Qualiport

[ March 3, 2000 ]

No Gloating Here

By Bruce Jackson (TMF Googly)

There's been a few posts on the Qualiport discussion board commending us on our decisions to sell Marks & Spencer (LSE: MKS) and Rentokil Initial (LSE: RTO), although rightfully reminding us that they probably shouldn't have been bought in the first place. I'd dispute that in the case of Rentokil, because when we bought them, there were very few signs of the impending revenue growth problems. In hindsight of course, it's all plain to see, but unfortunately we never invest with hindsight.

Whilst it gives us some satisfaction to have sold at prices significantly above those currently prevailing, we're not about to gloat. I actually sincerely hope both M&S and Rentokil can turn things around, and that their stock will once again rise and rise. They are both former great companies, and over the years have significantly enhanced shareholder value. Neither sit in the Qualiport today because we struggle to see how they're going to achieve this turnaround. But, here's hoping they can do it again --eventually.

Independent Insurance

Next Tuesday Independent Insurance (LSE: IIG) report their full year results, and Stuart (TMF Tiger) and I have been invited along for the post-results press briefing. The shares peaked at 390p in 1998, but now wallow at around 230p. What's happened? Well, not a lot really. The company has continued to perform at a satisfactory level, growing underwriting profits at an excellent clip, and dividends by an average of 20% per annum. The reason the share price has plummeted despite this growth is that in 1998 the shares traded on an average price to earnings ratio (P/E) of 30, while today the market values the company at just 12 times earnings. Do you think valuation doesn't matter? You bet it does.

Insurance company accounts are often thought of as difficult to understand. There are some aspects to them in which I struggle, but by and large I can work out what's going on. Put simply, a pure insurance company makes (or loses) money in two ways.

1. Profits or losses on the sale of insurance premiums. This is known as underwriting profit or loss. If I pay £200 per annum for my household insurance and don't make a claim in that year, my insurance company makes a £200 underwriting profit, less any administration costs incurred. Many companies struggle to break even on their underwriting. For example, earlier this week Royal & SunAlliance (LSE: RSA) reported a massive £755m underwriting loss.
2. Profit or loss on investments. I see insurance companies largely as investment companies. Because insurance premiums are received in advance of any claim, the company has the use of that cash, and it tries to maximise returns from that cash. Over time, insurance companies also build up what's called a "float" for investment purposes. This cash is usually invested in bonds or equities, largely depending on the skill of the insurance company's investment officer. Warren Buffett's Berkshire Hathaway (NYSE: BRK.A) is largely an insurance company, and Buffett has used his skill as an investor to successfully invest the float, largely in equities such as Coca-Cola (NYSE: KO) and American Express (NYSE: AXP).

Got it? See, I told you it wasn't that bad.

Independent Insurance have an absolutely fantastic track record when it comes to underwriting. They've grown underwriting profits for 12 years in a row, with 1999 set to become number 13. On the investment side however, the story isn't looking quite so good in 1999, and I'm expecting to see them struggle here. That's largely because of a weak bond market, although with the FTSE 100 finishing 1999 at a record 6930, any index tracking fund should be showing reasonable returns.

Here's the key numbers as I see them...

                         6 mths to   6 mths to   12 mths to
                          30/6/99     30/6/98     31/12/98
                            £m          £m          £m

Net insurance premiums     203.0       184.4       392.7
Underwriting profit         17.3        10.8        26.2
Investment income & gains    7.3        34.8        70.4
Net Profit                  17.5        32.3        66.9
Diluted EPS                  7.3p       13.5p       28.0p 

As you can see, there's little chance of IIG hitting full year fully diluted EPS of 28.0p based on their first half results. That's entirely due to the big fall in their investment income and gains. All earnings forecasts are based on IIG's trading profit after tax. That takes into account underwriting profit and actual investment income, but excludes any gains or losses on investments. By this measure, fully diluted EPS for 1998 were 15.5p, quite a lot different to the 28.0p stated above.

I prefer to concentrate on the real bottom line EPS number, taking into account all gains and losses. In 1998 that was 28.0p. With the shares hovering around 230p, that puts them on a trailing P/E of just 8.2 and an earnings yield (the reciprocal of the P/E) of 12.2%. Cheap? You betcha. But be aware that IIG's P/E is about to rise, because net profits will fall in 1999. I'd hazard a guess that fully diluted EPS will be about 19.2p, putting IIG on a P/E of 12.0. Still cheap? Relatively so, but not quite as cheap as it first appeared. And then there's the cash 'issue'...

The thing that's always worried me about IIG has been its cash generation. Debtors have been rising over the past few years, the company putting that down to the long-term nature of their policies. When I met them last year, I was told this cash outflow would start reversing in the second half of 1999. Looking at the following table, you can see it needs to.

                         6 mths to   6 mths to   12 mths to
                          30/6/99     30/6/98     31/12/98
                            £m          £m          £m

Operating profit           24.6        45.6        91.6
Cashflow from operations  (21.3)       (4.5)      (15.3)

As ever I'm looking forward to IIG's results. I like the company, and the people. If there's tangible evidence of the cash shortfall turning around, the Qualiport's surplus cash could soon find its new home.

Emap

As of writing, the shares in our media company are up almost 11%. This £400 million increase in their market capitalisation is presumably coming on the back of Emap's (LSE: EMA) £4m investment in US and French web ventures. That's what I call a good return on investment. Here's a link to the Emap quote and summary page, where you can find the relevant AFX news story.

And Finally…

As you may have noticed, our site is looking a little different today. The left hand links have been better organised and categorised, hopefully making navigation that much easier, and highlighting some of our somewhat previously hidden content. This is all part of our programme of continual site improvement. There's more to come...

Have a Foolish weekend. Check out the new Qualiport Resource Centre below for links to the discussion board, and lots more.

Note
The Qualiport was launched on December 19th 1997 with an initial investment of £4040.63, all in Rentokil Initial. Further cash was added as holdings in Emap, Marks & Spencer and Unilever were bought during 1998. The vagaries of the value per share accounting method caused percentage return calculations for calendar 1998 to be somewhat distorted. To avoid confusion and somewhat misleading figures, the Qualiport's returns are being measured from 1/1/99, at which point the total portfolio value, including cash, stood at £16,809.60. An additional £2000 cash is added to the portfolio on April 1st and October 1st each year. The total cash investment in the portfolio to date has been £20,184.62. To access the Qualiport's total trade history, click here.