We are all looking for high quality businesses. Mostly this high quality is apparent (to everyone) only when the price has reached levels from where it is very much fun to look backwards. Many investors find high quality businesses within the ranks of well known companies and better known stocks (and ticker symbols). Maybe I have found something off the beaten path in less crowded markets …
This is one of my longer posts, as it was usually the case with my Initial Analysis write-ups. If you want to to read my conclusions first, to see what’s in it for you (time is scarce), feel free to skip to my summary. Otherwise,
One conclusion of Going to the most fertile hunting grounds was to look at market segments with less competition, meaning the main boards might not always give us the best chances to bind a bargain. This idea fits pretty well within this framework. From the picture above you might already have guessed, I found a promising company in Mexico and it might come with mucho Quálitas.
I read a lot of quarterly inverstor letters from various funds. Depending on the quality of the writing I might read it carefully (concepts) or barely skim (ideas) it. This company I am going to write about is originally from one such letter. I initially got to know about it in the fourth quarterly letter of Vltava (4/2020 Inflation – Vltava Fund).
The stock price already made 450%+ during the last five years (usually I have problems /biases buying stocks after such a run). It even was the best performer in its market segment for at least one year during that period. It trades at a mid-single digit P/E since covid greatly influenced earnings and forward P/E is indicated as low-double digit P/E. The company pays a small dividend (1.5%) and some shares are bought back.
Capital allocation is mostly for supporting the company’s growth in its domestic market and international expansion. Book value per share as well as earnings developed very nicely over the last ten years, signalling very profitable growth but distributions to shareholders remained low. Future capital allocation will be key for creating shareholder value.
The company is a Mexican-based Auto Insurance company: Quálitas Controladora SAB de CV (the company, or group, Quálitas, Q* MM). My personal impression, and probably I read it somewhere else before (Vlata?), is that this is pretty much the Mexican Progressive (PGR US). Let’s see why …
Qualitas’ DNA resembles PGR’s to a certain extend. It tries to provide superior services, driving efficiency and profitability. A look at slide 3 of their corporate presentation makes that clear. One non-financial metric I love: 94% of the time our adjusters arrive to the accident site before competition, if that is up from 85% in 2019, p29, that’s even more impressive. This might seem trivial, but: accidents often result in a stressful situation for (both) drivers, no matter if they are perpetrator or merely aggrieved party. During such situations it can happen, that the wronged party wrongfully agrees to be the (sole) perpetrator. Economically speaking, having your adjuster arriving first, might result in less (false) claims. Apart from that, it just speaks about the quality and service level (perception: imagine a branded Qualitás car arriving 1st). As does PGR, the company makes use of ‘agents’ to sell its products, i.e. auto financing companies or financial instituations provide insurance at the time of purchasing a vehicle). And very importantly, the company leverages its technology (auto. assignment using geolocation, higher recovery for auto-theft).
The company has a very high domestic market share of ~30%, indicating that they are doing a lot right (see above). Luckily, they have a long way to go, with domestic market penetration only at 39%. Their auto-segment underwriting results are especially strong. Qualitàs’ vertical integration helps them to operate more efficiently (see AR 2019, p17).
Non-insurance subsidiaries […] linked to the process of claims assistance in aspects such as the provision of spare parts and windshield repair. With the purpose of obtaining total control, during the year, we acquired the remaining shares of […] to manage the operations of these three subsidiaries directly.(AR 2019)
International expansion is taking place in the US but mostly Middle and Latin America (El Salvador, Costa Rica, Peru). So far, their international market shares are very low (singl-digits) and potentially offer a very long runway for profitable growth. For example, the US operations seems to perform strongly on the basis of a unique cross-border-trucking product offering:
1) The total written premium by Quálitas Controladora includes the issuance of the car insurance subsidiaries and the sales of the other non-insurance subsidiaries related to the insurance or claim assistance processes.
2) It refers to the sum of acquisition, loss and operating costs divided by the earned premium, and is provided for purposes of comparison with international ratios.
Their very strong financial position, with solvency margin sitting at 718% for 2020 and was at a comfortable 487% for 2019, toghether with little dividends/buybacks, enables them to (potentially) grow their operations and expand internationally.
Invested assets grew strongly over the last few years but return on invested assets or ROI came down with a -300bp reference rate cut. Government bonds comprise most of the investment portfolio but plans are for increasing investments in equitites.
Recent results were strongly impacted by the pandemic, again, as with the case with PGR. Understandably, there were less new cars sold and less driving in Mexico. Thus, taking a look at longer-term trends is the way to go and I like what I see. Loss ratios and combined ratios show a downward trend (see my initial PGR post for insurance economics 101). Qualitás’ expense ratio (ER) is 4/5 acquisition costs and only 1/5 operating costs.
The company grows very profitable as shown below for the last five years. Financial income shows a more volatile development and should do so in the future.
Profitablity is high and various metrics look very strong (extraordinarily so if we look at 2020). Even if we base our simple valuation on 2019 results, it seems to me Qualitás isn’t expensive with a high single digit P/E. Qualitás’ 2021 objectives or guidance support this notion.
But longer-term developments are much more important: shareholder value will be driven by good (or bad) capital allocation decisions by management within the prevailing ‘economic setting’.
- If efficiency in its domestic Mexican market continues to be strong, that should set a strong base case for returns, and, they have a potential long runway for profitable growth.
- The strong capital position is there for international expansion and chances are there
- M&A is usually a prime recepe for destroying value and managements’ adventures searching for new business opportunities aren’t that differnet (watch!)
Mexico should perform rather well going forward, maybe with a little bumb the next (two) years with fewer new car sales due to the pandemic. Longer term, there is ample growth opportunty (39% penetration) and the company can leverage its market position and operating efficiency (vertically integrated, technology). So far the base case. Potential positives: If the US is more serious about getting more production closer to home (away from Asia) but realizes that wages are a bit higher, producing in Mexico might present a nice alternative in between. In general, after Trump economic integration between the US and Mexico could strengthen once again and drive Mexican GDP higher as could many other general factors. This would strengthen Mexican incomes and demand for car insurance would likely grow. Their US business should profit as well! Potential negatives include all things imaginable for emerging markets and simply put it’s a general downcase for the economy. In addition, Qualitás’ operations could disappoint as well on a spectrum from less profitability and losing a bit of market share to total disruption (unlikely).
International expansion and new business opportunites in a more general sense could turn out very well (or not) from a shareholder perspective. Its successful domestic insurance operations could be the base for its international expansion providing a blueprint for operations, best practices and technology – and obviously capital. International results for 2019 (p13) seem quite good so far, but only time will tell. Apart from the regional expansion, new business lines could potentially add tremendous amounts of value (or destroy it). They expect the non-Mexico car insurance business to hopefully represent between 15% and 20% in the next three years, up from ~8% today and 2% five years ago. Still, they realize that growing proditable beyond a 30% domestic market share will be a challenge, thus new business lines are a smart strategy.
New business lines: For several months, Qualitás is in the process of getting all the licenses and approvals for starting a new business line. They want to offer medical and health insurance first in Mexico City and then in the metropolitan area to learn and adjust before expanding further regionally making use of its established network of agents thoughout the country. They are confident and working towards issuing the first policy during this year (hopefully Q3).
The right momentum call comes when you’re well capitalized with an unprecedented good reputation and agent network and the commercial offices that now cover the full country.Bernardo Risoul Salas, CFO, during Q4 2020 earnings call Q&A
Investment returns will be lower and Qualitás aims for 100 to 150bp above the reference rate, likely increasing their equity allocation. But absolute investment returns could still grow, if the base of invested assets grows strongly on the basis of strong customers/policies growth. A new CIO, Alejandro Elizond started toghether with a newly hired investment team.
Corporate income tax rates in Mexico sit at a stable 30% since 2010, according to tradingeconomics and PWC. Distributed after tax profits (dividends) are taxed at 10% (withholding tax). For German foreign individual investors this is OK, since these 10% are cleared for German income taxes payable (BZSt 2020).
Overall quality seems good, but is largely dependent on future capital allocation which needs to be proven and executed well over the next few years – strong hints are to be found in the recent earnings call or below. Executive managements tenors could be longer but board members (and owner families) make it up. Strategy and recent statements from the CFO point in the right direction:
Regarding capital allocation, the philosophy remains unchanged. We are going to be disciplined and to try to do things that we believe are going to maximize value for our shareholders.Bernardo Risoul Salas , CFO (Q4 2020 earnings call)
Further comments from Mr Salas (CFO) indicate that some excess capital will be returned to shareholders after the general shareholders meeting on April.
A grasp on valuation
As usual, I struggle a bit with valuing financial-companies because I tend to base my valuations on cashflows (DCFs). But Qualitás looks rather cheap with regard to various valuation metrics (below) and huge potential. The stock is up 450% over five years, how can this (still) be cheap? I tend to shy away from stocks with such a run-up, but Qualitás fundamentals support that (and more)! Anchoring on the early-Febraury price level before the slump also ‘helps’ not to look at the current price and dismiss it …
- a low P/E of 7x
- , 10x for 2019,
- a 2.5x P/B combined with high ROEs
- Shareholder returns are a bit low, regardless of very lofty solvency ratios (700%)
- Dividend yield at 1.5%
- shall be raised, though
- smaller share buybacks, likely a new program after finishing current prgm
- solvency ratio provides basis for business expansions
- Dividend yield at 1.5%
Mexican 10yr governemnt bonds yield 5.6%, down from a rather flat yield curve with 10yr bonds offering 6.9% at the beginning of 2020. Currently, short term rates are at 4% and 20yr yields are at 6.6% This provides a perspective for a required earnings yield, which currently sits at about 10%, depending on the source and respective estimates which can be widely off.
Growth with regard to the top line will be difficult to deliver in the short term but mid-to-long term Qualitás wants to deliver double digit growth, based on mid to high single-digits growth for Mexian car insurance business and accelerated growth on the subsidiaries.
Why is it cheap today? The answer is probably just: Mexico. Further, who wants to buy a boring foreign Mexican insurane businesses (profitability is out of style) if he can buy the next (would-be) google on a domestic US bourse. And Qualitás has a rather small market cap of MXN 46bn (US$ 2.4bn) which might be too small for most international funds investing in such (boring) assets. Despite much higher daily trading volumes vs few years ago, volume ($3.5m) is probabaly still too small for big international funds. Despite numerous analysts following the stock, according to slides, earnings estimates (EE) seem to be ‘uninspiring‘. EE are for basically flat EPS until 2023 (MXN 10) and only for 11.30 in 2024, which is still below 2019. Hard to believe at a first glance, despite probably lower investment income and less new car sales, both due to the pandemic. In the last five years, Qualitás’ adj. EPS usually beat consensus estimates. As the company continues to grow profitably, bigger market capitalization could become a potential catalyst with more funds being able/considering to invest. This effect could be stronger since the company continues its journey of becoming a world class ESG company and/or investors re-focus on fundamentals.
- With the pandemic dragging along, low tourist numbers and business closures, a general slow economic recovery and thus fewer new cars sales for months (or years?) to come, top line growth could be disappointing.
Pre-mortem: I invested a considerable amount of money based on todays significant under-valuation based on my above valuation. It is the year 2025 and I lost 50% of my investment and I ask: What happened? Tourist numbers and the broader economy in Mexico recovered later than initially anticipated and MXN depreciated further against mayor currencies. Economic integration with the US never revived after Trump. With the broader economy and incomes staying at lower levels, less Mexicans bought new cars and did not need insurance. Many opted not to own a car but simply use mobility-as-a-service offers when needed, depressing the total number of cars. On top of that, gangs figured out how to steal cars ad remove Q’s technology resulting in drastically lower theft recovery numbers. International expansion did not work out and even the US business depending n the unique cross-border trucking product was facing drastically lower demand. Dividend payments stayed low, share price performance and shareholder returns followed the company’s fundamanetal downward development – even more so when measured in EUR or USD (USD/MXN is not back at 20, seen a few times during last 5yrs, in early 2020 MXN spiked at 25).
Summary and decision
Based on the above I want to initiate a small position in Q* MM. I bought a 3% position.
I look forward to ‘partner’ with a company taking the long-term view and focusing on profitable growth.
I will review my portfolio with regard to my big position in Progressive.
The investment opportunity in Qualitás (Q* MM) lies in a very profitable and well capitalized Mexican auto insurer with a dominant domestic market position. This provides the basis for international expansion and new business lines. Vertically integrated operations and operational efficiency can act as a blue print. Owner-families ensure the right long-term focus and put the right management in place for superior capital allocation and profitable growth in the future. This could be(come) the Mexican Progressive (and much more) but currently seems to small for more international funds to bother!
I hope you enjoyed this blog post. What’s your take on Qualitás? If you liked my article just like it 😉 If you want to receive notifications about future posts, just follow my blog.
It is important also to inform that the Brockman family and the Castillo family will continue
to be involved in the board. (Q4 2020)
Joaquin Brockman Lozano, our Founder and Chairman of the board, passed away in January and he seems to have held just shy from 50% of Qualitas shares held in trust (no info about share ownership in bloomberg /financial data providers). They will remain in a trust. The Brockman family has the intention to continue being involved heavily in the running of the company as will likely be the case for the Castillo family.
|Top holders||% Tot Sh Outstand||Pos Date|
|Joaquín Brockman Lozano (died Jan ’21)||45.84%*||31-Dec-2018|
|Wilfrido Javier Castillo Sánchez Mejorada||14.24%||31-Dec-2018|
|Van Eck Associates Corporation||1.93%||31-Mar-2020|
|The Vanguard Group, Inc.||1.47%||30-Jun-2020|
Hints on value creation
snippets from Q4 2020 earnings call:
I love this CEO’s comment: On this regard, let me reassure you that we are working, but in no rush to make decisions. Actually, we have concluded two processes without reaching a deal, either because of valuation expectations or because we did not see it would be accretive to our businesses.
Next when there is light at the end of the tunnel, it seems that it would be a very long tunnel. With such an environment, it is quite challenging time to forecast the near-term. And even when we assess performance each quarter, we play for the long-term. We strive to make decisions that will deliver sustainable results.
We have mentioned our intention to expand our service to other business lines and we are making progress and we expect to reach our first premium during 2021. We are also open to mergers and acquisitions as long as there is certainty it would create value to stakeholders.
After reading rgaia q4 2020 (and numerous other quarterly investor letters before) I wanted to incorporate a checklist with features like the below. This is my start to check these items more explicitly within my write-ups and investment process.
- Value or a degree of identifiable cheapness is there, the current P/E with recent underlying growth rates seems cheap
- Growth and structural tailwinds are there: low penetration, economic growth, expansion,
- though high market share in domestir core business
- value to each key stakeholder: trained employees, agents (high bonuses recently due to low frequency)
- management team with aligned interests: still an open question
- but families involved holding more than half of total shares
- identifiable strong unit economics: yes, generally the case in insurance
- moat against competition: yes, (narrow) through more efficient operations, and better quality service
- can be widened with multiple (bundled) insurance policies per customer/family
- Change: more like some disruption (bumper) due to covid: fewer new car sales / economy depressed
- Strategic asset: at below $3bn it could be a desired asset for big(ger) US insurers hungry for M&A /int. expansion, but
- with the two families involved this seems very unlikely!
- Optionality: if Qualitás is highly trusted by its customers, financial services or auto-businesses might be a good cross-sell further into the future. Near term, medical and health insurance provides a huge potential for new insurance business, and
- why stop there … (asset management, investment products [new CIO], … ?)