Is the plunge in mid-cap shareoverdone or a moment of truth how its 2014 flotation claims were hype? Does the chief executive's buying £99,500 worth at 138.2p reflect value or an attempt to shore up confidence?
Down initially 25% from 180p, at 140p the stock presently trades on a forward price/earnings (PE) multiple of about 10.5 times, with a 7% yield covered 1.5 times by earnings, although cash flow cover may be tighter. It's a prime example to be wary of ex-private equity-owned businesses floated with high hopes, but which may be in strategic deadlock.
In June 2014, I described Saga as "an over-glorified insurance business in a highly competitive market; (at 185p) anyone who applied in the hope of a quick turn had best sell."
The £550 million raised was mainly to pay down debt that private equity operators had used to maximise their return on capital. The balance sheet also remains £1.5 billion goodwill-loaded from acquisitions.
'Affluent older folk' database concept dashed
The flotation pitch aimed for a valuation based on an "affinity marketing" opportunity harnessing its customer database aged over 50, this segment of the population being relatively wealthy if they own property and have a decent pension. A tension has always existed whether to value Saga thus, or as an insurer in highly competitive markets, hence its volatile-sideways chart in a 185p to 225p range until recently.
The market has given Saga the benefit of doubt: an historic annual average PE multiple of 14 or higher compares with.that rose from about 8 times to the low teens, helped by cost-cutting. In fairness to Saga, its track record shows operating margins rising from 12% to 24.1% if providing scope for competition to strike.
Saga's PR has also been adept in terms of coverage on this profit warning: blamed largely (by photos and headlines) on Monarch Airlines' administration creating a £2 million cost when Saga had to pursue alternative carriers for its travel side. This takes attention off £10 million to be spent on "customer acquisition" and tough trading in insurance, that represented 89% of group profit in its last financial year.
Besides a sense this shouldn't be necessary if the database is already an asset, the upshot for value is impossible to guess without knowing what aspect of customer attrition may be involved. Maybe, like me, you get regular mail from insurers trying to poach car and home policies with offers not only to match the best terms but offer say £50 as well. Might Saga "invest" £10 million to trump with £100 offers?
If something like this, which compromises margin, is involved, it is more like defensive aggression than investing for growth. Only time will tell.
Narrative has changed since September interims
Figures to end-July showed a 5.5% rise in underlying pre-tax profit to £110 million, but which disregarded losses on derivatives and debt write-off costs, otherwise profit fell 6.3%. Chief executive Lance Batchelor was upbeat about the group's trajectory: "I believe these results continue to demonstrate that Saga is growing, has good momentum, and is on track to deliver expectations for the full year" (that anticipated about 2% profits growth this year and over 7% next).
Just over two months later, however, guidance has changed to flat pre-tax profit of about £190 million, a 3% downgrade to consensus, then about £180 million next year, which is a more serious 17% downgrade. It reflects insurance becoming more competitive, claims increasing, plus some accounting subtleties.
Saga's shift from insurance underwriting to broking has lost a £20 million revenue recognition benefit due to timing, down to £10 million this year and nothing thereafter. Co-incidentally, lower levels of underwriting (from competition) are reducing reserves able to be released to smooth profits - by £10-15 million from the next financial year.
This has come as a surprise and, though it can seem "accounting" than "underlying" related, it all adds up. Easy to feel management should have known about this in September and communicated it.
Aside from the Monarch collapse, the travel side is said to be "strongly ahead" of last year, but looking at last year's breakdown, while travel represented 51% of group revenue it was only 11% of profit. Insurance still predominates: underwriting was 31% of group profit, home insurance 26%, motor insurance 19% and other insurance 13%.
Experienced investors know the adage how profit warnings are liable to come in threes, and, given the caution in this update relates to insurance, it's an amber light for investing currently.
How secure is the dividend?
I've flagged plenty of times the risk around companies where a growth rationale gets hit, then the stock has to de-rate to a yield sufficient to tempt income investors -considering risks both to capital and the dividend.
More positively, if growth can resume then the stock will rise as a lower yield is perceived necessary on a revaluation of risk. Hence the dynamics surrounding Saga have got more interesting to watch.
The update asserts a current year dividend in line with expectations "and we remain fully committed to our stated dividend policy" which has included the word "progressive". Thus, brokers have kept their forecasts. So, is the market justified to price for a 7% yield, which implies relatively high risk?
The table suggests earnings cover of 1.5, reducing to 1.3 times, though the cash flow profile is more crucial. The interims showed a 5.6% like-for-like rise in net cash from operations to £96.8 million, with financial asset disposals responsible for £27.9 million cash from "investing" inflows; within which profile the dividend payment was £65.1 million.
This means profits really need to grow for there to be progressive payouts, longer-term. Meanwhile, in the short to medium term, Saga is buttressed with £144 million cash. The crux is whether taking out £10 million costs combined with better "customer acquisition" can deliver progress given the current state of the insurance industry.
Frankly, I agree, a 7% yield given this situation and management track record, is fair pricing.
|Saga - financial summary|
|year ended 31 Jan||Consensus estimates|
|Turnover (£ million)||1,310||944||900||963||871|
|IFRS3 pre-tax profit (£m)||150||171||114||176||193|
|Normalised pre-tax profit (£m)||172||179||138||185||195||190||180.0|
|Operating margin (%)||12.0||17.6||17.6||20.5||24.1|
|IFRS3 earnings/share (p)||10.2||11.4||8.5||13.2||14.0|
|Normalised earnings/share (p)||12.2||12.1||10.8||13.9||14.2||13.9||13.2|
|Earnings per share growth (%)||17.0||-0.6||-10.8||28.1||2.0||-2.1||-5.0|
|Price/earnings multiple (x)||9.9||10.1||10.6|
|Historic annual average P/E (x)||14.2||17.8||14.9||14.0|
|Cash flow/share (p)||21.1||15.7||15.4||13.5||12.4|
|Dividend per share (p)||4.1||7.2||8.5||9.4||10.3|
|Dividend yield (%)||6.1||6.7||7.4|
|Covered by earnings (x)||2.6||1.9||1.7||1.5||1.3|
|Net tangible assets per share (p)||-47.0||-40.2||-30.7|
|Source: Company REFS|
Will the chief executive last?
CEO Batchelor looks exposed if 2018 proceeds to a second profits warning. He is secure currently due to Saga's lack of a strong independent chairman to judge strategy and actions: the incumbent has signalled intention to retire next year after 14 years as chairman and 26 years with the company.
So, unless Artemis Investment Management (holding 10%) convenes with any other dissatisfied holders to install a firm new chairman, the status quo will persist. By their track record to date I'm not convinced this management can deliver what the Saga concept was set out to be; yet there's a scenario where a new chairman implements a fresh review and either installs new top management or breaks it up to exact value on a sum-of-parts basis. For what it's worth, Goldman Sachs (which floated Saga) has entertained 230p per share.
For a hedge fund with a £1 billion war chest for pro-active investing, Saga could be a lucrative target. Smaller investors, meanwhile, have to play according to industry/company events, now flagging caution.
Continue to hold Saga if you already own them and appreciate the risks, but fresh money should wait to see how next year's numbers evolve, and the appointment of a new chairman. Avoid.
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