Aegon's Too Cheap to Ignore

Aegon’s AEG strategic framework continues to center on simplification and growth. What initially attracted us is a very cheap valuation, but that isn’t really enough to warrant investment. However, when we map out a reasonable path to earnings, we find Aegon too cheap to ignore, though admittedly, it is still probably one of the lowest-quality names in our European insurance coverage and in the whole of the European insurance space. Within our valuation, we are much less interested in cost savings and much more interested in retirement product conversions and retention; this is particularly pertinent to the United States.

The market ascribes a 4.5% average return on equity to this business over the next five years, which we have backed out of the current valuation. We basically think this is a bear-case scenario with continuing high outflows and withdrawals and not factoring what we think now are better management incentives and control over the actuarial model and assumption environment. Our base-case return on equity averages 6.0%, in line with the business’ average profitability over the past 13 years.

Management has exited the Czech Republic, Ireland, and Slovakia, sold the noncore businesses of UMG and its U.K. annuity book, reduced required capital by $1.3 billion through bank-owned/corporate-owned life insurance and Transamerica Reinsurance sales, and expanded its accumulation footprint in the U.S. and United Kingdom through Mercer, Cofunds, and BlackRock defined contribution acquisitions. There are also some legal mergers of various businesses taking place in the Netherlands. Managing complexity--the ability to think clearly with a targeted and well-packaged business shape in mind--has historically been a problem for Aegon, in our opinion. However, we continue to believe that management is making inroads into addressing this.

There is some business rationalizing going on in Asia with a capital-efficiency program, but ultimately this unit is superfluous, as are Portugal and Spain, and we think Aegon would do well to divest these. Central and Eastern Europe is a little closer to home, and while underlying earnings here are still slim, we think the business has a better chance of gaining traction than in its other peripheral markets.

Better Than It Might Appear Aegon has had its fair share of problems, which have stretched across capital, solvency, governance, management, recurring nonrecurring items, and a missing strategy. Communication from management to the investment community has been very weak at best. However, we think Aegon has turned a corner and management is addressing all of these issues. The stock is still languishing at 0.5 times book value; in our view, this is because investors are still anchoring to the past. While there have been signs of cheer recently and the market has demonstrated willingness to start getting onside with Aegon, this hasn't followed through. The business is still posting some horrible key performance indicators from one of its renaissance acquisitions.

However, we think (1) historical issues have abated; (2) there is a strategy, and investors just have to dig deep to see it; and (3) the eyesore key performance indicators are not as bad as they seem.

We do rate Aegon as being a no-moat business. This is because it predominantly operates in commoditized lines of life insurance where it is difficult to establish an edge, and the problems of operating in these more commoditized lines are absolutely clear. Focusing on growth is not the way to run an insurance company, but where a business does not have an edge, we can see that this is much easier to do, and management’s variable compensation objectives have encouraged this. As a result, Aegon has been through an extensive period of actuarial model and assumption updates, and management compensation objectives are now emphasizing control. The business has also divested a stream of capital-intensive business units, which has helped shore up its balance sheet and solvency and relieved some underwriting risk. It is now focusing on more asset-light accumulation lines and rollover retention.