Stockwatch: A very "special situation"

Hiscox has revealed an upturn in first-half performance, showing how the £2.6 billion specialist insurer's strategy is bearing fruit. While the approach of the American hurricane season can still in the chairman's words, "deliver some surprises in the second half", any retreat in the stock would be useful for buyers. Its share price has re-rated from about 700p to test 950p, currently 915p with markets under pressure generally.

Insurance can be a tricky area to feel conviction about investing. It's often hard to judge any industry cycle and what extent stocks discount it. There are unpredictable catastrophes and business tends to be competitive, too. Yet Hiscox has established a long history since it was founded in 1946 and its retail specialty insurance is now doing particularly well in the UK, continental Europe and the US. This includes high-value household items, fine art, collectibles and luxury cars, so the company could also be seen as a play on "the rich getting richer" in the modern world.

With the company incorporated in Bermuda its financials tend not to appear in databases such as Company REFS; its low profile is also shown by scant discussion on bulletin boards; and what information is available on broker advice has been pretty negative with the recent consensus as a 'sell' with price target of about 800-870p. Yet the price/earnings (P/E) multiple is not at all stretched, possibly about 12 times for the 2015 year, and a prospective yield of 2.5% to 3% based on the ordinary dividend, is being achieved with earnings cover of three times. In the last three years the annual yield has been substantially enhanced - recently near 10% - by special dividends, although this aspect is likely to vary with industry conditions.

First-half results proclaim "an excellent start" to 2015

Despite the 27 July interims benefiting from good claims experience and favourable foreign exchange movements, "big ticket" insurance has seen price reductions - so it is creditable how revenues, in the sense of gross premiums written, advanced by 12% to £1.09 billion. Overall, pre-tax profit rose 8.4% to £135.1 million, with the retail side achieving record profits, up nearly 60% to £59.3 million, for earnings per share of 43.7p, up 20%.

Annualised return on equity is now very close to 20%, highly respectable. As to the durability of all this: Hiscox's strategy is to balance volatile big-ticket business with more stable specialty retail - enabling opportunities to be found regardless of market conditions, and where management sees plenty of room for expansion. This is attractive for investors at a time of worries over mainstream corporate earnings, especially in the US, and with interest rate rises approaching, plus having to judge insurance industry cycles. It gives Hiscox "special situation" appeal, i.e. a capability to deliver growth despite the big picture issues.

Strong cash flow means attractive dividends

During the first half-year, Hiscox returned £192 million, or 60p per share, to shareholders in addition to the 2014 final dividend of £48 million, or 15p per share. This derived from a strong cash flow profile and came after the board had considered capital needs and growth opportunities. It was the third successive year of special dividends, although the board has also cautioned: "this is a reaction to market conditions and not a long-term strategy to return capital every year." Even so, the interim cash flow statement reflected a company well-positioned for a culture of shareholder returns, as net cash flows from operations jumped from £97.8 million to £320.9 million. How many other companies can you see, achieving that?

Total distributions paid to shareholders rose from £175.8 million to £189.6 million, leaving a £107.5 million net increase in cash to £746.4 million at end-June. This means ample scope also for the objective of smaller bolt-on acquisitions, e.g. the recent £9 million purchase of R&Q Marine Services, specialising in yachts and general marine leisure insurance - to form the basis of a new managing agency business. Debt is not needed to run the business in the sense that note 18 to the balance sheet clarifies £273.7 million total financial liabilities as a third party investment. Finance costs clipped just £4.4 million off £138.8 million operating profit, while cash has jumped 65% to £746.4 million.

The table shows the "combined ratio" is on a generally reducing trend, i.e. an improved performance in operations, which is a measure of the sum of incurred losses and expenses divided by the earned premium. So a ratio below 100 implies an underwriting profit, although investment income can also influence insurance company results - in Hiscox's case, £29.4 million additional to £709.8 million net premiums earned.

Risk of catastrophe losses - but not an Achilles heel

The 2011 profits plunge was caused by £270 million natural catastrophe losses. However, the board still increased the dividend by 3% to 17p despite earnings per share slumping near 5p - confident in the business's underlying strength versus an exceptional hit. It is something apparently scarred into management minds: "in our industry we regularly model the impact of a wide range of serious catastrophes" although the chairman reckons "this does not go far enough...there needs to be a detailed practical 'dry run' of how a serious catastrophe may play out involving all London Market players, including our supervisors..." Militant Islam is obviously the main threat, but at least security services are highly alert - compared say with "9/11" in New York. So you have to appreciate such a risk as a potential short-term hit, albeit likely buying opportunity - given the way Hiscox is evolving.

A shareholder-friendly business

The latest results affirm Hiscox's strategy to harness growth and the group's ability to generate cash, which will aid continued expansion and shareholder returns. I would not, therefore, be put off by broker "sell" advice. Hopefully, they will maintain it and jittery markets also help bring the price back for fresh buyers. Otherwise the five-year chart is justifiably asserting a superior business.

For more information see: hiscoxgroup.com.