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Evolving Aviva is undervalued

The life insurer is concentrating on growing its asset management arm, while reaping the rewards of its Friends Life takeover
September 22, 2016

Life insurers are evolving into more diversified businesses, in particular increasing their focus on asset management work. And after some significant upheaval, industry giant Aviva (AV.) is fast headed in this direction. Last year's acquisition of Friends Life extended the group's presence in the corporate pensions market and bulked up fund management arm Aviva Investors, which is now putting more emphasis on bringing in more third-party cash. What’s more, cash generation and pre-tax profits are growing strongly, which is supporting expectations that the shares will yield more than 6 per cent next year. Trading at a discount to its peers, we think the shares are undervalued considering the income and growth potential on offer.

IC TIP: Buy at 430.7p
Tip style
Income
Risk rating
Medium
Timescale
Medium Term
Bull points
  • Trading at a discount to peers
  • Sizeable dividend yield
  • Growing fund management business
  • Increasingly profitable life business
Bear points
  • Low interest rate risk
  • Reduced Solvency II coverage ratio

Improving cash generation and strengthening the group's balance sheet has been one of chief executive Mark Wilson's primary goals since being appointed in 2013. During the first half of the year, cash generated by the group increased by more than half to £752m. This is supporting steady increases in dividend payments. After rebasing the dividend in 2013, Aviva is moving towards a target payout ratio of half of its operating profits per share by the end of 2017. During 2015 the group achieved a ratio of 42 per cent and there are signs that further progress will be made this year, with management increasing its interim dividend by 10 per cent to 7.42p a share at the end of June.

 

 

Aviva's UK life business is driving its improved cash generation and profit growth. During the first half, operating profit for UK life grew by a quarter to £711m, while cash generated doubled to £577m. This was largely as a result of a three-month contribution from Friends Life, which has historically been highly cash generative. Stripping this out, UK life still produced low-to-mid single-digit operating profit growth, despite falling annuity sales. This was due to the continued strength of its protection business, which includes insurance against unemployment or illness, as well as integration synergies from the Friends Life acquisition. At the end of June Aviva had secured £201m of the targeted £225m operational synergies management expects to achieve by the end of the calendar year - a year ahead of schedule. The group has reduced its property footprint by 258,000 sq ft and cut more than 1,500 jobs following the takeover.

Asset management arm Aviva Investors has historically been the weak link among the group's businesses, but this is starting to change. The Friends Life acquisition provided £47bn-worth of assets for Aviva Investors. And management had turned its attention towards its fund management business even before Friends Life was on the scene, hiring former Standard Life head of fixed-income and multi-asset investing Euan Munro in 2013 to head up and reshape the business. As chief executive of Aviva Investors, Mr Munro has overseen the creation of Aviva Investors Multi-Strategy (AIMS) funds. Created as a rival to Standard Life's (SL.) Guaranteed Absolute Return Strategies (GARS), AIMS is a lower-risk range of funds.

During the first half Aviva Investors reported £1.7bn in net inflows, in addition to £1.5bn assets transferred across from Friends Life - £45bn of Friends' assets were transferred in the previous reporting period. Along with positive exchange rate movements and £15bn of market gains, assets under management rose £29bn in the six months to the end of June to £319bn. Higher management fees charged on the AIMS funds also contributed to an increase in fund management operating profits of almost half to £49m.

Lower for longer interest rates pose a threat to all life insurers, pushing up the value of their liabilities as gilt yields rise. This in turn can reduce life insurers' Solvency II coverage ratio. A further 25 basis point reduction in the base rate would reduce Aviva’s Solvency II coverage ratio by 3 percentage points, according to management estimates. At the end of June Aviva had a Solvency II coverage ratio, of capital over the required regulatory minimum, of 174 per cent. While this is down from 180 per cent in the previous year, it remains at the top end of Aviva's working range and superior to all its rivals apart from Prudential (PRU).

AVIVA (AV.)

ORD PRICE:430.7pMARKET VALUE:£17.5bn
TOUCH:430.7-430.9p12M HIGH / LOW:523p290p
FORWARD DIVIDEND YIELD:6.4%FORWARD PE RATIO:8
NET ASSET VALUE:444p*SOLVENCY RATIO:174%

Year to 31 Dec

Present value of new business premiums (£bn)

Pre-tax profit (£bn)**Earnings per share (p)**Dividend per share (p)
201322.84.5745.5 15.0
201424.42.2848.318.1
201529.81.4149.720.8
2016**34.01.1451.723.5
2017**37.02.1855.527.7
% change+9+92+7+18

Normal market size: 5,000

Matched bargain trading

Beta:1.10

*Includes intangible assets of £7.4bn, or 183p a share

**Shore Capital forecasts, adjusted PTP and EPS figures