Across client portfolios that have elected the ‘Growth’ AEQ option, we have implemented the following changes:

  • Bought Insurance Australia Group (IAG), Oilsearch (OSH) and Ansell (ANN); and
  • Sold Woolworths (WOW) and Seek (SEK)

Insurance Australia Group Purchase

IAG is a general insurer with controlled operations in Australia, New Zealand, Thailand and Vietnam.  The Group also has joint ventures in Malaysia, India and China.  In Australia and New Zealand (“A&NZ”) it is one of the two largest domestic general insurers with well-known brands and high market share. Gross written premium (“GWP”) across the various businesses is approaching $10 billion. The Group has recently finally exited its struggling U.K. business to focus on its core business in A&NZ and its Asian strategy.  The UK business represented c. 6% of GWP but its profit contribution was immaterial.

We like IAG for the following reasons:

  • The strong GWP growth which the Group has enjoyed over the past 18 months has continued into the 2nd half of this year, albeit at a reduced forecast of between 3-5%. Management has increased guidance to gross insurance margin to 12.5 – 14.5% which should be reflected in strong second half earnings;
  • The recently announced purchase of Wesfarmers Underwriting business for $1.85 bln should significantly strengthen their market position in Australia and NZ and is forecast to improve earnings by 5% by the second year of integration;
  • Earnings certainty has been increased due to the purchase of A$100m peril reinsurance cover in excess of the already conservative natural perils allowance of 7% of net earned premium (i.e. A$640m).  A period of low catastrophe costs could result in higher dividends;
  • The NSW compulsory third party (“CTP”) reforms (which had been expected to negatively impact Group GWP by -4 to -5%) have been removed given the government’s inability to pass the legislation;
  • Trends in the Asian business are very positive with the franchises making a reasonable profit contribution in FY13 following very strong growth.  While still only a small contributor to overall profitability, these businesses will increasingly be factored into valuations of the Group as they continue to expand; and
  • The domestic industry duopoly continues to act rationally and remain disciplined on pricing as they balance margins vs. volume.  This is illustrated by the fact that IAG has put the Queensland CTP book of business in run-off as it was uneconomical.

General insurance is of course an inherently risky business with adverse weather or catastrophe events which could cause significant claims losses beyond the control of management.  In our view IAG has however largely mitigated this risk via its existing reinsurance and peril allowance provisions.

Oil Search Purchase

Oil Search is a PNG based oil and gas producer.  Oilsearch is nearing completion of the USD 19 billion PNG LNG development of substantial liquids rich natural gas resources that have previously been constrained by lack of infrastructure and difficult access.

We like Oil Search for the following reasons:

  • Transformational project nearing completion with 90% of development in place;
  • Oil Search has a strong balance sheet and has the capacity to meet any impediments in the final stages of PNG LNG;
  • Upon completion output could more than triple to 24 mmboe;
  • An active exploration program has the potential to significantly add to reserves, this is particularly attractive after major infrastructure has been completed; and
  • The proximity of the resources to major Asian markets gives them a strong advantage in pricing and margins over competitors.

Production and earnings will increase materially with first LNG output projected in 2014, boding well for future cashflows.  With the vast majority of project risk behind them we see the potential for a rerating of Oil Search from the market as these cashflows become available for shareholder returns.

Ansell Purchase

Ansell is a global provider of health and safety protection products, with operations throughout North and South America, Europe and Asia.  Ansell recently acquired Barrier Safe Solutions to expand its North American footprint.  Ansell has pursued a strategy of growth by acquisition as well as organic growth and it’s suite of products is increasingly diversified and innovative.

We like Ansell for the following reasons:

  • A strong balance sheet has enabled them to pursue a disciplined and targeted acquisition program that will significantly add to earnings growth in coming periods;
  • Low capital intensity and concentration on high margin businesses means strong cash flows;
  • Geographical diversity and offshore earnings will benefit from a weaker AUD going forward;
  • Strong and disciplined management have performed well in recent challenging environments; and
  • Barrier Safe acquisition provides accelerated growth in a key market.

Ansell is developing a track record of good acquisitions and increasingly high margin product portfolio.  Coupled with excellent organic growth we see increasing cashflow auguring well for shareholder returns in the medium and long term, particularly in an environment of a declining AUD.

Woolworths Sale

Woolworths is a major player in the supermarket and retail space.  While Australian supermarkets contributed 68% of group sales other operations include Big W department stores, petrol through their alliance with Caltex and hotels.  More recently Woolworth has sought to diversify into home improvements through their Masters stores.

While Woolworth has an effective duopoly in the supermarket environment with Coles and has enjoyed a dominant market position with an extremely strong brand, we decided to sell Woolworths due to the following:

  • Coles is an increasingly strong competitor and in many areas is now challenging WOW and along with new and aggressive entrants such as Costco will pressure operating margins;
  • The entry into home improvement has not been optimal and is behind schedule on a number of key metrics and has the potential to deflect management attention and resources from the key operations in particular Supermarkets;
  • Continued tepid growth in consumer spending would weigh on revenues and result in margin pressure; and
  • With an estimated PE of 16.71 and earnings per share growth of 6.3%, we see the stock as relatively expensive.

While Woolworth is a well-run company with a strong market position, we see greater growth opportunities in OSH, IAG and ANN.

Seek Sale

Seek is Australia’s leading employment website and also has two non-employment businesses domestically,  SEEK Commercial which allows users to browse for business and franchises for sale and SEEK Learning which assists jobseekers with career development by providing vocational education through partnerships with leading training providers.  Seek has also bought minority stakes in dominant online employment sites within developing markets with large populations and low Internet penetration which represent longer-term opportunities for expansion.

Despite its dominant domestic position, robust cash generation and the attractive growth options offered by the international investments, we decided to sell Seek due to the following:

  • The core Australian classified job ads business has reached maturity and offers limited growth potential.  Despite the increasing contribution from the international businesses, the domestic employment business remains the largest contributor to Group profit;
  • The volume of domestic online job advertisements remain under pressure with the latest ANZ Job advertisement series having declined for six consecutive months, with jobs ads now only 5% above the lowest level reached during the GFC;
  • The weaker online advertising market is inhibiting Seek’s ability to pass on price increases – prices across its Australian employment products have been increased by an average 5.5% for FY14 versus average increases of 8-10% during 2010/11 and increases in excess of 10% pre-GFC; and
  • International experience suggests that competition from new entrants such as LinkedIn are limiting the pricing power of incumbents even once the job market starts recovering.

While the risk obviously exists that we are overly pessimistic on the outlook for the domestic employment business and are underestimating the potential growth from the international businesses, with consensus FY14 EPS growth of 14.4% and the shares trading at 24.7x forecast earnings we see significant downside risk should earnings disappoint.

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