2023 ended up being a rather mild year for British life insurance and savings company Phoenix Group (OTCPK:PNXGF), whose shares fell slightly on a total return basis, underperforming UK peers with similar businesses like Aviva (OTCPK: AVVIY)(OTCPK: AIVAF), Legal and General (OTCPK: LGGNY)(OTCPK:LGGNF) and M&G (OTCPK: MGPUF).
As frustrating as this has been for Phoenix shareholders, the recent underperformance makes it worthwhile, with the stock’s dividend yield of around 10% looking particularly attractive at this point. With the company also set to bank on some growth in the coming years, these stocks seem like an intriguing choice for value investors, and I open the name with a Buy rating.
With 12 million customers and approximately £270 billion in assets under administration (“AUA”), Phoenix is one of the UK’s largest life/savings businesses. Generally speaking, the company’s activity can be broken down into two divisions: Heritage and Open. Heritage mainly means managing existing policyholders who hold products that are no longer marketed to new clients, such as conventional “with profits” funds. Conversely, and as its name suggests, Open represents companies open to new customers. This covers a wide range of activities, but includes workplace and retail pensions, individual and blanket annuities, over 50s life insurance, equity release products and much more. The portfolio represents approximately 45% of assets under management, the remainder being taken up by its various open book activities. The split is similar in terms of operating profit: Heritage accounted for around 40% of the £299 million pre-tax adjusted operating profit posted by Phoenix in the first half (before group expenses), and Open at around 60%. .
As suggested, Heritage is essentially a melting ice cube type company. Over time, AUA would steadily decline without new customers, as policy maturities and surrenders exceed the ongoing premiums of existing contracts. That said, Phoenix is a closely held consolidator of other companies looking to shed existing assets, so M&A can offset this natural liquidation for a while. Indeed, AAU Heritage has remained broadly stable over the past five years, at around £120 billion. Additionally, the company estimates that UK Heritage’s assets total around £435 billion, so it is still possible that future mergers and acquisitions will continue this trend.
This is part of the reason why Phoenix has been able to pay a slightly growing dividend over the years, even though much of its business is in liquidation. Annualized dividend growth of around 4% may not seem that high, but with its yield historically above 7%, it can lead to good overall returns for investors.
The other aspect to appreciate about Phoenix is that 2024 could represent an inflection point in terms of offsetting the liquidation of assets with the opening of new activities. In the first half, Heritage’s losses totaled £4.6 billion since the start of the year. Although this was only partially offset by £3.1 billion in net flows from new business opened, the latter figure represents a 70% increase year-on-year. Management expects net funds flow to be positive in 2024, which would be the first time in the group’s history that it has achieved this. Additionally, even though net fund flows were negative in the first half, M&A and market movements nonetheless led to an overall increase in AUCs. The Group’s long-term free cash flow, which essentially measures expected future cash generation from current in-force business (less net debt repayment and debt servicing costs), also increased during the period.
While Phoenix is transitioning to a business model more focused on organic growth, its shares still offer a dividend yield more suited to a non-growth company. Management declared an interim dividend of £0.26 per share, an increase of just under 5% year-on-year which took the trailing twelve month payout to £0.52 per share. This equates to a return of just under 10% given a 2023 closing share price of £5.34.
Even though a high yield sometimes means a struggling dividend, the cash generation seems sufficient to cover the payout. Phoenix operating companies handed over just under £900 million in cash to holding companies in the first half, with management expecting the full year figure to be at the high end of its forecast range of £1.3 billion to £1.4 billion. The annual dividend costs around £500m in cash, so even after subtracting annual operating expenses (~£80m) and interest on debt (~£250m) it should remain sufficiently money to fund the dividend with cash to invest in. growth and mergers and acquisitions.
While the dividend appears covered and Phoenix is on track to accelerate its organic growth, the stock’s valuation has only become cheaper. Modest dividend growth and a decline in the stock price in 2023 saw its yield increase by around 3 points from the 2019-2022 average value of around 7%.
This may well reflect the fact that interest rates and yields have risen sharply over this period, with a higher risk-free rate naturally having a similar impact on high-yielding stocks like Phoenix. Concerns about the UK economy and credit risk in its investment portfolio could also be a factor, with a significant portion of its portfolio invested in corporate bonds. On the other hand, rate hikes appear to be happening in the UK given that the Bank of England has been keep calm during the last meetings, while the economy is doing much better than expected (including the BoE).
This lays the foundation for a compelling investment proposition. Even without a tailwind, if the dividend yield gradually fell back towards the 7% area, a base yield of 10% and continued annualized dividend growth of around 4% would be good for annual returns of around 15%. The risks here obviously include the investment portfolio I mentioned above, as well as insurance risk which would also apply to other life insurance providers (e.g. mortality, lapse rates, longevity of annuitants, etc.). However, with return potential already implying a significant margin of safety, Phoenix looks too cheap to ignore at this point, and I’m opening on the stock with a Buy rating.
Editor’s Note: This article discusses one or more securities that are not traded on a major U.S. exchange. Please be aware of the risks associated with these actions.