Interactive Investor

Stockwatch: a new buying opportunity at bid target Direct Line?

Following news of another takeover approach for a UK mid-cap company, analyst Edmond Jackson discusses how high the price might go. He thinks there might even be money to be made by new investors and speculators.

1st March 2024 11:19

Edmond Jackson from interactive investor

A year ago I made a “buy” case for mid-cap Direct Line Insurance Group (LSE:DLG) after sector analysts postulated (or were guided towards) a 2023 dividend per share of 13.7p. Covered 1.4x by targeted earnings per share (EPS) of 19.2 - if the forecasts were dependable - then it was possibly a chance to lock in a near 9% yield with the shares then at 158p.

I also suggested that if Direct Line was rated similarly as Admiral Group (LSE:ADM), it implied a re-rating to around 230p.

“Possibly” is now under test after Direct Line rejected a possible cash and shares offer from Belgian insurer Ageas SA/ NV (EURONEXT:AGS) that values the group at 233p a share. Market price is currently settled around 204p. Possibly they will raise this “offer” over the heads of the Direct Line board – appealing directly to weary shareholders.

Meanwhile, and for what consensus expectations are worth, 8.4p of dividends is now targeted in respect of 2023 with 2.3x cover, albeit 14.2p for 2024 with cover dropping to 1.1x. Still a 9% yield then, possibly.

Shrewdly timed but not well thought out

Direct Line shares have only quite recently recovered somewhat from an all-time low of 132p – significantly as a result of inflation-boosting claims values, especially motor, during 2022 and 2023.

An offer equivalent to 233p would barely represent the median of Direct Line’s long-term chart. From around 150p in 2012, the price had rallied to a circa 300-350p range that persisted from 2015 to 2022. But the real damage to DLG shares happened through 2022 and the first half of 2023 – with an all-time low of 132p struck last July. 

Yet cash of 100p per share, plus one newly issued Ageas share for every 25 Direct Line owned, is not especially appealing. How many UK income funds would want to retain Euronext-traded shares, and private shareholders find Ageas amenable to follow?  

I suspect Ageas will need to raise its cash element, 100p could just be the opener. This approach was made in January, rejected by the Direct Line board and its advisers as “uncertain, unattractive and significantly undervaluing Direct Line Group and its future prospects”.

Quite whether the media flushed out the story or were tipped off in frustration, as last Wednesday Ageas responded immediately with a detailed announcement on the terms and strategic/financial rationale for the possible offer, appealing directly to shareholders.

It is happening very soon after Elliott Management’s “possible” offer for Currys (LSE:CURY), disclosure of which revealed the Chinese online retailer JD.com Inc ADR (NASDAQ:JD), as also interested. Elliott’s initial 62p a share, indicated terms, have already been raised to 67p but are still rejected. Similarly, as JD.com is the dark horse lurking, the market senses other insurance groups will have spreadsheets up on Direct Line, hence its shares remaining firmly bid.

Likewise, Ageas being an industry operator (than private equity) positions it much better, like JD.com, to exact synergies.

Nature of modern insurance also encourages mergers

This industry is highly competitive and where growth – especially for larger operators – can only effectively be achieved by acquisitions. The UK stock market is relatively undervalued in an international context. Both factors are significantly why Toronto-based Intact acquired RSA in 2020, then a year later Hastings fell to Finnish group Sampo.  

I doubt a large company such as Ageas would engage management time and cost of advisers, without serious intent, although exploring mergers and acquisitions is probably also typical of the industry.

Saga (LSE:SAGA), for example, continues to work with its advisers on the sale of its underwriting business, if chiefly to cut debt. Its insurance side continues to sully an operations’ story where cruises have otherwise achieved 30% revenue growth.

Too many of the established insurers have complacently assumed they could just hike renewal prices and expect customers to stay on their direct debits, but more shop around online nowadays and this has enabled new entrants such as Dial Direct and Urban Jungle to take share and gain trust.

So yes, there is a current aspect to the industry – how Direct Line really has to pull out the stops and explain to shareholders how it is going to recover value – such that they should indeed ignore Ageas’ approach. And also how, on a standalone basis, the shares can recover at least to 300p – the level at which they traded two years ago, after eight years of sideways’ consolidation.

Hence another aspect to Ageas’ shrewd timing is a new CEO at Direct Line, literally starting today. He has not had time to settle in, to mount a robust defence and consider whether Ageas should raise terms and make an offer.

Adam Winslow was previously the insurance chief for UK and Ireland at Aviva (LSE:AV.) – whose shares have risen over 20% since last September but have otherwise been in a sideways-volatile trend since the 2008 financial crisis. True, Aviva has more strands such as wealth management, as a £12 billion company, versus Direct Line worth £2.7 billion in the market currently. But you have to ask, what will be Winslow’s radical agenda, and will it be better than Ageas taking out head-office costs and achieving synergies?

Direct Line Insurance Group - financial summary
Year end 31 Dec

 201420152016201720182019202020212022
Turnover (£ million)3,3493,2533,3213,4963,4273,2843,2023,2303,168
Operating margin (%)13.615.410.415.216.815.414.013.6-1.4
Operating profit (£m)457500345531577506447441-45.1
Net profit (£m)373580279434472420367344-39.5
Reported EPS (p)26.027.620.231.532.929.225.524.1-4.3
Normalised EPS (p)26.726.524.133.633.029.928.230.0-4.3
Earnings per share growth (%)1.8-0.8-8.939.4-1.7-9.4-5.76.4-115
Operating cashflow/share (p)51.437.662.439.635.633.442.532.461.6
Capex/share (p)13.99.99.56.911.313.611.710.29.2
Free cashflow/share (p)37.527.753.032.724.319.930.822.252.4
Ordinary dividend per share (p)12.613.814.620.421.021.622.122.77.6
Covered by earnings (x)1.82.01.41.51.61.41.21.1-0.6
Special dividend per share (p)14.027.510.015.08.30.014.40.00.0
Cash (£m)8809641,1661,3591,1549491,2209561,004
Net debt (£m)-284-381-571-523-319-126-153-897-939
Net assets/share (p)205191185198187193200194176

Source: historic company REFS and company accounts

Near-term prospects are uninspiring as a standalone

Direct Line’s 2023 results were meant to be out today – but are not, as of early morning.

Last September’s interims had guided for higher operating profit into 2024, helped by an improvement in motor margins. This seems yet to manifest in the consensus expectations, given £272 million net profit for 2023 is targeted to decline £188 million. Revenue is projected to recover to levels achieved five to 10 years ago, albeit with profitability down.

It clearly invites an acquirer to more vigorously take out costs.

Consensus for 2023 profit may be dodgy, however, unless boosted by the £520 million sale of a commercial insurance business; yet the £272 million net profit is meant to be “normalised”.

The first half-year saw Direct Line’s net insurance margin plunge from 11.3% to minus 6.4% - hence a like-for-like operating profit of £197 million in 2022, becoming a £78 million interim loss. Yet the damage was done by higher motor claims whereas in home, commercial and rescue insurance, the net margin was 12.2%. 

It is unclear quite how sustainable is a 10% first half growth in premiums written, given the number of in-force policies eased by 3% - as if retained customers are paying higher prices. It already suggests some are being attracted elsewhere.

300p a share would probably secure a takeover

The difficulty is figuring 2025 as a likely earnings benchmark, considering Sampo’s buying Hastings on a circa 14x price/earnings. That would imply a 280p per share offer for Direct Line if it is considered capable of generating EPS of around 20p – which it should, given Ageas can exact synergies.

My guesstimate is for Ageas to raise its offer say to 275p once it has secured debt to do so, but the killing area could be around 300p especially if another insurer intervenes.

The risk/reward profile is therefore interesting for speculators according to what odds you set on a takeover. A price of 275p per share implies 35% upside but, if Ageas walks, the downside might be less than 15% to around 175p. The trend of foreign takeovers, Direct Line’s exposed position and Ageas’ capability to add debt, altogether lead me to conclude: Buy.

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

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