Interactive Investor

Stockwatch: is this insurer really returning to growth?

6th August 2021 11:49

Edmond Jackson from interactive investor

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Our stocks expert considers the merits of one of the country’s best-known insurance groups after tipping it back in March.

After ostensibly strong interims from mid-cap Direct Line Insurance Group (LSE:DLG), I am interested to review my case for the stock last March at 315p – in context of a “buy” note last week from Berenberg, the German-owned broker, targeting 395p.  

Not to seek confirmation bias but this could be an early sign of the market identifying potential for status change.

The target implies 29% upside from a current price around 306p plus the chance to lock in an 8%+ prospective yield.

The essential view is similar to mine: that yield is priced over-generously because the stock lacks growth characteristics. But if the market senses genuine growth emerging, mean reversion upwards is likely.  

A 250p to 350p consolidation range since 2015 

Although Direct Line rewarded my drawing attention in 2012, rising from 175p to 350p over four years, and has spiked from 280p in mid-July to 316p, as yet there is no genuine “break-out”. 

Legal & General (LSE:LGEN) has a quite similar chart over the last five years, and has also managed just a 2% rise despite declaring a £1.3 billion interim operating profit last Wednesday.  

Most likely, it reflects belief that insurance is too competitive nowadays, to deliver meaningful growth. Although Direct Line has healthy operating margins around 15% versus 3% for L&G, hence in principle higher odds of returns. 

Assuming market forecasts, L&G is on a forward price/earnings (PE) of 8x and yields just over 7%, while Direct Line offers nearer 8% on a PE of 12x. However, Berenberg reckons a 20% upgrade in the 2021 earnings per share (EPS) forecast for Direct Line is warranted. 

By contrast, Admiral (LSE:ADM) (ADM) boasts a long-term bull chart due to its success in motor insurance, with a 6% yield and 19x forward PE.

It enjoys a 46% operating margin, mind. Quite what the future will hold, whether laggards present better risk/reward if underlying dynamics are changing. 

The classic income stock conundrum 

In fairness to Direct Line as a long-term investment, its prowess at generating cash has enabled special dividends that boosted yield as high as 15% to 20% back in 2015. 

But when a stock gets stubbornly perceived as an income play, an annoying feature can become ingrained where market price falls by more – when going ex-dividend – than the value of the payout.

Some holders may then trade the stock around such dates but it is a hassle and potential tax complication unless held in an ISA or SIPP. 

On fundamentals, the CEO asserts: “we returned to growth in the second quarter, with commercial, home and rescue performing strongly”. Is this true, sustainably? 

It is denied by the sense of policies and gross written premiums being 1% or so easier, like-for-like at end-June.  

More positively, the combined operating ratio – a measure of profitability, of costs versus premiums, where over 100% is unprofitable – has improved from 90% to 84%.

That looks quite a one-off however, helped by lower claims (such as fewer weather-related) given management’s medium-term target is 93% to 95%.  

In truth, an exceptional gain from releasing reserves 

Profit headlines certainly look good: up 40% at the operating level, to £370 million, and by 11% to £261 million at the pre-tax level. This has helped annualised return on equity jump from 20% over 30%. 

Yet 41% of this operating profit relates to a 24% rise in prior year reserves releases to £153 million.This is where insurance companies have squirrelled money away, in the anticipation of claims that subsequently do not materialise.  

There is a read-across from Admiral citing in a 12 July trading update, boosting its own profits via reserves releases made against UK motor bodily injury claims.

Perhaps the industry is surmounting fraudulent whiplash claims that are now over-provided for, although Direct Line does cite lower motor claims amid fewer new car sales and new drivers. 

Strictly, I feel reserves releases should be regarded as an “exceptional” gain but insurers do often smooth earnings this way.  

Berenberg implicitly argues, the 2021 EPS scenario is now more like 29p than 24p – i.e. bringing forward the 2022 forecast.

This would still be flat performance however, in context of recent years (see table). 

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 3,427 3,284 3,202
Operating margin (%) 13.6 15.4 10.4 15.2 16.8 15.4 14.0
Operating profit (£m) 457 500 345 531 577 506 447
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 28.2
Earnings per share growth (%) 1.8 -0.8 -8.9 39.4 -1.7 -9.4 -5.7
Price/earnings multiple (x)             11.0
Operating cashflow/share (p) 51.4 37.6 62.4 39.6 35.6 33.4 42.5
Capex/share (p) 13.9 9.9 9.5 6.9 11.3 13.6 11.7
Free cashflow/share (p) 37.5 27.7 53.0 32.7 24.3 19.9 30.8
Ordinary dividend per share (p) 12.6 13.8 14.6 20.4 21.0 21.6 22.1
Ordinary dividend yield (%)             7.2
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 -153
Net assets/share (p) 205 191 185 198 187 193 200

Source: historic company REFS and company accounts

Becoming a data and technology-led insurer 

Notably, the CEO proclaims “an exciting and pivotal point for the business: “we’ve completed the majority of our tech transformation and we’re starting to reap the benefits of what the new systems offer us. This is driving real momentum and means we are entering the second half-year with ambition and confidence.” 

Is such change a genuine step change for value, or what is essential simply to remain competitive as tech advances?  

Efficiencies arising are certainly behind Berenberg’s profit upgrade for the second-half-year.  

Furthest through this transformation is Direct Line’s commercial side – albeit just 6% of total policies – the CEO says “demonstrates what can be achieved when new technology is paired with great service”.     

Key advances are said completed on the motor side: “We are already seeing benefits in pricing with further scheduled to come through over the next 18 months.” 

A new partnership Motability Operations, providing on-demand vehicles, is projected to increase motor gross written premium by around £500 million annually (versus £278 million achieved in the first half of 2021). A 22nd auto repair centre has also been acquired.  

Such options do however seem quite similar to what all insurers offer nowadays, according to what extent of assistance you want after any breakdown or accident. 

Rescue policies – linked to Green Flag – eased 1%. Meanwhile, newish competitor Dial Direct provides RAC breakdown cover freely across its motor policies. 

Home policies are up 6% helped by high retention rates although the average premium eased by nearly 4% - seemingly amid price cuts in support of retention. This affirms a low-growth image. 

Prospective yield rising over 8% is backed by cash 

A proposed interim ordinary dividend of 7.6p a share is a near 3% increase over the first half of 2020, where consensus anticipates a 24.2p total dividend in respect of this year and 25.4p for 2022, for a yield rising over 8%.  

There is no guidance as to resuming special dividends, instead remarks on up to £100 million share buy-backs. 2020 free cash flow was particularly strong (see table) after a second-half boost. 

The 2021 interim cash flow statement shows net cash flow from operations before investment of insurance assets up 112% to £108 million, with £9 million then absorbed by those assets.

Investment activities took £74 million, while £207 million went out on dividends also £104 million on lease payments. Cash held, reduced by £630 million but was still a substantial £805 million which underwrites near-term dividend growth.   

Resumption of special dividends instead of buy-backs, would to my mind have clinched a “conviction” buy.

Instead, you are left guessing at optimism held by the CEO and Berenberg – as to a sustainable profits re-rating. On a one-year view, I retain my stance: Buy. 

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

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