Healthy cash flow is key for investors in iSelect offering
Financial products aggregator iSelect could come to the market within a year.
THERE has been a dearth of financial services companies coming to the market in recent years, for obvious reasons. But the pipeline is building.
General insurance buying group Steadfast is targeting a $300 million-plus float. Another that could come to the market within a year is financial products aggregator iSelect.
It promotes itself as a one-stop shop for comparison of Australian household and financial products.
We understand iSelect has successfully raised $30 million via a private placement at $18.50 a share, representing a multiple of almost 20 times 2013 forecast earnings.
Investors were apparently told iSelect should generate revenue of $134 million in 2013, up 19.7 per cent on the previous year, with earnings before interest, tax, depreciation and amortisation expected to rise 27.4 per cent to $30.7 million.
Its health insurance offering is the driver of the business (81 per cent of revenue in 2012), boosted by increased churn before the introduction of means-testing of the health insurance rebate from July 1. The promoters of its latest capital-raising, while emphasising absolute valuation techniques, also note valuation comparisons with listed online businesses Carsales.com, iProperty Group, REA Group, Seek, Webjet and Wotif.com.
A key point of differentiation is the cash-generating capabilities of these businesses. The peer group are all strong cash-generating businesses, typically converting at least 70 per cent of EBITDA into operating cash flows in recent years and paying respectable dividends as a result.
By contrast, iSelect has generated negative operating cash flows over the past three years, despite reporting strong earnings growth, and is expected to generate only about $6 million in operating cash flows in 2013.
The promoters of the capital-raising are not forecasting a dividend for the next three financial years. At the time of an earlier capital-raising in 2010 the same promoters had forecast iSelect to be operating cash-flow positive in 2011 and 2012. It wasn't to be.
This underwhelming production of cash is at least partly linked to the preference of some third-party product providers to pay sales commission to iSelect over time (known as trail commissions) instead of upfront commissions at the time iSelect generates a sale.
However, iSelect has elected to account for future trail commission revenue at the time of the sale of policies rather than on the basis of actual payments received. So while healthy growth in revenues can be reported, this does not necessarily translate to healthy growth in operating cash, especially when the business is growing rapidly.
The end result is that in 2010 iSelect's cash receipts made up just 31 per cent of reported revenues. This rose to 45 per cent in 2012. A $91.5 million trail commission asset was booked in the 2012 accounts, which is calculated using estimates and assumptions about expected lapse rates, mortality rates, inflation, future premium increases and government policy.
We understand iSelect has told investors that the ''lag'' between EBITDA and operating cash flow will unwind over the next three financial years as its book matures and new business lines that are fee-based continue to grow.
Clearly, growth plans and customer behaviour will influence this outcome and, therefore, nothing is certain. In the meantime, we believe investors should focus on discounting expected cash flows from the iSelect book of policies rather than comparing the business with cash-generating peers using multiples of reported earnings. Ultimately, cash flow is what matters to investors.
All that said, it must be acknowledged that iSelect has established a wonderful brand presence and customer loyalty and its health offering looks to have performed ahead of expectations in the past year. It looks to be winning up to 20 per cent of new health insurance policy sales - an extraordinary achievement. But the operating environment remains capable of throwing up challenges.
The consumer regulator, ASIC, looks to have increased its interest in the sector. It said this year that aggregators should show a warning if not all providers are included in a comparison. It also said aggregators should disclose any links to the providers, including commissions, referral fees and payments for inclusion in comparisons. We understand that iSelect's strategic partnership with health.com.au includes an exclusive third-party distribution contract. An iSelect spokesman said the company complied with all its obligations.
Stewart Oldfield is a research analyst at Investorfirst Securities. firstname.lastname@example.org