LIC IPO – the elephant makes an entry

Views are personal. This is not a call on the LIC IPO. PrimeInvestor will cover the IPO separately.

The biggest show in town is set to open. An organization that has grown over 66 years, at the benevolence of the taxpayers, with every rupee they have earned so far representing a sacrifice by the tax-payers. Built with protection of the law and unquestioned governance, the bride has been dressed. LIC has been a vehicle for covering up so many of the problems in the public space. Whether it is bailing out IL&FS or IDBI or buying debt which no one may have the appetite for, the company is now going to be under public scrutiny.  

LIC, if valued by the conventional price to book or price to earnings ratios, will be an untouchable one. Even if you give it five times book, the market cap of the company will be a paltry Rs.40,000 crore or so. Isn’t this number shockingly low? Well, we are ignoring the value.

The ‘value’ in the LIC IPO

Instead, we have this concept called “EMBEDDED VALUE” (EV), the lynchpin for any life insurer and a significant number in the case of LIC. EV estimates the profits from all the policies in force (Returns on the investment made with the premium minus expenses minus what will be paid on maturity or on an event plus the current book value). It is like computing what we normally call the cash flows and then discount it to come to a present value. There are various assumptions based on past experience and present trends. 

Thus, the EV estimates the value of the life insurance company as a going concern, with assumptions on growth rates, returns etc. The variables include expenses, interest rates, investment quality, human longevity, business growth, and every other line item that will go into a P&L account.

In other words, the EV is akin to a value that someone ought to be paying to buy out the entire company.

In the two tables below, I present the highlights of the three listed life insurance companies alongside LIC of India. I heard of an issue price of Rs 2000 for the LIC IPO, so I have used that as a basis for comparison. At this price, the value of the company would be around 2.34 times the EV, which would be at the lower end of the three listed entities. This is the optics that will be played in order to push the shares.

The IPO makeup

Set aside what the EV may say. My question is with the efficiency of LIC as a profitable enterprise. 

One, sixty plus years of whatever profits it reported have gone to the promoter as dividend. You can see in the first table above that the quantum of reserves available is insignificant compared with even newer players. 

Two, in sixty four years, the government has used the organization to bail out enterprises, fund cronies, fund state governments, park inconvenient financial burdens etc. So far, all of this has been pushed into the ‘policy holder’ accounts. The shareholder has been taking out the profits every year, so there was nothing left for the shareholder. 

Three, the firm hardly had a capital structure with just Rs 100 crore of share capital. This was shored up in September 2021 through a couple of huge bonus issues to up the number of shares. Its reserves and surplus also jumped 7.5 times in FY-21 (to Rs 6705 crore) compared with FY-20. It did so by not paying dividends to its shareholders – the government. In other words, it has simply resorted to one-time measures to make shareholder-fund value IPO-ready! 

Still, with relatively low reserves and not much to show in the shareholder’s kitty, LIC has resorted to business/financial changes that will help boost its shareholder valuation. To explain, LIC invests the premium money and the return/profit it gets goes to a ‘Life Fund’. 95% of this is distributed to policyholders and 5% to shareholders. Now, it has resorted to splitting the Life Fund into participatory (profits from which policy holders can participate) and non-participatory (a practice prevalent with private players). 

It has stated that the participatory sharing ratio between policyholders and shareholders would eventually move to 90:10 and the entire non-participatory fund would go to shareholders. And voila, this pushed the embedded value by five-fold in one stroke! (see extract from DRHP later in the article).

But does that make for a respectable valuation?

Yes, as a buyer, EV is relevant because it appears to be a number that other buyers may believe in. But it is NOT reflected in the actual profits that get reported. So, there is an element of ‘value’ that is perceived. We have to believe that LIC will grow its business. But how well can it?

Since the entry of private players, LIC has been steadily losing market share. The governance by the promoter puts the risk of getting loaded with inefficient assets. 

There is also a very key risk of the profit-sharing ratio impacting the popularity of some of its key products. LIC has stated in its document that a significant portion of its premiums comes from participating and single-premium products. Should the participating products generate lower than expected returns for policy holders (since the sharing ratio will reduce from 95% to 90%) it could lead to policy surrenders. 

It can also hurt the pricing of future products, eroding competitive pricing abilities.

Measuring profitability

If we use ROE as a benchmark (see the first table), LIC comes out with shining colours. But this is an optical illusion. In its lifetime, a company builds reserves by retaining part of its earnings every year, in order to grow. LIC, however, had the luxury of having an owner who owned the mint and had no need for conventional ‘capital’. It is only in the last three years that a capital structure has been created and hence this measure of ROE is absolutely flawed.

I just took another simple measure. Every insurer has deployed the policyholder monies across various investments, earns a return and meets obligations and expenses from that. There is a residual, which will be its profit. Call it efficiency or pricing power or what-will-you. 

If the reported profit is the share of profits of the shareholder, it is a measure of efficiency. And logically, the better the percentage, the more will be the return to the shareholder. If I have built a business that dwarfs the others by, say, ten times, I should be able to show at least ten times the profits (ignoring economies of scale). I leave you with this table and judge for yourselves:

If you see the value of PAT/Total assets, the company that is most inefficient – next to LIC is at least 6 times better than LIC’s return on assets. This is far from reflecting any dominant position and size plus the decades of head start it has had. Clearly, it is not an efficient money-making machine for a shareholder. In sixty plus years, it should have been making at least ten times the profits that are currently being shown. I have not used long term averages in the absence of time. However, I do figure out that the current reported profits are probably the highest for LIC, as per the DRHP.

Thus, if we believe that valuation in the marketplace has to be a ‘multiple’ of the EV, I will clearly state that the multiple should depend on the profit that is made on the assets deployed. As to what the fair multiple is, I have no clue. 

The EV itself is a number that is derived based on so many variables. And as a shareholder, I can pay a price that is measured on this foundation only so long as others believe in this method. Clearly, the EV has to be a function of the profits that a company makes. Even if I assume that the profits in an insurance policy are back ended, this entity has been around for sixty plus years and the profits should be flowing. 

To me, the reasons for this poor profitability can only be due to one or more of the following factors:

1. Inefficient in costs. Bloated organization costs;
2. Poor lending decisions leading to write offs;
3. Excessive commission to agents;
4. Investment in low yielding assets.

Clearly, the ownership and the sovereign protection have taken its toll on the organization. What should be a money-spinning machine is now coming to the market. One can only hope that the tomorrows are better than the yesterdays. This means a big change that will take time. Hopefully, the profit numbers will become better with the reduced interference of the promoter. What worries me is the declining market share and what it will do to expected growth rates that the EV calculations would have factored in.

And, there is one more thought that I would like to leave with the readers. Assuming that price as a multiple of the EV is the right thing, and is say , three times EV, then it assumes that the share price will come to that number. Once having come there, there should be a growth that is exactly equal to the growth in business.

But as mentioned earlier, the question of whether LIC can grow at a rate that justifies its valuation, at a time when it is losing market share as well as reducing the profits it shares with policyholders does make the valuation game tricky. Single-digit growth, for instance, can mean very little change to share price if we use the same EV as a metric. And temporary gains (or losses) in spurts, cannot have a lasting impact on EV as it is based on long-term numbers. 

In this business, pricing of the share seems to be an art rather than a science. I cannot understand a business that is valued at a hundred times the profits and growth cannot be more than eight to nine percent every year. Plus a market position that is gradually sliding down.

However, there is one thing that can change big. Due to the change in the profit share ratios, the EV went up by more than five times. Here is an extract from the EV certification given in the DRHP:

“ The IEV computed as at 30 September 2021 is Rs 539,686 crores. For comparative purposes the IEV (i.e. before the impact of the fund bifurcation) calculated based on the same fund structure (i.e. a single policyholders’ fund) as that reflected in the APS10 Report would be INR 124,767 crores.

The increase in IEV is due to the shareholders’ interest in the non-participating funds increasing to 100% (as described in Section 2.1), following the decision of the Board of Directors of the Corporation on 8 January 2022 for the bifurcation of the single policyholders’ fund into participating and non-participating funds on 30 September 2021. This reflects the assets backing the statutory liabilities, provisions for solvency margin and non- participating global reserves residing in the non-participating funds. “

It is reasonable to expect that there should be a quantum jump in the reported PAT in the full year 2021-22. LIC, to my mind, should be throwing up at least Rs.20,000 crores plus as profit after tax, given its size and vintage. How soon will it get there and grow from there? At Rs.20,000 crores, a five lakh crore EV is twenty five times the profits with a growth rate in single digits.

On the LIC IPO, a lot is at stake. Rules have been bent, timelines collapsed and all the corners cut to meet deadlines and valuation numbers. The secondary market price is extremely critical for the government as it will decide the annual dilution of five percent that is likely to happen, to reduce the government ownership to seventy five percent over five years. So, for those who are worried about the price now, there is hope. The owner has lots more to sell.

The LIC tagline says “With you during the lifetime and beyond”. The investors surely wish for the same with this share issuance.