Interactive Investor

Stockwatch: pricing in a recovery at bombed-out Direct Line

14th March 2023 11:34

Edmond Jackson from interactive investor

A plunge in its share price to a record low has got analyst Edmond Jackson interested in the FTSE 250 insurer. Here’s what he’d do with the shares right now.

In January, I queried whether a disappointing update from Direct Line Insurance Group (LSE:DLG) reflected mainly the industry or management. If the former, then what extent might cyclicality be involved, hence a recovery play emerging. If it is management failure, then what chances of a takeover? 

There was a read-across to Saga (LSE:SAGA) which has been a perennial recovery play – on Covid restrictions easing, hence new cruise ships capitalising on greater travel. Hopes were also raised that the insurance underwriting side would be divested, although talks have since collapsed. 

In its own way, Direct Line has enticed investors over the years – for a sound cash flow profile begetting a high single-digit dividend yield – although more recently this is been a sign of a business and stock under pressure.

Others are suffering too. On 8 March, Admiral Group (LSE:ADM) declared 2022 profit, earnings per share (EPS) and dividend per share (DPS) all down 40%. Notably, however, management asserted tough times on the motor side as essentially cyclical and “near the bottom”, in which case yields on insurers merit analysis. If at some point they are deemed generous, then stocks will also rise. 

Again, Direct Line apparently offers a near 9% yield 

With £446 million of profit turning into a £46 million loss at the pre-tax level, and EPS also turning negative, Direct Line’s final dividend was omitted – hence the 7.6p interim payout was the total for the year. This represents a 4.8% historic yield at the current market price of 158p. 

But unless sector analysts are slavishly adhering to management guidance, consensus expects a 2023 recovery to DPS of 13.7p – covered 1.4 times by normalised EPS of 19.2p – implying a chance to lock in an 8.7% yield.  

If claims cost inflation in motor is as cyclical as Admiral portrays, then with industry improvement, and say if Direct Line becomes priced similarly as Admiral – for a 6% yield – then it implies a stock price more like 230p. This would constitute over 40% upside besides locking in a near 9% yield. 

It explains why enough buyers yesterday took Direct Line up from a 155p low to near 160p.  

Results have not added materially extra negative info 

Direct Line’s 11 January update blamed a cold December for boosting bad weather claims from the North West and Scotland, which together with ongoing rises in the value of motor-related claims had hit underwriting. There had also been a circa 15% reduction in the value of commercial property held in the investment portfolio. 

This is now reflected in a 2022 combined operating ratio – the sum of incurred losses and expenses, divided by earned premium – rising from 89.5% to 105.8%. It means Direct Line has been paying out more money in claims than received from premiums. In motor, the ratio went from 92.4% to 114.7%.  

Weather event claims do look quite exceptional – £149 million being more than twice budget and the highest since the group listed over a decade ago. Yet this may be a new reality of climate change. What chance also of motor claims abating in the near term, after last winter was apparently perfect for exacerbating Britain’s already terrible pot-holes? 

Management concedes that higher claims inflation in motor is expected to continue in early 2023. It’s unclear whether it is a sop to say: “the group continues to believe it has a fundamentally strong business and is pursuing a range of actions to both restore earnings and improve its solvency.” 

The crux is whether this point in Direct Line’s progress and stock, prices in the bad news such that you could get lucky, and also with takeover interest a possibility. Alternatively, might a difficult situation just fester on?  

In due respect, its commercial insurance operations have performed well, a factor helping Aviva recently drive strong progress. Together with Direct Line’s Green Flag breakdown cover operations, this could constitute a decent portion of Direct Line’s circa £2 billion market value, which starts to assemble a takeover rationale.  

Is “strong pricing action” a satisfactory response? 

In my experience of checking out home and motor insurance, Direct Line has for some years been at the pricey end of premiums. 

It does not take much effort to use price comparison websites, which may also include offers such as £100 or so free “excess” in the event of a claim. Moreover, no-frills operators such as Dial Direct – offering free RAC breakdown cover with motor insurance – and Urban Jungle in home insurance, were already under-cutting Direct Line well before its latest price rises. 

I am therefore wary how consumers will respond, or management might compromise the business this way. It implies that buying additional or fresh equity remains as yet premature. 

Mind how insurers’ profits can still contain an element of surprise. For example, changes in the discount rate assumption for gilt-edged stock they hold as part of reserves. Direct Line’s 2022 profit benefited by £147 million this way, which is quite similar to the way bank sector profits sometimes benefit from releasing provisions (for bad debts that did not materialise).  

This is very tricky to predict, but my point is how fear about one aspect of the insurer’s profit might be offset by surprise gains elsewhere.  

£1bn cash within net tangible assets of 112p a share 

It is a moot point whether Direct Line’s balance sheet starts to offer support at the current stock price level, and that it might encourage a private equity operator. 

Goodwill and intangibles constitute 36% of net assets, although you could say brand value is involved here. Writing it off would still leave £1,459 million net tangible assets equivalent to 112p a share. There is exactly £1 billion cash if at least partly reflecting a regulatory buffer for operations than what is strictly accessible.  

Yet the free cash flow record is plenty strong and there is only a modest £65 million debt. The industry context is challenging but tough competition implies takeovers may need considering as a means to growth. 

Not to create a speculative “buy” case here, but if an approach materialised say in the 250p a share area, the board could find that hard to dismiss given management’s track record. 

Direct Line Insurance Group - financial summary
year end 31 Dec201420152016201720182019202020212022
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)
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)
Special dividend per share (p)14.027.510.
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

When might the market start pricing in recovery?   

The industry context looks like a tough 2023, certainly in the first half. Yet it is possible for the stock market to begin pricing in recovery from the point when “at least the news is not getting any worse”. 

So if Admiral is right to judge that now is pretty much the trough for motor insurance woes, you might consider a nibble or average down in Direct Line. I would be more inclined to pencil in a circa 5% dividend yield rather than consensus expectation for a near 9% yield though. 

Mind how recession or market turbulence is liable to take most financial stocks lower. But at some point the market is likely to try and price in some recovery for 2024. If any potential bidder exists, then the time to act is now. As a starter position: Buy.  

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

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