Aviva’s (LSE: AV) purchase of Friends Life during the first half of this year was more than just a merger of equals. The deal marked the beginning of the end of Aviva’s turnaround, a process that has been under way for several years and has seen the group clean up and reverse years of mismanagement.
Now the path is clear for Aviva to concentrate on growth. The merger with Friends created an insurance giant, with 16m UK customers and £340bn of assets under management. But one of the deal’s main advantages was a stronger balance sheet for Aviva.
Stronger balance sheet
At the beginning of this month, Aviva reported its first-half results — the first comprehensive set of results since the deal with Friends closed. After merging, the combined group now has an economic capital surplus of £10.8bn, up from 35% Aviva’s standalone figure of £8bn as reported last year.
With a robust balance sheet and capital surplus in place, Aviva’s management was able to hike the company’s dividend payout by 15% when it announced first-half results at the beginning of this month. However, a double-digit dividend increase and stronger balance sheet weren’t the only bright spots in Aviva’s first-half numbers.
Growing the business
Aviva’s operating profits during the first-half rose 9% year on year, as underlying growth and the first contribution from Friends Life more than offset adverse forex movements and disposals.
Excluding Friends Life, Aviva’s core UK life division grew the value of new business 31% and operating profits 5% to £1.02bn. The enlarged group’s insurance arm grew operating profits 5% to £422m and enjoyed the best combined ratio in eight years of 93.1%. A combined ratio above 100% means the insurer is paying out more in claims than it is receiving back in premiums.
Nevertheless, even though operating profits rose broadly across the Aviva group, operating earnings per share fell 9% to 22.1p as the benefits of the Friends deal have yet to be earned on the higher number of shares now in issue. Additionally, pre-tax profit fell more than 30% due to £271m of acquisition related integration and amortisation costs. More than £63m of run-rate synergies between the Aviva and Friends businesses have already been achieved.
So overall, Aviva’s costs are falling, the company’s operating profits are rising, and the group’s balance sheet is stronger than it has been for almost a decade. And on top of these factors, Aviva’s shares currently look undervalued.
Undervalued
At present, Aviva is trading at a forward P/E of 10.5, although due to integration costs associated with the Friends merger, earnings per share are expected to fall by 1% this year. However, next year City analysts are expecting earnings per share growth of 11%.
Based on these forecasts, Aviva is trading at a 2016 P/E of 9.6. The shares currently support a dividend yield of 4.1%, and City analysts are expecting dividend payout growth of around 20% next year. Based on these projections, Aviva’s shares are set to support a dividend yield of 4.8% during 2016.
Foolish summary
Aviva is set to benefit from the increasing demand for pension management services within the UK, making it the perfect buy-and-forget investment.
