In Perspective

Discovery: Turning accounting adjustments into investment potential

Discovery’s transition to IFRS 17 led to a swift market reaction, creating an attractive entry point for us to increase our stake in a strong business with a robust earnings profile.

04 Dec 2024

5 minutes

Sarine Barnard
Boipelo Tlala
In managing the Ninety One SA Equity and Balanced Strategies, we have an earnings focused investment approach, with a preference for companies where earnings expectations are being revised higher.

This requires fundamental research that unpacks the reason for revisions from an operating environment to ensure we can identify the sustainability of these revisions.

Understanding the complexity of changes in the accounting regulatory framework, coupled with the opportunity provided by negative market sentiment, gave us insight and a discounted-price entry point to invest in Discovery earlier this year.

Short-term adjustments, long-term opportunities

January 2023 marked a significant milestone for South African insurers as the industry transitioned to a new accounting standard, IFRS 17. The move formed part of a global initiative aimed at standardising accounting practices across the insurance industry. For insurers, this meant having to adopt a uniform approach to recognising profits and measuring contract liabilities, a characteristic that was far less formalised under the previous standard, IFRS 4.

The 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). 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. However, when Discovery published its restated financials in March 2024, the extent of the decline caught the market off guard. Normalised operating profits for 2023 fell by 16%, while net asset value was down by 22%, amounting to an adjustment of R12.6 billion.

The restated headline figures led to a swift market reaction, with Discovery’s share price falling sharply as a result. The macro backdrop was also not very favourable at the time. Investor sentiment had grown increasingly more cautious leading up to the national elections and the possibility of political instability. In May 2024, the government passed the widely-debated National Health Insurance (NHI) Act, which, once implemented, would have drastic implications on the earnings profile of Discovery’s health business (its most cash generative subsidiary). With the balance sheet impaired due to IFRS17, this left investors somewhat pessimistic about the overall outlook for the company.

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. 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. Our analysis showed that Discovery is a strong business with a robust earnings profile, where the market underestimated its earnings potential. Following the share price sell-off, it was trading at a significant discount to its intrinsic value. These characteristics are precisely the sort of business profiles and opportunities that we look out for at Ninety One, since our strategy looks for companies with positive earnings revisions that are trading at reasonable valuations.

The value created when selling insurance contracts doesn’t change under IFRS 17, but rather the timing of when that value is recorded.

Adjusting from IFRS 4 to IFRS 17

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.

Figure 1: Impact on Discovery’s annual profit due to the change in accounting regulations

Figure 1: Impact on Discovery’s annual profit due to the change in accounting regulations

Source: Discovery, September 2024.

A stock that stands out

Many of the headwinds identified earlier have since dissipated. The political situation has turned from a negative into a positive following the formation of the Government of National Unity. Regarding balance sheet strength, IFRS 17 introduced the Contractual Service Margin (CSM), which captures unearned profits reflected on the balance sheet and allows Discovery’s debt metrics to be viewed in line with global peers. Comparatively, Discovery’s debt levels are not at all excessive.

Discovery’s core businesses, on aggregate, performed better than expected.

Despite the market’s initial reaction, Discovery’s fundamentals remain strong in our view. The company’s historical strategy of reinvesting operational profits into new ventures is now paying off. Discovery Bank, which was a substantial drag on earnings and cash flows, for example, has substantially reduced its losses and is on a clear path to profitability, while spend on other new initiatives have come down dramatically and are either culled, made more efficient or scaled. 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. Discovery’s more recent financial performance underpins this optimism. 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. These results reflect the resilience of its core business operations despite the accounting transition.

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.

Figure 2: Discovery offering exceptional value relative to its 10-year history

Figure 1: Impact on Discovery’s annual profit due to the change in accounting regulations

Source: UBS, Ninety One; November 2024.

A good time to buy

In terms of our investment philosophy and process, we believe that there is a ‘tension’ that exists between earnings revisions and valuation. More expensive stocks are typically less sensitive to positive earnings revisions, while cheaper stocks tend to be more sensitive to positive revisions. As depicted in the below image, we prefer to hold stocks in the top-right quadrant, and sell those in the bottom left. Based on our analysis, we believe Discovery sits firmly in the ‘buy’ quadrant.

More expensive stocks are typically less sensitive to positive earnings revisions, while cheaper stocks tend to be more sensitive to positive revisions.

Figure 3: The tension between earnings revisions and valuation

Figure 3: The tension between earnings revisions and valuation

Source: Ninety One; November 2024.

A turning point in perception

The market’s perception of Discovery began to shift after the release of its full-year results in September 2024. Consensus earnings expectations for 2025 were upgraded by 6%, reflecting improving sentiment. During its results presentation, Discovery announced that it had entered a new phase of growth. Management highlighted reduced spending and streamlined initiatives that are expected to enhance profitability and drive long-term value creation. Added to this, Discovery indicated that it would exceed its normal growth target for the next five years with a target of 15 to 20% for operating profit growth set for 2024 to 2029.

Figure 4: Three distinct phases. Operating profit by phase of growth (Rm)

Figure 4: Three distinct phases. Operating profit by phase of growth (Rm)

Source: Discovery, September 2024.

Our forward-looking analysis remains similarly optimistic, with our earnings expectations for 2025 4% ahead of market consensus. Our view is that Discovery is on track to exceed its historical growth targets over the next five years, supported by robust operational performance and strategic investments in high-potential ventures.

Table 1: The new phase of growth should have a positive impact on financial metrics

Average Where we were (FY16-FY23) Where we are today (FY24) Where we are headed (FY25-FY29)
Earnings growth 9% CAGR 17% 15-20% CAGR
% spend on New 15% (maxed at 25%) 8% c5%
Cash conversion 56% 66% 60-70%
RoE 13% 13% 15-20%
FLR 22% 20% 10-20%
Dividend cover 5.7x 5x <5x

Source: Discovery, September 2024.

Conviction in Discovery’s long-term growth prospects

While the transition to IFRS 17 has created short-term challenges and market volatility, Discovery’s underlying business remains operationally sound and strategically focused. The temporary adjustments to reported earnings have created a mispricing opportunity, allowing long-term investors like ourselves to capitalise on a fundamentally strong business at an attractive valuation.

We hold a high conviction in Discovery’s long-term growth prospects. The company’s commitment to innovation, its more disciplined focus on high-return ventures, and its improving financial metrics provide a clear path to sustained value creation. As the market adjusts to the new reporting framework and Discovery’s earnings results begin to normalise, we believe its growth trajectory will outpace market expectations.

In our view, Discovery’s resilience, coupled with its ability to generate and scale profitable ventures ahead of market expectations, positions it as one of the most compelling investment opportunities in the sector today. For this reason, we hold it as a key overweight position within our SA Equity and Multi-Asset portfolios, a position that we believe will continue to benefit our clients over the long term.


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Authored by

Sarine Barnard
Analyst, SA Equity & Multi-Asset
Boipelo Tlala
Analyst, SA Equity & Multi-Asset

Important information

The information contained in this Viewpoint is intended primarily for professional investors and should not be relied upon by private investors or any other persons to make financial decisions. All of the views expressed about the markets, securities or companies in this document accurately reflect the personal views of the individual fund manager (or team) named. While opinions stated are honestly held, they are not guarantees and should not be relied on. Ninety One SA in the normal course of its activities as an international investment manager may already hold or intend to purchase or sell the stocks mentioned on behalf of its clients. The information or opinions provided should not be taken as specific advice on the merits of any investment decision. We do not undertake to update, modify or amend the information on a frequent basis or to advise any person if such information subsequently becomes inaccurate.

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