).

The industry over-earned in 2020-21 because lockdown restrictions reduced claim frequency, but underearned in 2022 because claim cost inflation exceeded expectations and it took time for pricing in annual contracts to catch up. The reason to believe the industry will at least breakeven over time is that providers will ultimately be rational and cannot sustain losses forever, especially after new solvency regulations in the past decade have narrowed the scope in using investment returns on insurance “float” to subsidise underwriting losses.

The third component of our investment case is Admiral’s cost advantage. Motor insurance is a commodity and most drivers seem to choose providers mainly on price. Admiral has historically had a significantly lower Expense Ratio than comparable peers, owing to its scale, quality of management, culture and ability to handle higher-risk policies (which have higher premiums and thus a lower Expense Ratio on the same unit costs):

U.K. Motor Underwriting Ratios (2019)

Source: Company filings.

Admiral’s cost advantage means it can profitably underwrite policies at prices where its competitors only break even. This has enabled it to operate on industry-leading profit margins, while also gaining market share over multiple years:

U.K. Motor Insurance Policy Numbers by Provider (2012-22)

Source: Company filings.

In the 5 years before the pandemic, Admiral’s U.K. Motor business has grown its number of vehicles at a CAGR of 6.8%, and its total premiums and PBT at CAGRs of around 8% (with some volatility):

Admiral UK Motor Growth Rates (2015-19)

Source: Admiral company filings.

We expect the same dynamics to prevail in the long term. The industry’s fundamentals are undiminished, notwithstanding technological developments (for example, Uber/Lyft have largely cannibalised public transport usage, not private vehicles, and created extra demand from delivery drivers; Electric Cars are more expensive cars and have higher premiums) and other changes.  The biggest change in U.K. motor insurance in recent years is the FCA ban on “price walking” at the start of 2022, and we see this as positive for profit margins because it has removed insurers’ ability to use loss-making policies to attract new customers and should dampen competitive intensity over time.

Admiral’s businesses outside U.K. Motor are marginal to the investment case. Some, like U.K. Household, have natural synergies with U.K. Motor. Others are at best low-risk side bets and more likely a management distraction. The venture into U.S. Motor seems misguided and is now being scaled down further. Admiral Money (unsecured personal loans) presents a tail risk with its £890m loan book, but even a disaster there is survivable given pre-COVID PBT of around £500m a year and solvency capital of £1.20bn (with a regulatory Solvency Ratio of 150%).

We have been involved in U.K. motor insurance stocks for nearly a decade, and our current Buy rating on Admiral originated from an upgrade in October 2020. Shares have lost 1.7% since then (with dividends offsetting the decline in share price), though our actual entry price is materially lower due to the timing of our purchases.

Citi Downgrades Admiral to Sell

The trigger for this morning’s price decline appears to be Citi downgrading its rating on Admiral from Neutral to Sell, as part of an industry-wide “deep dive” where it disagrees with consensus sector earnings estimates for H1 2023.

We do not access to the Citi report, but it reportedly contains the following quotes:

“Elevated 4Q claims inflation and a slow pace of rate increases means that we now expect the UK industry motor combined ratio to be circa 110% in 2023 with a loss ratio that is 6.6pts worse than pre-pandemic levels ... This leaves consensus estimates for key players looking optimistic and we turn more cautious on the sub sector ahead of results that start next week"

“We think that Admiral could post a flat development in the 2022 loss pick of 93% which could be taken positively but margin pressure is building across the sector … We downgrade Admiral to sell and issue a negative catalyst watch as we expect an earnings expectation reset and material downside risk into 1H23E numbers.”

We agree there may be risks to the sector’s near-term earnings, mostly due to the lagging impact of 2022 policies, but we believe profitability has likely normalized on new policies and Admiral’s current valuation offers an opportunity for long-term investors.

Admiral Valuation: 14.8x 2019 EPS

With shares at 2,189p as of 12:50 London time, Admiral is trading at a 17.7x P/E with respect to 2022 financials. However, 2022 earnings are not representative, because claim cost inflation was elevated (after COVID supply chain disruptions and the Russian invasion of Ukraine), and it took time for pricing (typically set annually) to catch up. U.K. Household was also impacted by severe U.K. weather last year, costing £31.6m in PBT.

More meaningfully, Admiral shares are at 14.8x 2019 EPS (excluding a regulatory revision in the Ogden discount rate), despite the company now insuring 13% more vehicles in the U.K.

Admiral shares have a Dividend Yield of 5.2% based on 2022 dividends of 112.0p (excluding Price Comparison Website disposal proceeds). This is a lower figure than in 2019 (140.0p) and represented 91% of 2022 EPS. (Admiral's policy is to pay out 65% of the EPS as regular dividends and any surplus capital as special dividends, and the Payout Ratio has exceeded 90% every year since at least 2014.)

Short-Term Headwinds from 2022 Inflation

Admiral earnings can be volatile in the near term because of lagging impact of elevated claim cost inflation in 2022.

Profits in U.K. Motor each year includes profits from that year’s underwriting (premiums earned, less expenses and claim costs, the latter including both actual claim costs incurred and reserves for expected costs), reserve releases (when costs for prior-year claims turn out to be less than expected), profit commission (calculated on both current-year underwriting profits and reserve releases), investment income and other revenues:

Admiral U.K. Motor PBT by Component (2016-22)

Source: Admiral company filings.

Before COVID, reserve releases were equivalent to around 40% of U.K. Motor PBT each year (in 2017-19, they were lower in 2016 due to a reduction in the Ogden rate). The high percentage means that the same profit on each policy is effectively recognised later, because excessive reserves are added in year 1 only to be released in subsequent years. This is a sign of underwriting prudence, though it also potentially allows more earnings “management”.

In 2022, current-year underwriting profit was negative, while reserve releases and the associated profit commission (which by definition was not from the loss-making 2022) were equivalent to 78% of U.K. Motor’s PBT.

High inflation in 2022 increased the costs of both claims on that year’s policies and on prior-year claims still being handled, reducing current-year underwriting profits and reserve releases (as well as profit commissions). The result was that the Booked Loss Ratio for the 2022 underwriting year was a loss-making 102%, and the Booked Loss for the 2021 underwriting also improved less than they would have in a more typical year:

Admiral U.K. Motor Booked Loss Ratio by Underwriting Year (2017-22)

Source: Admiral results presentation (2022).

However, the progression in the Booked Loss Ratios for the underwriting years before 2021 appeared to have continued unchanged. CFO Geraint Jones also stated on the 2022 earnings call that, while the 2021 and 2022 underwriting years would ultimately have lower profitability, “there is plenty of reserve release to come on years that are currently enormously profitable”.

Reserve releases from each underwriting year tends to be spread fairly evenly over time, with releases from the preceding two years typically accounting for much less than half of net releases in each financial year. So the effects of the 2021 and 2022 underwriting years may linger for some years but will likely be moderate in each annual P&L.

Admiral U.K. Motor Reserve Release by Year (for 2019 P&L)

NB. 2016 impacted by Ogden rate reduction. Source: Admiral results release (2019).

More importantly, we believe policies written since H2 2022 are likely to be solidly profitable.

Policy Profitability Likely Back to Normal

Admiral has taken decisive action on U.K. Motor pricing in 2022, raising prices significant ahead of peers:

Admiral U.K. Motor New Business Pricing – Indexed (Since 2021)

Source: Admiral results presentation (2022).

Management stated at 2022 results that they have raised prices by 25% for both new business and renewals since March 2022. Prior to that, because of the FCA “price walking” ban in January 2022, Admiral raised new business prices by double-digits but reduced renewal prices by mid-single-digits at the start of 2022.

We believe the price increases mean that new policies written since H2 2022 should be solidly profitable. Admiral prices its policies to make a profit, it margins are structurally higher than peers, and has a record of being disciplined. Lower underwriting margins in 2022 were the result of claim cost inflation rising higher and faster than expected due to exceptional exogeneous factors, and the in-built time lag for price increases to work through a base of largely annual insurance contracts. On the 2022 earnings call, management expected profitability on a policy level to have troughed in 2022 and improve in 2023:

“We think 2022 is the worst year in the cycle, and we expect a better outlook for '23.”

Cristina Nestares, Admiral Head of U.K.

“From an underwriting point of view, we do expect the business to be more profitable in 2023”

Milena Mondini, Admiral CEO

We agree. U.K inflation (as measured by the Consumer Price Index) peaked at 11.1% last October and has moderated since (to 8.7% as of April 2023), and has been driven by components (notably food and housing costs) that largely do not impact motor claim costs. U.K. used car prices fell between January and August of 2022, and remain lower than at the start of 2022. We expect Admiral policies to have sufficiently priced in 2023 inflation.

Positive Sector Trends in Recent Datapoints

Recent datapoints show that sector prices have continued to rise, supporting sector profitability.

Confused.com / Willis Towers Watson industry data showed that the average U.K. motor insurance premium has risen by 20% year-on-year (and 4.5% sequentially) to £657 as of Q1 2023.

Direct Line’s Q1 2023 update on May 9 showed strong price increases in its U.K. Motor business, with average premium growing 19.2% year-on-year for renewal policies and 11.0% for all policies (the latter likely reflecting a mix shift to lower risk). It again lost market share, with the number of policies down 2.5% from Q4 and down 5.4% year-on-year. Claim cost inflation (for Motor and Home combined) was described as still in high-single-digits, though Direct Line has also experienced worse-than-expected claims, especially in damage.

Sabre Insurance’s AGM update on May 25 mentioned “evidence of positive momentum in market pricing since late March”, and the view that claims cost inflation would remain at around 10% as expected.

All of these should help Admiral’s long-term profitability and market share.

Admiral Return Forecasts & Conclusion

We keep the assumptions in our Admiral forecasts unchanged from our last update in March:

• 2023 Net Income to be £414m, 11% higher than 2022 but 7% lower than 2019

• From 2024, Net Profit to grow at 8% annually

• Share count to grow at 1% annually

• Dividends to generally be 90% of EPS

• 2025 P/E of 20.0x, implying a 4.5% Dividend Yield

Our new 2025 EPS forecast is unchanged at 155.4p:

Illustrative Admiral Return Forecasts

Source: Librarian Capital estimates.

Our 2023 dividend forecast is 122.3p, 22% lower than the 2022 total (including 45.0p from disposal proceeds; excluding these it is 9% higher), implying a 5.6% Dividend Yield at the current share price.

With shares at 2,189p as of 12:50 in London, we expect an exit price of 3,109p and a total return of 54% (20.7% annualised) by 2025 year-end, driven by both earnings recovery (relative to 2022), dividends and an upward re-rating.

We reiterate our Buy rating on Admiral.

Ends

Stocks mentioned: ADM LN, DLG LN, SBRE LN PGR 0.00%↑ . We are long Admiral.

Disclaimer: This article consists of personal opinions, based on information believed to be correct at the time of writing, but not guaranteed. We undertake no responsibility in updating content in this article. Nothing published here should be taken as financial advice.