On February 20, just over six months ago, shareholders in RSA Insurance Group (LSE: RSA) (NASDAQOTH: RSANY.US) flocked to hit the sell button, reducing the insurance company’s market value by 15% in one day.
The cause, of course, was the announcement of a 33% cut to the firm’s final dividend, along with a promise to cut the next interim dividend by the same amount.
In one fell swoop, RSA’s prospective yield was cut from 6.8% to around 5.3%, disappointing investors who had convinced themselves that RSA’s yield was high because the shares were undervalued, not because the payout was unaffordable.
A healthy cut
The reality is that RSA’s dividend payout was simply unsustainable, and in my view RSA’s board should take credit for making the cut.
Although the firm’s dividend was still covered by earnings, the level of cover had fallen from 2.7 in 2007 to 1.3 in 2011, and the payout had only been covered by free cash flow once since 2007. These trends, combined with falling earnings per share, were a classic warning of an unsustainable payout, and investors should have taken note.
Luckily, both trends look likely to reverse this year. Based on current analysts’ consensus forecasts, dividend cover should increase to around 1.8 for 2013, and the expected 6.6p payout should be covered by free cash flow, for the first time since 2008.
Earnings are rising
Current forecasts also suggest that RSA’s earnings per share will rise this year from 9.6p to 11.7p. This places RSA on a forecast P/E of 10, which is at the lower end of its peer group, and fairly undemanding.
These forecasts were backed up by RSA’s recent half-year results. Return on equity rose to 10%, up from 8% for the same period last year, while net written premiums rose by 7% on a constant exchange rate basis. The firm’s combined ratio of 94.2% was below target, and suggests that RSA should deliver a strong underwriting profit this year, in addition to its investment returns.
RSA looks cheap
I believe that RSA’s declining earnings have bottomed out, and that the firm is now positioned to deliver steady growth, thanks to its growing emerging markets business.
RSA’s profit margins remain thin in the UK, but overall, I rate the firm’s shares as a buy, and believe they look very attractively priced at the moment.
An inflation-beating income?
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The Fool’s analysts have named the share “The Top Income Share For Today” and believe that in addition to an inflation-beating 5.7% dividend yield, its shares are currently undervalued by approximately 15%.
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> Roland does not own shares in any of the companies mentioned in this article.
