M&A is back with a vengeance in the insurance sector. Aviva (LSE: AV) (NYSE: AV.US) and Friends Life (LSE: FLG) are in talks about a multi-billion merger, which values the latter at £5.6bn. Aviva needs Friends Life more than Friends Life needs Aviva, in my view.
The Deal
The boards of Aviva and Friends “have reached agreement on the key financial terms” of a possible all-share combination, it emerged on Friday. Aviva is offering a 15% premium to Friends Life’s closing price on 21 November, and a 28% premium to Friends Life’s three-month average share price.
That may just be enough to get the deal done. If the merger goes through, Friends Life shareholders will hold a 26% stake in the combined company. That’s a lot to give away for Aviva, based on the relative value of each company’s stock. Still, if cost synergies are achieved, improved cash flows may even allow for higher dividends at the combined entity, whose net leverage will be lower than Aviva’s.
The Combined Entity
Based on estimates for 2014, the combined entity would report a pro-forma 2014 operating profit margin of 8.2%, according to my back-of-the-envelope calculation. That compares with a 7.4% operating profit margin for Aviva in 2014.
The board of Aviva believes that “the combination with Friends Life would deliver significantly higher cash flows enhanced by substantial synergies, principally through operating efficiencies in the combined back books and the removal of overlapping overheads”.
“An estimated 2,000 insurance jobs are likely to be cut as Aviva tries to placate scepticism about its bid for Friends Life,” The Times reports on Monday. THAT number seems about right.
It’s always hard to estimate synergies, but assuming a very aggressive scenario according to which cost synergies will equate to 10% of Friends Life’s revenue for 2014, about £140m will have to be added back to the combined entity’s operating profit, for an increase in the operating profit margin of 1.3 percentage points to 8.7%.
Going with the number of layoffs suggested by The Times, cost savings per head would come in at £70,000.
Of course, restructuring charges will have a short-term impact on profitability, but they are destined to disappear over time. And Aviva may argue that additional economic benefits may come from revenue synergies that will likely be achieved in the new asset under management division.
Will The Merger Go Ahead?
So a material improvement in cash flows from 2016 may be the outcome, which would support a more generous dividend policy, although it’s too early to speculate that. There’s no certainty that a formal offer will emerge, even though Aviva and Friends Life have agreed the main terms of the merger.
Investors do not seem to back Aviva’s management: the insurer’s stock is down 4.5% on Monday, while the shares of Friends Life have risen by about 6%. No bidding war is expected at this point in time.
Consolidation in the UK life sector has been on the cards for some time, and it looks like Aviva is getting a fair price for a key deal in the industry: Friends Life shareholders should have asked for more. If the indicative proposal doesn’t change, however, Aviva’s managers — who have delivered in the last few years — may have the last laugh.