Interactive Investor

Stockwatch: odds tilt in favour of this cheap small-cap share

6th April 2023 11:41

by Edmond Jackson from interactive investor

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There have been false recoveries since the Covid crash, but analyst Edmond Jackson believes the risk/reward profile is attractive at this low share price.

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Is Saga (LSE:SAGA), the insurance-to-leisure services group for over-50s, finally gaining substance as a recovery play? 

Hopes were raised nearly three years ago when Sir Roger De Haan, the son of Saga’s founder, agreed to invest £100 million into placings to become a 20% shareholder and chair. Back in 2004, he had stepped down as chair and sold his 100% stake for £1.35 billion to a management team backed by private equity. 

Yet the recent years have seen an overall poor share price performance, de-rating Saga to small cap status.

In snakes and ladders surrounding Covid, the stock fell from over 600p to a 130p low by October 2020, then soared 240% to over 440p by June 2021 on hopes that vaccines and termination of lockdowns would prompt a travel bonanza.  

Yet it festered back to 75p last October, as it became clear the insurance side – like many – was challenged, for example by regulation requiring equal pricing between new and renewing policies. 

Saga then joined the wider market recovery, rallying to over 180p in late January. However, after last Tuesday’s annual results to 31 January, the price dropped 15% to 115p. Yet it twitched 6% to 121p from 3pm yesterday afternoon and is currently 123p.

Annual results are a mixed bag 

An underlying pre-tax profit of £21.5 million was achieved in the year to 31 January against a £6.7 million loss last time, on revenue up 54% to £581 million as cruise and travel continued to recover post the pandemic. 

Goodwill impairment on the insurance side, however, meant the reported pre-tax loss soared from £24 million to £254 million. 

Net debt eased only 2% to £712 million in a context of £370 million net assets equivalent to 264p a share. Yet the balance sheet is swollen by £501 million goodwill/intangibles, meaning net assets are constituted 135% thus. 

The debt chiefly relates to ship loans taken out to launch two splendid liners able, we were told, to radically improve Saga’s marketing – by way of a “boutique” cruise experience, versus mass travel. 

Net finance costs are flat at near £41 million, half of which appears to relate to the ship loans, and it’s unclear quite how high they could go if interest rates continue rising to contain inflation. While takeover interest is possible, I tend to think Saga’s debt will limit renewed private equity interest. 

Consensus anticipates £37 million net profit on £650 million revenue in the current year to end-January 2024, rising to near £46 million profit in January 2025. 

Forward earnings per share (EPS) of 26p, rising to 38p, implies an enticingly cheap price/earnings (PE) ratio of 4.7 times, easing as low as 3.2 – albeit with scant prospect of dividends, given the debt. Looking back to the pre-Covid years, however, Saga’s free cash flow profile was consistently good: 

Saga - financial summary
Year end 31 Jan

Revenue (£ million)901963871860842797338377581
Operating margin (%)12.618.322.221.0-16.0-37.7-18.1-6.2-43.7
Operating profit (£m)114176194181-135-301-61.2-23.5-254
Net profit (£m)-134141157139-162-313-67.8-28.0-259
Reported EPS (p)117180191179-198-382-67.0-20.1-186
Normalised EPS (p)12918319318551.5-56.3-17.3-15.2-55.7
Operating cashflow/share (p)212183169164181112-77.533.3-10.0
Capital expenditure/share (p)
Free cashflow/share (p)17614211564.1104-248-35919.824.9
Dividend/share (p)56.098.411612354.617.
Earnings cover (x)
Cash (£m)19910710983.212397.9102227177
Net debt (£m)499461379373347565721705715
Net asset value (£m)9841,0881,1951,226961588681653370
Net asset value/share (p)1,2101,3301,4601,4951,170716486465263

Source: historic company REFS and company accounts

Justifiably cheap or now offering value? 

A pertinent reason for Saga’s low rating is £150 million bonds due to be redeemed in May 2024, likely motivating the attempted sale of the insurance underwriting side to (help) cover this. A £250 million bond then matures in 2026.  

A 2 March announcement cited talks failing with Open Insurance Technologies, although annual results say discussions on a sale continue. Meanwhile, Saga has agreed a £50 million loan facility with Sir Roger De Haan, from January 2024 to June 2025, at 10% interest plus draw-down, plus “milestone” fees up to a maximum 6% of the facility. 

Operationally, it looks like insurance will remain challenged as – like others – Saga tries to raise policy prices against motor claims inflation especially. Will its over-50 customer base sluggishly accept or increasingly shop around online? As an over-50, I have never found Saga’s pricing remotely competitive, but some say the test of an insurer is when you need to make a claim. 

Broking did however contribute £69 million of underlying profit, up 4%, while underwriting fell 65% to £19 million (after £25 million reserves releases).  

The bullish rationale for Saga has been: insurance ticking over nicely, generating cash, then a profits-kicker from two new cruisers each able to deliver around £40 million operating profit. 

As a crux for value, does this still hold?      

Poor performance in underwriting needs to recover 

The combined ratio – where the sum of incurred losses and expenses is divided by earned premium – rose from 96% to 126%, hence from profit to loss.  

It is said to be due to “the unwinding of Covid frequency benefits” and a sharp rise in claims: at the motor business, more vehicles are driving post-lockdown, plus there’s also repair cost inflation; and in home due to bad weather. 

So it hardly appears a good time to be selling this operation, and the question arises if it will end up more costly without an in-house underwriter. 

In broking, under the surface of £68 million profit, travel insurance doubled yet total policies eased 3% to 1.7 million. Customer retention was 84% yet new policies sold declined by 7%, as if some are becoming motivated to obtain keener prices. 

“We continue to apply material price increase to the motor book,” Saga said. Indeed, I found the lowest rise I could achieve in a 2 April policy renewal was 18% via Dial Direct, but they include free RAC breakdown cover. 

Insurance prospects therefore appear uncertain, but I do not think that this pulls the rug from under a bull case. 

Cruise industry indicators look positive from 2023

A potential saving grace is how cruising looks very well placed as Covid anxiety eases among travellers. Repeat waves of the pandemic, with variants defying vaccines, have not materialised. 

For 2022, Saga ocean cruising made a £0.7 million pre-tax loss, albeit a £6.2 million profit in the second half. River cruises saw a £5.1 million loss although profitability is expected this year with bookings up 23%. 

This was based on “load factor” – or room occupancy – of 66% in the first half-year and 84% in the second, for 75% overall. 

Yet cruise industry executives near-uniformly expect their ships to be running full by mid-year.  

The CEO of Norwegian Cruise Line Holdings (NYSE:NCLH) has said average occupancy on its 29 vessels should reach 100% by summer and could be over 100% based on more than two people staying in a cabin. Similar to Saga, Norwegian’s capacity rose from 65% in spring/summer 2022, to 82% in autumn. 

Carnival (LSE:CCL), the world’s biggest cruise company, has similarly gone from 69% to 84% and expects 100% this summer. 

Royal Caribbean Group (NYSE:RCL) expects historical occupancy levels over 100% to re-establish this spring.  

Unless higher fuel prices compromise profit recovery, Saga’s new vessels could help surprise on the upside.  

Travel saw a £4.1 million loss on £108 million revenue, albeit end-March bookings up 32%, hence an expectation of profit this year. 

Speculative but cruise odds tilt in its favour 

Can Saga successfully navigate a course, with soaring cruise profits more than offsetting potentially higher interest rates on its debt, and also insurance industry challenges? 

The odds look to be improving, hence risk/reward is attractive at this relatively low share price. You must decide if you can stomach key risks. 

A pragmatic conclusion is a starter position with a view to average in. You might also have to cut if, say, stagflation means further woe ahead for businesses and consumers. Buy.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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