Fool's Eye View

[ August 3, 2000 ]

Is RSA Still a Value Share?

By Rob Davies (TMFEssex)

Carburton Street, London -- To my mind the Value Shares discussion board provides some of the most informed comment on investing to be found on the Internet. Under the watchful eye of TMFPyad discussion here ranges over a variety of shares, with positive and negative points debated sensibly without the partisan attitudes often found on the dedicated company boards. One of the shares currently in favour as a value play is Royal & Sun Alliance (LSE: RSA), and its interim results today provide a good opportunity to review the business and judge whether it still merits this status.

RSA is a large company formed by a merger a few years ago. It is one of the biggest insurers in the world and has a market capitalisation of £6,177m (that figure is obtained by multiplying today's share price of 432p by the 1430m shares in issue). Classifications of value shares vary a lot, but a common of way of doing it is to choose shares where the principal valuation ratios are lower than the market, or below normal levels.

Book value is less than the share price, but not much

The easiest ratio to look at is perhaps the price to book value, although some sagacious analysts, like TMF Mayn for example, have queried this tool. Nevertheless, I usually look at it because when we are picking shares we need all the help we can get. Book value in the accounts is called Shareholders' Funds, and in the case of RSA that figure is £6,452m, slightly more than the market capitalisation. On a per share basis, that works out at 451p, although the company records it as 460p because it has added back equalisation provisions (don't worry about that). However, what is significant is that the shareholders' funds have declined from the figure of £6,484m at the end of last year. The way that happened is instructive.

                                             £m
Shareholders' funds at 31 Dec 1999        6,484 
Share Capital Issued                          5
Shareholders' gains                          94
Dividends                                  (131)
Shareholders' funds at 30th June 2000     6,452 

What this table is telling us is that the company only added £94m in value to shareholders in the first six months of the year. However, the company has decided to pay out £131m to shareholders as dividends. To some extent it doesn't matter how shareholders get their returns, but these figures might suggest that level of payout is not sustainable for long unless earnings increase. Nevertheless, the gap between the share price and the book value has narrowed as a result of the rise in one and the fall in the other, making it less attractive than it was.

Price earnings ratio is low

So let's look at earnings per share (EPS) and how that affects the price to earnings ratio (PER). For a value share that should be less than the market average (currently 25). Unfortunately, insurance companies are a little bit more complex than most, so I apologise in advance for this level of complication. According to the statutory accounts the group had an operating profit of £22m, a whole lot lower than the £348m it made last year. The main reason for that was the £378m loss on underwriting. Yes, this company actually loses 7.6p on every 100p worth of business it writes. The market pushed the shares up today because that loss is lower than the 8p loss per 100p it made last year. The idea for an insurance company is that it recoups this loss by making gains on the premiums it has invested in the market. Except that RSA hasn't. It only made £760m instead of the £1,016m it made last year. Furthermore, it charged £422m of unrealised losses on investments to the accounts. That was because the effective return on equities in the half-year was only 7.8% against its long-term projection of 9.0%.

The net result was that after tax the company lost £57m on a statutory basis, equivalent to a loss of 4.4p per share. But insurance companies are allowed to restate their figures on the basis of longer-term investment returns. Reported that way RSA made a group operating result of £320m, equivalent to 13.3p a share. Assuming that is repeated in the second half, the annualised earnings per share (EPS) will be about 27p. Dividing that into the share price gives a price to earnings ratio P/E of 16, way under the market average. But is that the right EPS figure to use?

Yield is high

We have already talked about the effect of the dividend on the shareholders' funds; now we need to look at it from the yield aspect. For the half-year, the company has raised the payout to 8.8p from 8.4p. Last year it paid a final dividend of 16.3p and, assuming it pays the same again, it has an annualised dividend of 25.1p. Dividing that by the share price gives a yield of 5.8%. Compared to the market yield of 2.1% that looks pretty good and certainly puts the yield into the value category. But how sustainable is that cash payment? The cash flow statement shows that operating cash flow was a negative £88m in the first half. If it shells out £358m for the full year it will leave the coffers looking rather empty. To my mind that leaves open of the question of whether the dividend is sustainable.

But...

Value shares are cheap shares, but unless something happens to change things the shares can stay cheap for a long time. That process of re-pricing can either occur through a takeover or from earnings growth. For RSA to grow it has to either reduce its losses from general underwriting or enjoy better returns on its investments. It has tried to reduce underwriting losses by making double digit increases in motor premiums, but that resulted in a 6% loss of business in the UK. Clearly there is a limit to that route. As for investment returns, your guess is as good as mine. But its target of 9% looks high against the SFA's guideline of 6%.

Is RSA a value share? Probably, yes. But it is certainly not without risks. For more comment on this and other value shares have a look at the value shares discussion board. And don't forget the RSA board either.

Where Next?

Maynard Paton argues that Price to Book is Dead