Description

GCO: Grupo Catalana Occidente - A Secular Compounder at fair price !!

Elevator Pitch:

GCO is a very well run family owned (65% insider ownership) insurance business with strong track record of organic & inorganic growth since its listing 25 years back. The business has consistently compounded value at 12%+ CAGR through a combination of book value growth and dividends over every 5 years trailing period for the last 2 decades. 

The company has a strong market position and durable moats in both the insurance segments it operates in. It gets 46% of profits from credit insurance segment that is a global oligopoly with a strong moat for the 3 primary incumbents. It’s conservative underwriting culture and strong distribution networks has helped it to deliver strong numbers across economic cycles. 

The general short tail nature of the book along with strong market position and robust balance sheet (207% solvency with excess capital) would help GCO to continue compounding value even in a low interest world with an optionality of strong acquisition pipeline if there is a large market dislocation or economic crisis. 

For an extremely well run business with a long track record of value creation, the stock is trading at fairly attractive valuations of 1X book and 9.7X earnings. We believe that shareholders can expect long term compounding of 10%+ euro returns in GCO at current market price.

Investment Background:

GCO has two broad well-run insurance segments: Traditional Insurance (58.5%) and Credit Insurance (41.5%). 

The company’s traditional business is primarily providing short tail P&C insurance and life savings products in Spain. The company has been continuously acquiring small bolt-on opportunities to expand the traditional segments that it operates in Spain. 

Credit insurance (Atradius) is a well diversified global insurance operation. It is the global No:2 leader in this niche space. At a broader level, we believe that the traditional Spanish business is less moaty but is also less cyclical when compared with credit insurance. 

On the traditional insurance side, there is still a lot of scope for market share gains through both organic and inorganic growth. While the company might not be the largest in the traditional business segments, but it's one of the most profitable because of good cost discipline on operating and underwriting. 

The management team has a good long track record of smart capital allocation and inorganic growth through prudent acquisitions.  

The management team took advantage of the crisis in 2008, by consolidating Atradius. With a balance sheet that has excess capital, it is well positioned to do something similar if such a crisis emerges back. Historically, the firm has been disciplined on both the acquisition cost and the operations of the newly acquired bolt-on businesses. There are enough weak players in the market to be consolidated going forward as well. 

The pre-synergy multiples that GCO paid in its latest acquisitions of traditional insurance companies in Spain are: Seguros Bilbao (3.08x P/BV, 15.6x PE and an initial ROIC of 6.4%), Previsora Bilbaina (2.14x BV, 14.7x PE and an initial ROIC of 6.8%) and Antares (1.22x P/BV, 14.9x PE and an initial ROIC of 6.7%).

The company has been able to maintain ROE’s at 12%+ despite these low initial ROIC acquisitions because of the value creation post acquisition through cost synergies and better operations. This strong operational experience will be a tremendous asset for future acquisitions as well. 

The company has delivered consistent shareholder value creation. The Book Value per share has grown from 1.34 Euros/ share in 1994 to 29 Euros/ Share now at a compounded rate of around 13%. Even if someone had invested at the peak of the Spanish or global bull market pre-GFC, the book value per share has grown from 8.95 Euros/ Share in 2007 end to 29 Euros/ Share now.

For reference, the Spanish equity index IBEX 35 is still down over 40% from the pre-GFC peak. So, the book value compounding has happened despite a very weak equity market and a depressed economy that had to endure a tough decade.

The firm is guided by long term thinking family owners. The total outstanding shares in 1994 during listing was 118.4 Million and the current share count is 119. The firm has grown without diluting the existing shareholders. The total insider ownership of shares were 76.8 Million shares in 1994 and 77 Million shares currently. The family hasn’t sold a single share throughout this wealth creation period, indicating their long term commitment to the business. Insiders together hold 65.3% of the total shares of the firm. 

The Serra family have built a conservative and long term thinking culture within the firm. The family had also instituted proper councils for successional planning for working with professional executive management teams. The next generation of the family is involved in the business as well. 

GCO - Credit Insurance Business (Atradius) :

Premiums usually vary between 0.25% to 0.35% of the total receivables of the insured firm. This 35 basis points of costs is paid back to the firm through lower financing/ factoring costs and increased sales potential. Hence, there is a tremendous value add to clients through credit insurance.  A credit insurance business creates value through risk monitoring, bad debt collection and informational services. There are tremendous advantages of pooling risk together as no single firm can potentially diversify the way a credit insurance firm does. 

Credit insurance operations can reprice or manage risk exposure quickly according to the evolving economic conditions. I initially got interested in Credit insurance businesses when I learnt about one of our group’s subsidiaries going down in the GFC for lack of credit insurance, squeezing its working capital cycle. Similar was the case of the now listed UK furniture retailer SCS which despite healthy balance sheet in 2008-09 crisis had to go through bankruptcy because of no credit insurance and the subsequent liquidity issues. 

Credit insurance is interesting as the covers are usually for 60-120 days and for any incremental credit risk, you can always say NO to the firm. This short tail exposure enables them to be flexible and weather a crisis better. 

Credit Insurance market in a global oligopoly: Euler Hermes (37%), Atradius (31%) and Coface (19%).. The top 3 credit insurance firms globally have around 70% to 80% market share and the sub-regional market shares of the leaders are 40%+ in their core geographies, enabling strong pricing discipline. Credit Insurance is still under penetrated outside of Europe and can be a GDP+ growth business for many more years to come. 

Even during the global financial crisis, GCO had to pay 1.5X Price/ Book for acquiring Atradius. Allianz had to take out Euler in 2016 at slightly less than 2X book and almost 12.6X EV/ EBIT. The reasons for these premium valuations are the above mentioned oligopolistic characteristics and growth opportunities.

Atradius is a global business with strong distribution. Atradius or credit insurance is one of the high ROA insurance businesses in developed markets. For example, Atradius generates a post-tax ROA of 4% which allows it to deliver healthy ROE even with just 3 or 4X leverage. On the other hand, well run diversified insurance firms like Allianz generate ROA’s of less than 1% and hence need to increase leverage risk to generate healthy ROE’s. Credit Insurance businesses are also more global in nature with a large fee/ service income component, making them more durable. 

Euler Hermes has the longest history of being a publicly listed firm and hence it’s easier to look at the history there. 

Atradius has good sectoral and geographical diversity in its operations and there are no meaningful concentration risks in the business. Atradius was able to quickly get back to feet during the global financial crisis of 2008. Atradius has 95%+ kind of retention rates. On the Credit Insurance side, the firm currently transfers 41% of premiums to reinsurance companies, much more than peers. This will help it to weather a crisis well. This is basically a spread business and in good times or in a soft cycle as premiums are under pressure, there is some buffer for margins as reinsurance premiums shrink as well.

GCO - Traditional Spanish Insurance Business:

The company has healthy headroom to grow both organically and inorganically in the Spanish insurance market through market share gains. It’s strong agent network provides a healthy distribution edge. 

The firm has a long history of strong profitability in its traditional segments irrespective of the macro economic conditions as can be seen from the chart below, 

The firm has also been consistently outperforming its peers. On the traditional insurance business, GCO’s moat comes from its established distribution channel of loyal agent partners who have been associated with the company for long and disciplined underwriting culture. The customer satisfaction & retention rates are very high at 90%+ levels consistently. 

Strong brand and lean operations help in lower customer acquisition costs. Hence, the CAC/ LTV metric for GCO would be healthy with low churn rates and higher profitability as customers cohorts mature. 

The 3% difference in combined ratios vs peers along with superior investment performance would mean that GCO can continue to earn healthy ROE’s for shareholders even in an environment where peers are earning below their cost of equity. 

Potential Risks & Margin of Safety: 

Capital Allocation is the one main risk in this business. Since GCO operates with excess capital and no own balance sheet leverage, the company might be tempted to acquire/ diversify at uneconomic valuation multiples in a low interest rate scenario. This could deteriorate future value creation. The high skin in the game and the disciplined track record would mitigate this risk to an extent. 

Long sustained interest rates would also mean that the management might be forced to take undue risks on its investment book. Also there is still a lot of scope for the 150 Million+ investment income to vanish overtime as Europe completely moves into negative interest rate territory. In that case, ROE could slowly deteriorate to 8%+ kind of levels. The counterpoint to that is, anyways in such a sustained low interest rate scenario, I would assume the cost of equity should also fall considerably as well and hence even an 8% ROE would mean that book value is fair. Moreover, since most of the insurance segments of GCO are dependent on combined ratios for profits and not investment income, they are far better positioned to mitigate this risk than insurance peers with long tail books or in commoditized insurance segments. 

Also the negative interest rates can lead to irrational competitors who are fine with extremely low returns on equity. This would surely affect GCO at some point in the front book underwriting. The 3% positive combined ratio delta with peers help in some risk mitigation, but we need to watch out for irrational pricing in the marketplace.

The firm has been run with a fairly conservative investment book that is diversified sector, geography and security wise. Undue blow up in credit markets through higher delinquencies or rising interest rates is a meaningful risk. I believe that this would mean that GCO would suffer but since it's far better positioned than all its peers on investment book composition and balance sheet capital, it would still emerge stronger out of the crisis than now through acquisitions or more profitable front book underwriting as the duration is only around 4.5 years. Hopefully the management can navigate better than others in a crisis. 

Also as the company continued to acquire, around 20% of assets on the balance sheet is Goodwill. If you adjust for that, the return on tangible equity is around 15% and this matters from an incremental ROE perspective. This high incremental ROE provides some buffer as headwinds around investment returns will continue to persist over the next few years.

The investment book is also fairly divergent with its peer group. Property is 10%+ of the book and equities is another 15% of the book. This is far higher than most other European/ Spanish insurance companies that have mindlessly gone into credit to avoid mark to market losses despite poor risk-reward. 

We believe that this allocation is rational in the current environment and the company’s owners skin in the game and long term thinking has allowed them to run this large divergence versus peers. This allocation provides it to perform than peers on the investment side. We believe that the diversified book would help it to navigate different economic scenarios well. 

The book value of investment real estate property is 560 Million Euros. Rental Income on the real estate book is 33.5 Million on a Gross basis and around 18 Million on a net basis. So the gross rental yield is around 6% and net yield is around 3.21%. Almost 40% of the real estate book is self-occupied and its present only in the top Spanish commercial space. 

GCO has a very strong balance sheet to navigate stress. 

The stock is currently trading at the cheapest levels it’s ever been. On valuation metrics of, Price to Book - If you adjust for goodwill and there is no mark to market of real estate investment on GCO’s books, the stock is trading at 1.27X book. If you adjust for goodwill and include real estate MTM gains, the stock is trading at 1.05X book. With only real estate MTM adjustments, the stock is trading at 0.86X book. Without any adjustments at all, the stock is trading at 1X accounting book value. 

Price to Earnings - The stock is currently trading at 9.5X profit after tax and an equity yield of 10%+. Even if you adjust for across the cycle profits on credit insurance business and investment income, the stock is still trading at less than 17X earnings. 

Currently, the firm has been paying 30% of its profits as dividends, resulting in a healthy 2.8% dividend yield at current market price. On all the key valuation metrics, we believe that the stock is the cheapest it has been despite running a stronger balance sheet and a more diversified portfolio now. 

Final Summary:

In how many insurance companies/ financial institutions do we see such strong insider ownership or owners with tremendous skin-in-the game? The biggest attraction for me in this business has been the conservative culture and the long term orientation that the Serra family has instilled in the organizations without dampening the growth ambitions. 

With a strong balance sheet and durable moats in the existing business, the organization can be expected to grow both organically and inorganically at GDP+ growth. Even in a repeat of a 2008 kind of economic crisis, I believe that the diversification of GCO between credit insurance and traditional insurance will allow it to still make profits in that year. The insurance firm continued to be profitable throughout the GFC and Spanish economic crisis historically. 

With a 25 year+ track record of growth, durability and healthy shareholder returns, GCO is a compounder that is trading at fair valuations, if not cheap at the current market price. We have taken an initial bet on the stock and we would scale up our position as we gain more conviction on the management’s execution going forward.

Disclaimer: I have used images from other sell side reports, GCO’s investor resources and annual report and have mentioned their sources wherever possible. 

We have a portfolio position in GCO and our average acquisition price is around 30 Euros/ Share. I am biased and it is important to do your own research on this name. We would be nimble in this position and scale up or scale down our position based on how the situation evolves. Invest at your own risk.

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