Why investors are still hot for Discovery

A change in accounting standards hurt Discovery’s share price, but the company still presents a strong investment case.

This is according to Sarine Barnard and Boipelo Tlala from Ninety One – South Africa’s largest asset manager.

In January 2023, the new accounting standard, IFRS 17, was introduced, which formed part of a global initiative aimed at standardising accounting practices across the insurance industry.

This meant that insurers had to adopt a uniform approach to recognising profits and measuring contract liabilities. This was less formalised under the previous standard, IFRS 4. The extent of the decline caught the market off guard.

“As part of the transition to IFRS 17, all insurers were required to restate their 2023 financials in line with the new standard, leaving some companies with more adjustments to make than others depending on their approach under IFRS 4,” said the experts.

“One such company was Discovery. At the end of 2023, Discovery pre-emptively warned investors that its restated financials would show earnings to be lower than that of IFRS 4 but that growth on a forward basis would be faster.”

When Discovery published its restated financials in March 2024, the extent of the decline still caught the market off guard.

Normalised operating profits for 2023 dropped by 16%, while net asset value was down by 22%, amounting to an adjustment of R12.6 billion.

This saw Discovery’s share price fall dramatically, while the macro backdrop was also not very favourable at the time as investor sentiment was increasingly cautious heading into the national elections.

The NHI was also signed into law, and, if implemented, could seriously hurt Discovery’s health business – its most cash-generative subsidiary.

“In our view, however, the market had starkly overreacted. The decline in reported earnings was not due to operational issues but rather, as Discovery had forewarned, due to the short-term impact of adjusting the timing of its earnings,” said the experts.

“Even in a bear case scenario, the market was pricing in a far harsher outcome for the impact of the NHI Act on Discovery Health than was realistic, given that the legislation states that there will be no restrictions on medical schemes until the NHI is fully implemented.”

The experts added that Discovery is a strong business with a robust earnings profile, where the market underestimated its earning potential.

After the share price sell-off, the group was trading at a significant discount to its intrinsic value.

“One of the key differences under the previous accounting standard, IFRS 4, was that insurers had more discretion over the timing of when they recognised profits. IFRS 17, on the other hand, is significantly more prescriptive.”

“For Discovery, this meant slowing the pace at which it recognised and reported its profits compared to IFRS4. To help explain this to investors, Discovery used the below graph to demonstrate the compression of reported earnings in the short term, followed by an acceleration of earnings thereafter.”

“It’s worth noting, however, that the value created when selling insurance contracts doesn’t change under IFRS 17, but rather the timing of when that value is recorded.”

Many of the headwinds facing the business earlier this year have also dissipated, with the political situation having turned positive following the formation of the Government of National Unity.

Ninety One believes that Discovery’s fundamentals remain strong.

The group’s strategy of reinvesting operational profits into new ventures has paid off.

For instance, Discovery Bank is now on a clear path to profitability. Spending on other new initiatives has also come down dramatically.

“Operationally, our analysis shows that, apart from the IFRS17 adjustment required for the life businesses, Discovery’s core businesses, on aggregate, performed better than expected. Additionally, cash flow — a historical point of contention — is expected to improve.”

“This will enable the company to reduce debt, lower interest payments, and further strengthen its financial position.”

For the year ended 30 June 2024, Discovery’s normalised headline earnings had increased by 15% to R7.3 billion and normalised profit from operations rose by 17% to R11.6 billion – beating the market’s expectations. 

For the year ended 30 June 2024, Discovery reported that normalised headline earnings had increased by 15% to R7.3 billion, and normalised profit from operations rose by 17% to R11.6 billion, beating the market’s expectations. 

“From a valuation standpoint, Discovery offers compelling value. As shown in the graph below, the company’s price-to-embedded value (P: EV) ratio is trading significantly below its decade-long average.”

“Embedded value, which measures the value of existing business operations, excludes future growth potential from its non-life businesses like Discovery Bank, Discovery Insure, and its Chinese joint venture”, Ping An. This suggests that the market has not fully recognised Discovery’s broader potential.”

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