Description

Grupo Catalana Occidente (GCO) was written up by rajpgokul in December 2019. The stock has not done well since and is down 5% (though earnings have grown about 60% since then). rajpgokul did a fantastic job explaining the business and the competitive position and I have nothing to add on that front. There are two points I feel I can add some value:

First, GCO is a competitively advantaged business (esp. the credit insurance business) that generates a RoE 13% (return on tangible is about 15%) and grew earnings mid- to high-single-digit since the global financial crisis. Yet it currently trades at 7x FY22 normalized P/E (6.1x reported LTM) or 0.76x book value. Since the GFC average LTM PE was 11x so it was not always this cheap. To me this suggests that the market thinks GCO is overearning, but I don’t think that is the case.  

Second, since rajpgokul’s write-up there were a few developments. Some of them were important, so I will cover those as well.

Overearning?

About half of GCO’s earnings come from credit insurance. The credit insurance business has done very well recently with a combined ratio of 72.3%. However, the combined ratio has been flattered by the various government stimuli and the reopening since COVID. Many of the customers are small- and medium-sized companies for which the recent increase in interest rates and inflation is bound to create problems. Since the GFC, combined ratios have ranged between 64% in 2021 and 94% in 2020 with a 78% average. The average seems about right to me, but let’s assume a 10-percentage point increase to 82%. Why? Interest rates were very low since the GFC which improved small- and medium-sized business’ access to capital. If interest rates stay at their current level the opposite may turn out to be true with negative implications for credit quality and the profitability of the credit insurance business. But I don't think that the through-the-cycle combined ratio should end up above 82%. Ideally you would look at the long-term track record of the business during periods with higher interest rates, but that is unfortunately not possible as the business is the result of a merger post GFC. The next best thing I think is to look at the key competitor Euler Hermes. Euler Hermes had a combined ratio north of 80% only in 2001/02, 2008/09 and 2020. In the 1990s combined ratios were routinely above 80%, but then the industry was much less consolidated, so I do not think that is comparable.
A 10% increase in the combined ratio would have had a negative EUR 148 MM earning impact adjusted for minority interest and taxes (GCO owns 83% of the business and has a 25% marginal tax rate).

The other insurance businesses contribute the remaining half of earnings (they own a funeral business but that is small) and had a combined ratio of 91.8% slightly above the post GFC average of 90%. I don’t think these businesses are overearning (or underearning).

On the positive side, GCO undertook a restructuring charge in 2022 to cut costs and reduce headcount by 400-550 employees. There are obviously lots of companies that “restructure” all the time, the key aim seemingly being earnings management. However, GCO hasn’t taken a restructuring charge in a long time and the measures seem sensible to me (centralizing a lot of functions that are duplicated in each of the individual insurance businesses) and a genuine one-off. Net of tax (25%) the restructuring charge comes to EUR 90 MM. Another one-off is a loss of EUR 22 MM relating to the disposal of their Russian operations.

GCO also under-earns a bit on their financial assets which historically has been a big driver of ROE (see chart below) below. Note that “return on investments” in the following chart is defined as the financial result with the interest that is applied to the life business added back (gets reported as part of the technical income but that distinction is not relevant for our purposes).  

A sustained increase in interest rates should therefore be rather helpful. The current increase in rates has been partially captured in the 2022 results, but not fully. First, the average interest yield of the Spanish 5-year government bond (I think the best proxy as GCO invests a lot in Spanish Government debt and keeps maturities short) was about 1.5% about half the current 3.5%. Second, there is a lag as the bond investments which account for about half of the total get reinvested at the higher rate. How much more can they earn? Another 50 bps seems reasonable to me which works out to EUR 67 MM pretax or about EUR 50 MM post tax. Note that 17% of the GCO investments are in cash and the 51% held in bonds with an average duration of 3.28 years (at 2022 year end). I would therefore expect the improvement to materialize reasonably quickly.

In summary a EUR 148 MM negative impact from the credit insurance business offset by EUR 112 MM of exceptionals and EUR 50 MM of additional income from investments equating to EUR 4.19 normalized earnings per share slightly higher than the reported EUR 4.12 (but below the EUR 4.96 LTM EPS). GCO is not well covered, but for what it is worth consensus has EPS growing from EUR 4.52 in 2023 to EUR 4.80 in 2025 according to CapitalIQ.

Recent Developments

As rajpgokul outlined in his write-up GCO is essentially a slow-motion roll-up of insurance businesses primarily in Spain (the credit insurance business being the notable exception outside Spain). Recently GCO acquired a Spanish funeral business from OTPP for about EUR 600 MM enterprise value. This is quite interesting because it is a departure from the insurance focused acquisition strategy. The price GCO paid was not low (around 10x EV/ EBITDA), but I am happy to give them the benefit of the doubt for several reasons: First, historic acquisitions were also at optically high multiples and worked out well primarily due to the group's ability to cut costs subsequently. Second, they had a small funeral business for many years and seem to know the space well. Third, funeral businesses have good economics, are very predictable and there are some synergies with the funeral insurance products in which GCO has a strong market position. Fourth, the real returns available from buying whole businesses are higher than what is available from bonds over the long-term. Not coincidentally there are examples of spectacularly successful insurance companies that rely heavily on acquiring entire businesses and while I will not argue that GCO is the next Berkshire or Markel it does not have to be to achieve very attractive returns. You can get mid double digit returns on equity by combining high single digit investment returns with a 90% combined ratio underwriting operation. Granted that assumes you are doing two things well that are both intrinsically hard, but I think they have the right culture (incremental investments rather than big bets, strong focus on costs, staying close to industries they know well) and incentives (family ownership) to be successful. What would break the thesis are large, expensive, “strategic” acquisitions in areas where GCO lacks experience.

Beginning in 2022, Hugo Serra became the new CEO having joined the business in 2006. Unlike the previous CEO, Hugo is a member of the controlling Serra family (there are and have been several family members in other management positions within the group). The concern naturally is that the guy is an idiot who only got the job because of his last name and blows up the business in the futile attempt to prove otherwise. I can’t disprove that possibility, but so far it does not look like it. First, there are a lot of other family members on the board, some with substantial individual shareholdings. Second, the individual businesses have separate management teams limiting the role of the central CEO somewhat. Third, GCO prides itself in its team-based, consensual decision making and so far the way Hugo conducts earnings calls bears that out. However, this is a risk one should keep an eye on.

Valuation

Even with rates at near zero GCO managed a return on equity above 12% in every year aside from big crisis years (2001/02, 2008/10, 2020/21) and I trust them to be able to achieve similar returns going forward, but that requires them to find intelligent things to with the capital the business generates (payout ratio is about 25-30%) i.e. sensible acquisitions. I got comfortable with assumption, but that is the biggest leap of faith. Based on that belief I think they can achieve high single digit earnings growth (reinvestment at 10-12% ROE with a 30% payout ratio; the existing businesses have a 15% return on tangible equity and historic acquisitions were above 12% return on common equity). They will not do buybacks (share count has been essentially unchanged since the 80s I think), but they pay a dividend that adds about 2.7%. And then there is the potential rerating. I don’t see a reason why this company should not trade at its long-term average of 11x, but I admit it is possible that it takes a long time to get there. Let’s say 10 years. Earnings would about double which at a 11x implies a EUR 90+ share price for an IRR of about 14% including the dividend.

Why does this opportunity exist?

“I am not sure” is the short answer. European non-life insurers as a group have undemanding valuations esp. if you consider the changed interest rate environment. However, GCO trades at a substantial discount to its peer group despite being in my view of above average quality. One possible explanation is that while the operating business has grown very steadily over the last 20 years the share price has had several multi-year periods of underperformance followed by bursts of outperformance over a year or two. I think a lot of potential investors look at the share price chart thinking “value trap”. It does not help that there is no catalyst other than earnings growth, trading liquidity is less than million dollars, free float market cap slightly over billion and that it’s a controlled company in which the Serra family owns about two thirds of the shares outstanding.

Risks

Spanish Government default

Very sudden dramatic change in credit quality in the credit insurance business (credit insurance has typically 90-120 days duration). Think Covid, but without Government support

Value destructive acquisitions

Return to zero interest rates

Disclaimer

We own this (surprise!). 

We have tried to take care in preparing this write-up, but you know, it could be all wrong.

We may sell or change our mind and we won’t tell you about it.

Catalyst

Earnings growth