It’s not every day that a company’s share price slumps 10% after it announces a 70% jump in annual profit. But Discovery investors seem fed up with not receiving dividends for a second year in a row — even as competitors such as Standard Bank, Absa, Nedbank, Old Mutual and Sanlam dish out cash to shareholders as they unwind their provisions for the pandemic.
But Discovery, taking a page from Naspers’s playbook, is putting more cash aside to invest in new business ventures, notably Chinese health insurer Ping An — not to mention the capital demands from its growing bank and short-term insurance businesses.
“Parts of the market have always been sceptical about Discovery Life’s cash flow,” says Peter Armitage, CEO of Anchor Capital. “For instance, the life insurance business generates far less cash than the accounting profit it posts.”
As Armitage explains, this is partly due to Discovery’s “perceived aggressive” assumptions when it accounts for life insurance policies. “Discovery’s assumptions are more aggressive than those of Sanlam and Old Mutual,” he says.
Life insurers make estimations regarding mortality and morbidity as well as whether policyholders will let their policies lapse in future. These estimations are then discounted to today’s values, taking expected interest rates and inflation into account.
Aside from the aggressiveness with which Discovery accounts for its life insurance business, investors may also have had enough of the company’s lively push into new businesses — many of them overseas, especially its venture into the Chinese market. That is especially the case when a R1.5bn capital raise is looming on the horizon.
They’ve got a few big initiatives that are just chewing up capital and, in this environment, you wonder when those initiatives will turn a corner
— Patrick Mathidi
“Discovery is a growth-hungry business and with growth you need capital to build,” says Patrick Mathidi, head of equity and balanced funds at Aluwani Capital Partners. “They’ve got a few big initiatives that are just chewing up capital and, in this environment, where things are slowing down, you wonder when those initiatives will turn a corner.”
According to calculations from its cash flow statements, Discovery has over the past five years ploughed about R3bn into “new businesses and equity-accounted investments”. The bulk found its way to the company’s largest offshore bet: Ping An Health Insurance.
In the year to end-June alone, Discovery pumped R1.5bn into Ping An Health (not to be confused with life insurer Ping An Insurance). Due to delays at the regulatory oversight body in China, Discovery funded this capital through a bridging facility which it now plans to replace by issuing fresh shares to the market.
“The capital injected last year was outside our then current capital plan and so we announced the vendor capital placement [VCP] to keep to the discipline of our capital plan,” Discovery CEO Adrian Gore tells the FM. “We don’t, however, need to do the VCP [the injection having already been fully funded], though it is our preferred option and we will only proceed if market conditions are conducive.”
Discovery holds a 24.99% stake in Ping An Health, which covers about 28-million lives in a market that is increasingly adopting health insurance.
Ping An Health, however, started selling policies on its own insurance licence during the reporting period. This saw a reduction in the value of new business premiums by 15% to R11.5bn. The company is rolling out its own branch and sales network and provides its own capital, after the restructuring that saw it decoupled from Ping An Insurance’s trading licence.
Despite the sales upset the decoupling has seemingly caused, new business premiums through its own sales channels increased 6% to R8.9bn. In addition, the decoupling also called for more cash to boost the health insurer’s regulatory capital. But Discovery doesn’t foresee any more capital injections into Ping An Health.
“The business has a very healthy level of capital — 2.8 times solvency requirements — and we do not anticipate any further capital injections for the short to medium term,” Gore says.
The importance of Discovery’s stake in Ping An Health is shown by the core new business annualised premium income — a measure of revenue among insurers — which it contributes to the group. In the most recent reporting period, Ping An Health contributed R2.88bn (after calculating for Discovery’s stake) in premium income out of a total of R21.7bn.
The opportunity to tackle and cash in on the Chinese market, which has the world’s biggest population, has always been dear to Discovery’s investors. “If you look back a few years, it was viewed with massive excitement. And if you look now, market exposure to China has been very costly and Chinese shares have absolutely plummeted,” says Armitage.
Business in China has changed markedly since 2009, when Discovery took up the stake in Ping An Health. With the Chinese government’s clampdown on large corporates — especially tech companies — and its failure to vaccinate more of its population against Covid, it doesn’t look like the same endless growth tale any more. “I think the shine has gone off it from an investment point of view,” says Armitage. “And the market is not sure what to think.”
As Armitage explains, “their business model in China has changed where they are consumers of capital. The moment … Discovery had to put money in there, the market questioned whether there is a whole lot more to come.”
But as Armitage says, the R1.5bn in capital needed isn’t a large amount when compared with Discovery’s balance sheet. The company sits on assets worth R271bn, of which cash and cash equivalents came to R19.7bn at end-June. Rather, it is the idea of a rights issue which has investors rattled.
That will curtail the premium at which Discovery’s shares have traded to its peers. “From my estimates, Discovery is trading at a lower premium to peers than it did historically,” says Mathidi. “This is because Discovery grew ahead of its peers which attracted a premium to its valuations.”
After the release of its annual statements last week, the premium has shrunk. Discovery is trading on a p:e of 13.9 and a forward p:e of 9.5. Compare this with a forward p:e of 6.2 for Old Mutual, 7.3 for Nedbank and a similar rating for Absa. Since the beginning of the year, Discovery shares have slumped 21%, compared with the FTSE/JSE financial 15 index’s 3% gain over the same period.
Will the stock be able to regain this premium? “Discovery tends to be a pioneer in where it goes and it does things differently,” says Mathidi. “I think it will regain its premium, but it will take a while. The market needs to be comfortable that it is turning its new businesses around.”
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