AUB shares have performed well since our BUY recommendation in March this year. The key factors that have driven the strong performance include: i) Solid premium rate increases that have supported strong revenue growth and ii) Costs savings and restructuring initiatives, which have underpinned margin expansion.
However, the share price has given some ground since the release of full year results in August. Accordingly, we recently reviewed AUB’s fundamentals to assess whether the recent price weakness presents another entry opportunity.
About AUB Group
AUB Group (ASX:AUB) is the largest equity-based risk management, advice and solutions provider in Australasia. The Company operates an ‘owner-driver’ partner model (i.e. where it hold equity stakes in partner businesses) and has ~11% share of the intermediated general insurance market; and ~22% share of the general insurance SME segment in Australia. AUB’s business model is highly cashflow generative and carries no insurance risk, unlike the general insurers.
After divesting the Health & Rehab segment late in FY21, the Company presently operates three segments, with Insurance Broking (Australia) the main contributor to group profit. The other operating divisions include Insurance Broking (NZ) after the Company entered the NZ market in early 2015 and Underwriting Agencies.
Key Fundamental Drivers
Recent Acquisition to Support Australian Broking Operations
In February 2020, the Company acquired BizCover, the leading online small business insurance service provider in Australia. BizCover is now contributing close to 11% of AUB’s group earnings and while previously included in the Australian Broking division, will now be reported as a separate division.
BizCover generates significantly higher margin that the broader Australian Broking business (BizCover margin in FY21 was 37.5% and is also well above the group underlying EBIT margin of 31.9% for FY21) and revenue continues to grow strongly (+35%). Accordingly, AUB intend to growth the business further, by rolling out new products and entering new geographies. While BizCover is the market leader in the micro-SME market, its market share is small. To this end, AUB have identified a sizeable target market in the micro-SME segment (defined as < 5 employees). AUB believe there are between 2 million and 3.5 million micro-SMEs in Australia. In contrast, BizCover has ~100,000 of these already as customers.
Given that AUB intend to continue leveraging BizCover’s strong revenue growth, this is likely to come at the expense of a reduction in margin over the short term. However, margin is expected to recover as the Company builds additional scale.
Investment in Technology Expected to Improve Earnings Growth for NZ Division
The NZ division (predominantly broking, with a smaller underwriting business) continues to underperform, although in context, the NZ division comprises only 8% of group EBITDA. Overall, margin for the division declined by 390 basis points in FY21.
During FY21, AUB undertook a restructure of the business, including several leadership changes. The business is now better positioned to capitalise on its scale, capability, and reputation, evidenced by a major recent win of a large corporate account from a global broking competitor. Broadly speaking, the NZ broking market is competitive and premium rate growth is flat, as improvements in premium rates in NZ are typically inconsistent across geographies and classes.
To offset these challenges, the Company commenced a technology project (“Project Lola”) in early FY21 to transform the broking experience via a new platform that enhances sales and policy management. The earnings benefit from these initiatives are expected in 18-24 months (from commencement of Project Lola), implying that EBIT growth in FY22 is expected to be well above the FY21 EBIT growth rate of +3.6% (excluding accounting adjustments).
Lower Gearing Provides Increased Scope for Acquisitions
The gearing level has continued to trend down and is supported by strong cash generation and a strong interest cover level of ~16x as at 30 June 2021. AUB currently has ample capacity to fund further growth. To this end, it is worth noting that Merger & Acquisition multiples in Australian Broking have only increased marginally.
Further, at the results presentation, AUB noted that there is a good pipeline of new client and acquisition opportunities in NZ. AUB has previously flagged that it will target acquisitions in NZ in order to drive performance, given the above-mentioned challenges in NZ broking.
Is the Premium Rate Cycle About to Taper?
Revenue growth is expected to step down from +11.6% in FY21 to mid-single digit growth in each year over FY22-24. A key factor behind this is that the strong insurance premium rate cycle (while remaining in an expansionary phase) is expected to taper off in about 12-18 months based on prior market commentary and given that insurance premium cycles are considered to last 3-4 years based on historical trends.
With this in mind, the key focus for investors is the extent to which EBIT growth can continue to outstrip revenue growth. At present, operating leverage is likely to remain evident out to FY23 (i.e. EBIT growth forecasts over this period currently outstrip revenue growth) and reflects factors such as: i) A continuation of strong growth in Australian Broking, ii) A turnaround in the NZ broking business, iii) Potential for medium-term earnings growth from BizCover and iv) Continued margin expansion in Agencies.
With the shares having re-rated to a 1-year forward P/E multiple of ~24x, and currently at the top end of the trading range over the last three years, we revert to a NEUTRAL view. While operating leverage is likely to remain evident, we note that the underlying earnings growth profile (+8% over FY21-24 on a CAGR basis) has moderated since our last report.
Further, we consider that investment risk has increased as we are likely approaching the point where market earnings estimates will begin to factor in a tapering premium rate cycle for Australian Broking – that may not be fully offset by a turnaround in the NZ broking business, BizCover and margin expansion in Agencies – as the benefit from these initiatives are more likely to become evident over the medium term.
AUB remains in an uptrend. After peaking in August, the share price has come back towards support near $23. For the moment it appears to be holding in well at these levels. If it cannot hold in there, then we can see some major support nearby at $22.
Michael Gable is managing director of Fairmont Equities.
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