Rising interest rates are a gift to insurers such as Legal & General, which have vast books of annuities. Yet the potential for the FTSE 100 constituent to beat targets for capital generation and dividends is not reflected in an undemanding market rating. Why? Because of angst over the impact of any rise in corporate and sovereign debt defaults as economic prospects weaken.
However, even in the event of a credit stress scenario of the same ilk as the spike in defaults that occurred in 2001-02, which includes a “big letter” downgrade of 20 per cent of all assets, Legal & General’s Solvency II ratio would stand at 190 per cent, far above the regulatory minimum.
The shares trade at only eight times forward earnings, below a long-running average multiple of ten, which leaves it more cheaply valued than Aviva, the sector’s laggard. That valuation is too pessimistic, given the odds of Legal & General beating its medium-term capital generation target and the increased security of its generous dividend to 5.44p.
The company has set targets of generating between £8 billion and £9 billion in cash and capital between 2020 and 2024, significantly exceeding the £5.6 billion to £5.9 billion in dividends that it intends to pay over that period. The dividend is set to grow at a low-to-mid-single rate in percentage terms, which during the first six months of the year translated to a 5 per cent rise in the interim dividend. Rising interest rates mean the insurer is in a position of capital strength and at the end of June the Solvency II ratio stood at an enlarged 212 per cent. Over the first six months of the year, surplus capital generated by the business rose by 14 per cent. A large back book of annuities, which pay out a fixed amount to the holder, is a strength. As those policies mature, the capital held against them can be reinvested at higher interest rates, which should be a kicker to returns.
That means that even if Legal & General wrote no new annuity business and that cash and capital generation remained flat on an annual basis from now until 2024, it would still hit its 2024 capital generation targets. Not that it plans to pull up the drawbridge, having set out an intention to write between £40 billion and £50 billion of new bulk annuity business over the next five years. Higher interest rates should mean more transactions as pension scheme funding positions improve to the point where insurers are willing to take on their liabilities.
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More significantly for shareholders, surplus capital generation is growing at a faster pace than the dividend. Even after the impact of investing in new business, and the capital strain, it expects to churn out £1.8 billion in capital this year, against planned dividend payments totalling £1.1 billion. That naturally raises expectations that investors could see more cash handed back than the mid-single-digit growth target set out in 2020.
Jefferies, the broker, reckons the insurer will beat its capital and cash generation targets and forecasts £9.1 billion of capital generation and £9.6 billion in cash generation between 2020 and 2024, which prompted its analysts to upgrade dividend expectations from this year to 2026 by 6 per cent. That translates to a 20.73p dividend forecast for next year, leaving the shares offering a potential yield of 7.6 per cent at the latest share price.
Reforms to Solvency II regulations could provide another boost, reckons RBC Capital. If the layer of capital that insurers are required to hold to account for risk is reduced, it may also mean that the likes of Legal & General make less use of longevity reinsurance. That could boost its future earnings by 11 per cent, the broker thinks.
ADVICE Buy
WHY Beating capital generation targets could result in even more generous dividends
AO World
Focusing on profits should hardly constitute a lightbulb moment for someone running a former FTSE 250 company, but John Roberts, the AO World founder and boss, is banking on this revolutionary idea to win over investors after a bruising sell-off of the electricals retailer’s shares.
Shutting its German business, cost inflation, product shortages and waning post-pandemic demand drove AO World to a £37 million pre-tax loss, delayed figures for the year to the end of March showed. At least costs to complete the mop-up operation in Germany this year should be a maximum £5 million, rather than the £15 million that the company had feared.
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A rock-bottom enterprise value of just under 12 times forecast earnings before tax and other charges shouldn’t be interpreted as a sign of value. Revenue guidance for this financial year has been set at a wide range of £1 billion to £1.25 billion, below the £1.3 billion that analysts had expected and beneath the £1.37 billion reported by the British business alone last year, alongside pre-tax etc earnings of between £20 million and £30 million. On a statutory pre-tax basis, analysts still expect the group to be lossmaking this year. Yet there is room for trading this year to disappoint.
Roberts is aiming to halve capital expenditure to £5 million this year, terminating a sales partnership inside Tesco stores and with housebuilders and cutting warehouse space, staff numbers and reviewing its broader property footprint. But rampant inflation makes other daily operational expenses harder to keep a handle on, notably fuel and staff costs, which could erode margins.
The supply chain is still a challenge and manufacturers are cutting ranges, which will continue to pose a risk to sales this year. The greatest threat to hitting revenue guidance? Lower spending on big-ticket items as the rising cost of living bites. Price wars are likely in what is already an ultra-competitive consumer electricals market.
The market sell-off this year has left a slew of companies, with high margins and resilient sales channels, trading cheaply compared with historic norms. AO World’s cut-price isn’t enough of a draw.
ADVICE Avoid
WHY Inflation and the cost of living crisis
