Pay attention to this maturing income stock

By any measure, Phoenix’s 20-year progression from a bit player in the insurance consolidation market to a FTSE 100 stalwart and peer of Aviva (AV.) and Legal & General (LGEN) is worth a Harvard Business Review case study.

The company has grown its assets from £68.6bn in 2013 to £283bn today by acquiring large, but essentially redundant, books of life insurance policies and running them off for cash. It is a simple business model on its own terms that has funded large dividends. The company is set to generate around £4.4bn in cash over the next three years, higher than analysts previously expected, of which £3.7bn is operating cash from recurring revenues.  

This approach was epitomised in 2018 with the £3.28bn acquisition of Standard Life Aberdeen’s insurance arm. This was followed by the similarly huge £3.25bn deal for the ReAssure insurance book owned by Swiss Re. Since then, the deals have been getting smaller, although as recently as 2022 Phoenix bought closed book insurer Sun Life UK for £248mn.

This last deal is a good example of how the company expects book run-offs to deliver profits. Sun Life is forecast to deliver £470mn of cash over the lifetime of the book. It also helped bolster the company’s dividend growth, and the deal was done at a “decent” price, in the words of RBC analysts.    

A fresh strategy 

Over the past couple of years, however, questions about the long-term sustainability of Phoenix’s business model have grown, partly as a result of its mega-mergers. The ReAssure acquisition proved to be particularly troublesome once it completed, with consumer complaints over customer service in some of its legacy policies surging after Phoenix took over. While not serious enough in itself to undermine the rationale for the deal, this episode, as well as broader issues such as Phoenix’s increased leverage, did pose the question of whether the group’s size was starting to outrun its expertise.

Management’s response suggests that consolidating gains and expanding into new growth areas are the priority. This is reflected in the announced departure of chief financial officer (CFO) Rakesh Thakrar. CFO since 2020 but with the company since 2001, Thakrar is acknowledged to have masterminded the M&A strategy that took Phoenix into the FTSE 100 in 2020.

The mood music from management more recently has been about housekeeping and hiring to support the retail insurance business. The recent merger of the Phoenix and Standard Life funds into one consolidated business led to upgraded forecasts for cash generation, but also made the compnay simpler to manage.

The strategy as set out in the last annual report could not be clearer – or as clear as management-speak allows. “Our successful execution has enabled us to prove ‘the wedge’ hypothesis, with the new business cash from our open businesses more than offsetting the heritage run-off. That means we are today a sustainably growing business, and no longer reliant on M&A.”

In other words, Phoenix will build up its new businesses rather than rely on the run-off from its closed-book acquisitions or make large closed-book purchases in the future. The implications for investors are positive: Phoenix has long had a decent dividend yield but management announced a new progressive payout policy in March.

Pension promise

Pension risk transfers, where the liabilities from company pension schemes are transferred to life insurers’ balance sheets, are an area of promising growth, and the company has been getting in on the action. The level of written business in the bulk purchase annuities market has risen exponentially for Phoenix over the past two years, with premiums rising by a third to £6.2bn in 2023. Management has committed to investing about £200mn a year in annuities from 2024 onwards.

It seems unlikely that it will match Legal & General in the medium term when it comes to financing the big one-off annuity deals. Last year, Legal & General was able to take on the entire £4.8bn Boots pension scheme while barely breaking a sweat. However, the £50bn annual pension transfer market is big enough to offer Phoenix a reasonable slice of the pie. Indeed, Berenberg analysts found that there are only seven meaningful competitors in the bulk purchase market with which it has to compete. Many of these also target different sizes of pension schemes: Phoenix’s focus is typically on schemes in the £500mn to £2bn range

Push to reduce debt

The thorny problem for Phoenix – indeed for all insurers – is that the global increase in interest rates has acted as a double-edged sword, given their need to hold large amounts of regulatory capital.

The increase in yields on government debt and high-grade corporate bonds means that Phoenix has been striving to keep its solvency levels stable. It is succeeding. Last year it managed to keep its solvency ratio – which measures its ability to withstand risks such as falling asset prices – towards the upper end of its target range, and stay within much narrower margins than its peers. Berenberg reckons that since 2021 Phoenix’s solvency ratio has remained between 178 per cent and 189 per cent, whereas some of its big competitors have seen their solvency ratios fluctuate within a 40 percentage point range. It attributed this to Phoenix’s hedging strategy.

At the same time, however, Phoenix’s own funds have fluctuated and recently fallen. Given that own funds are what most investors use as the denominator when calculating leverage, this hasn’t done good things for Phoenix’s balance sheet and several analysts have flagged the urgent need to pay down debt. Management intends to repay at least £500mn of debt by the end of 2026, and is targeting a leverage ratio of 30 per cent, down from 36 per cent in 2023. 

Another problem is that the IFRS accounts do not consider future profits, so the impact of hedging can cause wild swings in reported profitability. However, the company expects that the negative variance will balance out over time.

Aside from these technical balance sheet issues, Phoenix faces a number of strategic choices about how to maintain the quality of its earnings. The company has a proven ability to generate cash, but must also build scale in consumer-facing life insurance to maintain earnings at a decent rate, and this is largely new territory for investors.

This partly explains why broker Berenberg expects that Phoenix’s share price will not return to the premium it has historically held over the other UK life insurance companies. Instead, the upside to the current share price will come from management continuing with its strategy for cash generation and dividend growth.

While a double-digit dividend yield is often a warning sign, it is not such a bad option if a company can prove itself reliable – particularly for investors who need regular income but want to diversify their holdings away from the bigger life insurance companies.