Interactive Investor

Stockwatch: what I’d do as crunch time approaches for Direct Line

As a bid deadline looms and with the new CEO already taking action to ‘deliver quick wins’, analyst Edmond Jackson explains his approach to this takeover situation.

22nd March 2024 12:10

Edmond Jackson from interactive investor

Since I maintained a “buy” case for Direct Line Insurance Group (LSE:DLG) at 204p on 1 March after a bid approach from Belgian insurer Ageas SA/ NV (EURONEXT:AGS), I am forced to reconsider my stance following a second “possible” offer and release of the 2023 results yesterday. The share price initially rose from about 212p to near 220p, but as views began to differ it closed flat.

What to do then, if Ageas backs off and – in the absence of any rival approach – the shares were to drop?

On 13 March, Ageas raised its offer from 100p per share plus one new Ageas share for every 25.24 Direct Line held, to 120p per share in cash plus one Ageas for every 28.41 Direct Line held. The new bid equates to around 239p per Direct Line share but was again rejected for undervaluing the business and its prospects.

Ageas therefore has to cede a bit of credibility to make a materially higher third offer by 5pm on 27 March or probably back off. I doubt they would “go hostile” up to say 250p a share equivalent, appealing directly to shareholders.

So, I begin to see cracks in the situation, including for example one of the Ageas’ top 10 shareholders protesting anonymously, about how the timing of such a takeover is not good. It would be disruptive after Ageas’ own recent weak performance, and significant headwinds exist by way of regulation and claims inflation in UK personal lines insurance.

Yet analysts at UBS still argue that the Belgian insurer would strengthen its position in Europe overall and diversify from life insurance by closing a deal. One key uncertainty, I think, is the extent of synergies that management can achieve – which will help define their price limit. Jefferies contend “much more” is still needed to make the deal attractive to Direct Line holders but reiterate their “buy” stance.

A dilemma is that Ageas still has to radically raise its terms, which it may currently be discussing with lenders.

Hence it is vital to wrest what clues there might be in the 2023 results and outlook, as to Direct Line’s merits as a standalone share. If you are unconvinced, then sell, as the case is mixed, but I can equally identify reasons to hold on – or potentially buy a drop.

Bad numbers yet a potentially improving scenario

There is a £190 million group operating loss, albeit due to a £332 million loss on the Motor side reflecting low-margin business written in 2022 and the first half of 2023. Otherwise, the rest of the group achieved £130 million operating profit in 2023. “This outcome does not reflect the profitability of the business we believe is being written by the group today,” the company said.

You have to scroll down quite a way to learn how the Motor side shows signs of turnaround, with 21% premium growth in the first two months of 2024. This is important because the division provides 59% of gross written premium versus Home at 21%, which rose 14%.

Motor policies written since August are estimated to be in line with a target for a net insurance margin over 10%. Good, but mind how such pricing ahead of claims inflation is liable to make Direct Line more exposed to cheaper “no frills” operators such as Churchill and Dial Direct. So long as you are content to be online rather than speak with customer service, Urban Jungle undermines virtually all home insurers on price.

Creditably also, the Commercial side (separate from the brokered commercial insurance business sold last September) is up 19% and constitutes 11% of premium. Rescue, the Green Flag vehicle support operation and other personal insurance lines, were flat at 9% of the total. While just a two-month snapshot, it is still good.

Profits rescued by a business disposal and investment income

There are numerous “performance” type statements in this release, but I reference the consolidated statement of profit or loss next to the balance sheet and cash flow statement.

See how insurance group performance is not just about selling policies adeptly. A £251 million loss on insurance is mitigated by £179 million net investment income after this rose 55%. Despite £194 million net finance expenses from insurance contracts issued, the statement concludes with a £137 million return from investments and insurance despite the latter’s loss. Applying a 25% tax rate to this would imply earnings per share (EPS) around 10p, hence a price/earnings (PE) multiple around 21 currently.

A £444 million gain on business disposal then raises annual profit to £223 million after tax, hence reported EPS near 16p.

The consolidated cash flow statement shows net cash generated from operations halved to £405 million, then £520 million business sale proceeds offset only by £143 million investment. It meant a net increase in cash over £750 million and year-end cash around £1.7 billion.

In this respect it is quite harsh how the board proposes only a 4p dividend per share, which I estimate will cost £52.5 million.

It would help if note 17 referencing the balance sheet cash entry clarified what, if any, of this is the equivalent of client money than accessible. At end-December there was £148 million cash at bank and over £1.6 billion in money market funds.

The board justifies a 4p dividend – relative to the table showing over 20p per share up to 2021, costing over £300 million – on grounds of a strong capital position after the sale of brokered commercial side and improving performance this year.

Direct Line Insurance Group - financial summary
Year end 31 Dec

 2014201520162017201820192020202120222023
Turnover (£ million)3,3493,2533,3213,4963,4273,2843,2023,2303,2293,602
Operating margin (%)13.615.410.415.216.815.414.013.6-7.03.8
Operating profit (£m)457500345531577506447441-226137
Net profit (£m)373580279434472420367344-232223
Reported EPS (p)26.027.620.231.532.929.225.524.1-19.115.9
Normalised EPS (p)26.726.524.133.633.029.928.230.0-19.115.7
Earnings per share growth (%)1.8-0.8-8.939.4-1.7-9.4-5.76.4-163176
Operating cashflow/share (p)51.437.662.439.635.633.442.532.461.630.9
Capex/share (p)13.99.99.56.911.313.611.710.29.230.4
Free cashflow/share (p)37.527.753.032.724.319.930.822.252.40.5
Ordinary dividend per share (p)12.613.814.620.421.021.622.122.77.64.0
Covered by earnings (x)1.82.01.41.51.61.41.21.1-0.64.0
Special dividend per share (p)14.027.510.015.08.30.014.40.00.00.0
Cash (£m)8809641,1661,3591,1549491,2209561,0041,772
Net debt (£m)-284-381-571-523-319-126-153-897-939-1,584
Net assets/share (p)205191185198187193200194176183

Source: historic company REFS and company accounts

But “the performance over which to judge the sustainability of Motor’s capital generation has been short and consequently this dividend should not be regarded as a resumption of regular dividends”. The payout policy will be updated with a strategic review in July.

I can appreciate how, with the new CEO moving swiftly to axe costs further, it would be very bad internally to make any extent of redundancies while being generous with shareholder returns. I think it relevant to point out that they do look buttressed.

Not to suggest dividends over 20p (up to 2021) can be restored, implying a double-digit yield, but there should be eventual scope to re-rate this 4.0p dividend to deliver something more like a 6% yield (for example) than 2% currently; unless, that is, insurance becomes a competitive fight such that once again we see a dip into unprofitability.

A comprehensive strategic review is declared

It has taken the new CEO just three weeks to take some immediate actions “to address some of the gaps and deliver quick wins” – not untypical of a new broom, but implicitly the board was dissatisfied with the previous boss.

A further minimum £100 million costs will be taken out by end-2025: “54% by way of further improvements in digital capability, reduced technology costs and 46% by removing complexity across the group.” Marketing costs are also targeted. Mind, it implies a raft of exceptional costs.

Once achieved, I would be inclined to empathise with his assertion how already “we have a strong platform to build from”. He implies brands and market reach, where for example net asset value of 183p per share looks supportive despite 34% constituting goodwill/intangibles.

Direct Line is quite complex to assess and there has to be a caveat over its medium-term competitiveness, with premiums hiked.

At 212p, and in terms of overall risk/reward profile, I retain an overall contrarian “buy” stance – finessed as “hold” specifically until the bid deadline, with scope to buy/add if the shares drop on no bid.

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

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