XL deal spooks AXA investors but it should prove “earnings accretive”

Investors were potentially spooked by AXA’s announcement yesterday (March 5) that it will  acquire XL Group for $15.3 billion. Its share price fell sharply by around 10 percent as investors worried on a fundamental shift in strategy, according to analysts.

A research note from analysts at Jefferies suggested that the fall in share price suggested “high level investor angst at the unexpected acceleration in corporate and strategic actions to reposition the group towards more underwriting risk”.

It suggested that the XL deal has been viewed by investors in the context of the expectation that 100 percent of the unit AXA Financial will be sold down over time. The share price drop meant that some €6 billion was wiped from AXA’s market cap initially meaning, Jefferies suggested, zero value been attached to any deal synergies by investors.

But Jefferies also suggests that a “more settled investor psychology” will emerge once investors fully appraise the XL deal.

“With management indicating that one quarter of earnings contribution from XL (at c€200m) equates to six months of lost earnings form AXA Financial, the deal/IPO outcome should on our calculations prove earnings accretive for 2019 (3-4 percent initially rising to 6-7 percent assuming full realisation of synergies),” Jefferies said.

It also noted that at the heart of this is a fundamental chance of strategy by AXA. “The purchase of XL together with management’s expectation that 100 percent of AXA Financial will be sold down over time certainly represents a seismic shift in the group away from life (and financial market risk) towards non-life (and underwriting risk),” Jefferies said.

It also noted that the size of the XL was unexpected. “XL will certainly be marked as a transformational deal for AXA at both the operational and corporate level with investors bound to revisit their investment thesis,” it said.

It also noted the operational risks at XL should considered. “Not least that earnings for 2018 might be impacted by another active hurricane season thereby undermining 2018 earnings stabilisation post AXA Financial exit.”

Jefferies summarised: “Our investment thesis on AXA has been predicated on the replacement of financial market risk by underwriting risk (non-life, health, protection) with management more in control of the margin destiny, with yesterday’s announcement representing a rapid acceleration in this strategy.

“Dividend momentum over the medium term should on our reckoning benefit in the process given the higher cash remittances that can generally be afforded by non-life businesses vs life, with management specifically guiding to a >80% payout on XL.”

Macquarie Equities Research has also issued a note on the deal. It is upgrading its recommendation on the stock to Neutral following an almost 10 percent correction, with a target price of €22.7 (from €22.2).

It noted that the fall in share price was probably not the reaction management expected. “However, we expect it reflects the fact that confidence in the earnings growth from the core business is lower, and also significant risk from the plan to grow the XL business. AXA’s management talked about a lower cost of equity, which has not been the case, as investors worry that growing large commercial risks could be problematic,” Macquarie said.

But it also noted some risks. In order for XL to generate $1bn of net income, we expect the combined ratio would need to be below 95 percent and it said it believes $0.86bn is more realistic given the pricing conditions.

It also noted that AXA’s management described XL’s reserves as best estimate, which “is concerning as changes in inflation could see some of the liability lines in particular need top ups”.

It also noted that XL management described the changes in the internal reinsurance in the 4Q call, which AXA confirmed they will unwind going forward. “We are surprised this does not slow dividends. AXA are saying they can pay 80% of the earnings of XL as dividends,” it said.

Macquarie summarised: “While the logic for the transaction seems less than compelling in our view and we expect the core business growth is weaker than many believe, if the business pays down the leverage and the XL combined ratio recovers, then the stock should recover. As AXA no longer meets our criteria for an Underperform, we are upgrading to Neutral.”

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