After a major shock to Direct Line’s identity as an income stock, analyst Edmond Jackson looks at the wider industry and gives a view on another big player.
Does a disappointing update from Direct Line Insurance Group (LSE:DLG) - which has dropped its final dividend - reflect mainly the industry or management? If the former, then how widespread might be the woe?
Besides other listed insurers such as Admiral Group (LSE:ADM) and Sabre Insurance Group (LSE:SBRE), I have concern for Saga (LSE:SAGA), the insurance-and-cruising group for the over-50’s whose chart has sported a firm recovery trend since last October.
Cold December weather contributes to claims inflation
Direct Line cites a volatile and challenging operating environment in the fourth quarter, significantly affected by bad weather claims, which together with further increases in the value of motor-related claims have hit underwriting.
Its asset base has also been affected by a circa 15% reduction in the value of commercial property held in its investment portfolio. Unless other insurers warn similarly, this will look like DLG as over-exposed.
Omitting the dividend pay-out is serious for a stock lacking growth credentials hence its appeal chiefly being income – unless the price falls so low that a de-risking of the yield creates upside potential.
There has been volatile-sideways performance, with an updated consensus for £190 million net profit in 2022 below what was achieved in 2016.
|Direct Line Insurance Group - financial summary|
|year end 31 Dec||2014||2015||2016||2017||2018||2019||2020||2021|
|Turnover (£ million)||3,349||3,253||3,321||3,496||3,427||3,284||3,202||3,230|
|Operating margin (%)||13.6||15.4||10.4||15.2||16.8||15.4||14.0||13.6|
|Operating profit (£m)||457||500||345||531||577||506||447||441|
|Net profit (£m)||373||580||279||434||472||420||367||344|
|Reported EPS (p)||26.0||27.6||20.2||31.5||32.9||29.2||25.5||24.1|
|Normalised EPS (p)||26.7||26.5||24.1||33.6||33.0||29.9||28.2||30.0|
|Earnings per share growth (%)||1.8||-0.8||-8.9||39.4||-1.7||-9.4||-5.7||6.4|
|Operating cashflow/share (p)||51.4||37.6||62.4||39.6||35.6||33.4||42.5||32.4|
|Free cashflow/share (p)||37.5||27.7||53.0||32.7||24.3||19.9||30.8||22.2|
|Ordinary dividend per share (p)||12.6||13.8||14.6||20.4||21.0||21.6||22.1||22.7|
|Covered by earnings (x)||1.8||2.0||1.4||1.5||1.6||1.4||1.2||1.1|
|Special dividend per share (p)||14.0||27.5||10.0||15.0||8.3||0.0||14.4||0.0|
|Net debt (£m)||-284||-381||-571||-523||-319||-126||-153||47.8|
|Net assets/share (p)||205||191||185||198||187||193||200||194|
|Source: historic Company REFS and company accounts|
Dividend realities come home to roost
Management likes to remind us how over £1.5 billion has been paid out in dividends over the last five years. It’s unclear whether that has been prudent as competition intensified.
Yes, free cash generation has been strong, likewise cash balances, but I have noticed online criticism about premiums being relatively pricey – as if DLG would lose business in time.
Tough competition makes it tricky to predict when dividends may resume.
Such a shock to an income stock’s identity meant a savage 28% initial drop in its price to 167p, and, despite a recovery to 183p, the chart as much implies the last two years’ downtrend is intact.
Weak underwriting performance may be industry-wide
Higher claims mean the combined operating ratio – insurance claims plus expenses, divided by earned premium – will be 102% to 103% for 2022, despite some normalising for cold weather. That implies paying out more money in claims than receiving in premiums.
Ideally, management should price premiums to ensure a margin of safety, although competition likely restricts that. DLG’s 2023 target is 97% to 98% inclusive of motor claims inflation.
Interestingly, the writing was on the wall last July when broker Jefferies published analysis suggesting UK motor insurers would not be able to keep pace with claims inflation.
It expected margins to deteriorate and specifically that DLG would cut its dividend, hence a downgrade from “buy” to “hold”. Admiral was de-rated to “underperform” in the expectation of lower margins impacting commissions.
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Small-cap Sabre Insurance cautioned last July that claims inflation had risen from 8% to 12%; its combined operating ratio tested 99% though was expected in a mid-90% area for the full year. That is well above 79% in 2021 and management’s 70-80% target range.
Motor insurance industry analysts have anticipated a 114% combined operating ratio for the market, with very little improvement in 2023, as pricing of premiums fails to keep up with claims inflation.
I find it curious how the Financial Conduct Authority was meant to have ruled out big rises in insurance renewals versus cheap deals for new customers. In my recent experience, this gulf seems to be getting wider, hence more incentive to change insurer.
Despite DLG’s 10% recovery from its low, the uncertainties make it hard to rate the stock better than a “hold” for those already in. Further disappointments could mean pressure for a CEO change albeit at the risk of disruption.
Yet Saga’s combined operating ratio is worse
Saga’s first-half results to 31 July showed a disappointing 110% combined operating ratio on the underwriting side – up 22% on the prior period, amid 13% claims inflation.
It said: “While we are seeing some short-term earnings pressure from high claims inflation, we are applying material increases to our pricing”.
The full-year 2022 ratio was, however, expected as similar to the first half, with the teaser of an improvement in 2023/2024 – I would say, assuming Saga’s mature customers are willing to wear price increases than shop around at renewal.
Management had cited strong customer retention in retail broking, albeit significantly lower new business. Meanwhile, “a disciplined approach to pricing has had some impact on our competitiveness”.
A simple but possibly accurate view is insurers in a cleft stick as to pricing policies, to improve their operating ratio, versus attracting/retaining business. If this lasts much length of time, you wonder why hold any such equity. I am unconvinced it is a near-term weather-related issue.
Saga is still very much an insurance company in financial terms. Retail broking contributed £36 million interim profit and underwriting £16 million profit, before £12 million losses on cruise and travel, £15 million central costs and £11 million net finance costs whittled underlying pre-tax profit down to £14 million.
Can new cruise liners radically offset challenges in insurance?
Holding Saga stock is therefore significantly a bet on the possibility that new cruise liners can radically offset challenges in insurance. Two new “boutique” liners in 2021 and 2022 are being augmented by four more – with launches through to 2026.
Three months ago, management anticipated a customer load factor of 66% on ocean cruises, rising over 80% by the second half of 2023 as Covid restrictions are removed.
The story on Saga cruises is attractive, providing a bolt-hole for affluent folk from the mega-liners. Yet at this still early stage for proving what the new ships can earn, net of finance costs, I find it speculative.
The six months to 31 July saw a £12 million gross profit for ocean cruising offset by nearly £10 million marketing and operating expenses, then £9 million finance costs took ocean cruising’s pre-tax loss near £7 million.
While finance costs were negligible on the river cruising side, its £9 million operating profit was swamped by nearly £5 million marketing and £9 million operating costs. Saga is well-known for blitzing its customers and the media with advertising.
It is a pity how Saga’s recovery story has been compromised first by Covid thwarting travel, and now there appears raised uncertainty for insurance.
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As yet, consensus anticipates net losses since the January 2019 year recovering to an £18 million net profit to 31 January 2023 and over £37 million in 2024.
Management has said it was on track to achieve £40 million EBITDA (near operating profit) per cruise liner, which offers shareholders some hope.
On last year’s form, a trading update is due later this month. It could possibly be good in parts as travel resumes, but I cannot see Saga avoiding a challenged context for insurance.
At 152p, the stock has barely flinched in response to Direct Line’s update and sports a firm uptrend from 73p last October:
Be aware that while near-£400 million net assets imply backing of 283p a share, 125% of it constitutes goodwill/intangibles.
Saga therefore looks a “hold” very much according to your risk appetite, and with fresh money I would await an update.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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