Interactive Investor

Stockwatch: are Direct Line’s bumper dividends sustainable?

9th March 2021 12:48

Edmond Jackson from interactive investor

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Insurer’s cash-backed growth record means there’s value here for investors, our columnist argues.

How significant is a strong dividend payout and yield in the overall investment context? The question is especially relevant now a shift from ‘growth’ to ‘value’ stocks appears under way, with one fund manager after another saying how they are re-positioning.

Theoretically it is nonsense, because the character of asset matters not a jot. Investment value is simply the net present value of projected cash flows, i.e. cumulative income and what you get on disposal. But crowd behaviour develops into camps: being pro- or anti-Brexit, for example. 

Polar opposites as to the significance of dividends  

In the 20th-century classic book Security Analysis – once favoured by Warren Buffett – authors Benjamin Graham and David Dodd advocated the long-term dividend record as key.

The touchstone of investment value is equity in well-established companies of sound dividend record, out of near-term favour for some reason. 

The opposing corner is perhaps best characterised by fund manager Terry Smith, who has often warned that high yields potentially signal declining companies – with less to offer by way of investment for retained cash. Better favour capital growth and sell off pieces of equity when it suits your income needs. 

I tend to be pragmatic. I ideally prefer capital growth but I am averse to paying over the odds – speculation not investment – which is all too easy after a long bull run since 2009.

Occasionally, a stock’s yield may be priced over-generously for the payout risk, meaning a fair chance the stock will rise – even in a sluggish or highly competitive industry – simply to reduce the yield versus the payout.

This was why, for example, I recently noted British American Tobacco (LSE:BATS) and Imperial Brands (LSE:IMB), on a medium-term contrarian view. 

Direct Line Insurance (DLG) is a prime example

I drew attention to this company various times after it floated in October 2012 at 175p. It went from just below 200p that November up to about 350p over some four years. During this time and thereafter, it was paying out ordinary dividends in the order of 8p to 15p a share.

But it also promptly began special dividend payouts, starting with 4p in respect of 2013 (taking that year’s total payout up to 16.6p).  

A 27.5p special dividend in respect of 2015 took that year’s total payout up to 50.1p – i.e. a yield of 15% to 20% as the stock rose that year.

It did, however, mark a peak, and the total payout halved to 24.6p in respect of 2016. This probably helped stall any further share price rise.

An all-time high of 363p was hit in August 2017, but then a gradual bear trend set in, which has only appeared to bottom out with a 250p low in last springtime’s Covid-19 sell-off. 

While a 35.4p total payout was made in respect of 2017, this declined to 29.3p then 21.6p for 2019. The latest 2020 preliminary results affirm a 22.1p total ordinary dividend plus a 14.4p special one.

I concede my sense of an exceptional yield – here, 11.6% historic, based on the current share price of 315p – has not pushed the stock higher. Indeed, in response to yesterday’s results it eased nearly 2%.  

But despite modest declines in revenue and profit, net cash generated from operations soared 27% to £585 million versus £161 million investment in businesses and property.

In this context, a 36.5p payout costs £493 million, however end-December balance sheet cash jumped 29% to £1.2 billion. There is negligible debt. It makes sense for Direct Line (LSE:DLG) to return this extent of cash. 

The board has also declared a share buy-back programme up to £100 million, which may provide some technical support besides slight earnings per share (EPS) enhancement for a £4.3 billion company. This must signal confidence as it would be daft to embark on buybacks only to cut special dividends. 

Respectable performance in a challenging 2020 year 

The combined operating ratio did ease from 92.2% to 91% but shows Direct Line making worthwhile profits. This is the most vital ratio for an insurer – representing its incurred losses plus expenses, divided by premium earned. Under 100% and the insurer makes an underwriting profit, more than 100% and it doesn’t – and the norm for motor insurers is that they don’t.

As often the case with insurance it is a mixed narrative, with growth in home and commercial policies – also the Green Flag vehicle rescue service pitched against the AA – while motor was slightly softer overall and travel insurance fell during the pandemic. 

While operating profit is down 5% to £522 million as gross premiums eased nearly 1% to £3.2 billion, with net profit down 13% to £367 million, this is 6% ahead of consensus for £347 million.

Weather costs of £41 million were a relatively exceptional hit compared with £8 million in 2019. Bear in mind that insurance company profits can be smoothed by management’s decision on reserves releases. 

Yet the table shows very respectable operating margins sustained in the mid-teen percentages, and management says it is on track to achieve a return on equity of at least 15%.

This is being assisted by a technology transformation. An upshot of Covid-19 is that it is also spurring new ways of working – potentially leading to more efficient use of office space.  

We all know how competitive consumer insurance is nowadays. Yet Direct Line’s outlook statement strikes a positive note overall: “Given the progress we are making with our transformation, we enter 2021 with real momentum and are confident in delivering our vision of being a technology and data-led insurance company of the future with our customers at its heart.” 

You could say that is essential simply to remain competitive, but it overall marks a positive note. Yes ‘growth’ is currently absent, but this mature business is modernising in a way that ought to sustain relatively superior returns to shareholders.   

Direct Line Insurance Group - financial summary
Year end 31 Dec

  2014 2015 2016 2017 2018 2019 2020
Turnover (£ million) 3,349 3,253 3,321 3,496 3,207 3,300 3,215
Operating margin (%) 13.6 15.4 10.4 15.2 16.8 16.6 16.2
Operating profit (£m) 457 500 345 531 577 547 522
Net profit (£m) 373 580 279 434 472 420 367
Reported EPS (p) 26.0 27.6 20.2 31.5 32.9 29.2 25.5
Normalised EPS (p) 26.7 26.5 24.1 33.6 33.0 29.9 26.0
Earnings per share growth (%) 1.8 -0.8 -8.9 39.4 -1.7 -9.4 -13.0
Price/earnings multiple (x)             12.0
Operating cashflow/share (p) 51.4 37.6 62.4 39.6 35.6 33.4 43.2
Capex/share (p) 13.9 9.9 9.5 6.9 11.3 13.6 11.9
Free cashflow/share (p) 37.5 27.7 53.0 32.7 24.3 19.9 31.3
Ordinary dividend per share (p) 14.4 13.8 14.6 20.4 21.0 21.6 22.1
Ordinary dividend yield (%)             7.0
Covered by earnings (x) 1.8 2.0 1.4 1.5 1.6 1.4 1.2
Special dividend per share (p) 14.0 27.5 10.0 15.0 8.3   14.4
Cash (£m) 880 964 1,166 1,359 1,154 949 1,220
Net debt (£m) -284 -381 -571 -523 -319 -126 -599
Net assets/share (p) 205 191 185 198 187 193 200

Source: historic company REFS and company accounts

So why is the market seemingly biased against it? 

Consensus forecasts look for £375 million net profit this year, for earnings per share (EPS) of 26.5p, implying a prospective price-to-earnings (PE) ratio of just below 12x – with dividends per share around 25p implying a full payout ratio of earnings.

As I have mentioned, the cash flow context, and cash reserves, supports this. Forecasts, indeed any reference to dividends in data, tend to focus on ordinary payouts – but special ones may well continue, otherwise it is odd to change policy to buy-backs. 

Bias would appear to exist due to Direct Line being perceived as a classic, dividend ‘value’ stock, in a time when capital ‘growth’ has been all the rage. Yet sentiment looks to be shifting generally, if not yet in favour of this insurer. 

It was similar back in 2012, when I noted the board probably feels it must pay a progressive dividend to attract support, and the market would price this attractively to help compensate for low capital growth prospects.

Around 200p back then, the prospective yield was about 5-6%, about twice covered by earnings. 

Yet the stock advanced 75% over four years, with attractive dividends to boot. The total payout became a tad convoluted when the 2019 final dividend of 14.4p was cancelled and paid as a special interim dividend in 2020. Otherwise, it has a respectable record of growth, backed by cash. 

Downside risk is also limited by net asset value of 200p a share, or 142p on a tangible basis. 

Irrespective of whether you are an income investor, on a medium-term discounted cash flow basis – of likely dividend returns – Direct Line offers investment value. ‘Buy.’ 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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