Direct Line (OTCPK:DIISF) continues to trade at a discount to its historical average and its peer group, but this seems to be justified by a weak operating performance and significant execution risk of its turnaround program.
As I’ve covered in previous articles, Direct Line’s operating performance was quite weak due to some issues in the U.K. motor segment, which justified its discounted valuation. Despite that, its shares are up by more than 23% including dividends since my last article, as Ageas (OTCPK:AGESF) shown interest in buying its competitor, supporting its shares in recent months.
As I’ve not covered Direct Line for some time and the company also performed a capital markets day recently, I think it’s now a good time to analyze its most recent financial performance and strategy, to see if its offers value for long-term investors in the European insurance sector.
Recent Events
A few months ago, Ageas made an offer to buy Direct Line for about $3.9 billion, which was rejected by its management for ‘undervaluing’ it. Ageas was not able to engage with Direct Line’s management following the offer and eventually did not proceed with a firm offer, walking away from this potential deal.
While an acquisition was not successful at this time, this shows that eventually Direct Line may be undervalued following a weak share price performance from 2021 to mid-2023. Direct Line’s current market value is about $3.2 billion, showing that Ageas offered a decent premium, even though on a long-term basis the company may be worth much more.
This happens because Direct Line is significantly exposed to the U.K. motor segment, which has been under pressure over the past few years, first by rising used-car values during the chip shortage issue, and afterwards by rising repair costs due to the inflationary environment.
These issues should, at least theoretically, be temporary, and Direct Line’s operating performance and profitability should ‘normalize’ in the near future, when these pressures subdue. Indeed, its return on tangible equity (RoTE) ratio, a key measure of profitability in the insurance sector, remained negative in Fiscal Year (FY) 2023 (RoTE of -15%), while in the past Direct Line used to report double-digit returns.
This is explained by a very poor performance in the motor segment, leading to an overall combined ratio of 108% in FY 2023 (vs. 101% in FY 2022), which means the company had operating losses during the past two years. However, its reported profit amounted to £223 million in FY 2023, due to a gain of £444 million in the sale of its brokered commercial insurance business.
In other insurance segments, Direct Line was able to report an operating profit during the past two years, but this was not enough to offset weakness in the motor segment, as shown in the next table.
Given this weak operating performance, Direct Line made some strategic actions to improve its underwriting profitability in the motor segment, namely increasing insurance premiums and expanding its own-managed repair network to have a better control on repair costs, and eventually improve its underwriting profitability in motor.
These measures had a positive effect on its gross premium written during the first quarter of fiscal year 2024, with premiums increasing by 18% YoY to £424 million in the last quarter. As the company only reports a trading update on a quarterly basis, it’s not possible to know how its profitability was in Q1, but Direct Line it expects written margins to be above 10%, thus its profitability is expected to recover in the first half of the year.
Indeed, according to analysts’ estimates, its combined ratio in H1 FY 2024 is expected to be around 96%, thus Direct Line should report an operating profit again, after three semi-annual consecutive losses since H2 FY 2022. This shows that higher insurance premiums were ahead of claims costs, as inflation and wage pressure have declined in recent quarters, boding well for Direct Line’s underwriting profit in the near future.
From a strategic point of view, Direct Line updated its business strategy recently in its capital markets day, aiming to focus its investments in insurance lines where it has a good market position and can deliver returns in the future, namely motor, home, commercial direct, and rescue insurance lines. Other business segments, such as pet or travel insurance aren’t part of its ‘core business’ and Direct Line will no longer make further investments in these insurance lines.
It aims to return to grow through better technical results, which means a good underwriting criteria will be key to its future profitability. This means Direct Line is expected to pursue profitability rather than volumes ahead, plus it has also implemented a cost savings program to improve its overall profitability over the next couple of years. The company is targeting gross run-rate cost savings of £100 million by the end of 2025, which should be an important contributor to a higher bottom-line over the medium term.
Its total cost base was £849 million in 2023, which means its gross savings are expected to reduce its annual operating expenses by about 12%, with the goal of closing the expense ratio gap between Direct Line and its peers of six percentage points in the last year. This means Direct Line is currently less efficient than peers and is performing several measures to reduce business complexity and applying machine learning and other technological developments to offer a better customer service, while reducing costs at the same time.
These efforts to improve its underwriting profits and operating efficiency should lead to a net insurance margin of about 13% by 2026, while previously was targeting at least 10%.
Regarding its capital and dividends, Direct Line’s target is to have a Solvency II ratio of at least 180% and distribute some 60% of its earnings to shareholders. Given that its Solvency ratio was 197% at the end of last March, the company seems to be well capitalized and its dividend payout ratio seems acceptable.
Given that Direct Line’s earnings are expected to recover in FY 2024 to a reported profit of about £171 million and its Solvency ratio should remain around 200% over the coming quarters, it’s quite likely that it will resume ‘normal’ dividend payments related to 2024 earnings.
Indeed, while Direct Line resumed dividend payments a couple of months related to 2023 earnings, following a dividend suspension in the previous year, its dividend was only £0.04 per share (vs. £0.227 per share related to 2021 earnings). According to analysts’ estimates, its dividend related to FY 2024, expected to be paid in Q2 2025, should increase to £0.11 per share, leading to a forward dividend yield of about 5.8%. This is an interesting yield, but I think investors should be skeptical about this dividend as Direct Line’s turnaround program is still ongoing and, in my opinion, its operating performance needs to improve over the coming quarters for its management to feel comfortable to increase the dividend so much. Note that its expected EPS in 2024 is around £0.13, thus a dividend payout ratio of 60% implies a dividend per share of £0.08, thus analysts seem to be quite aggressive in their dividend estimates and there is some room for disappointment ahead.
Regarding its valuation, Direct Line is currently trading at about book value and 10x forward earnings, a similar valuation when I last covered it. This is at a discount to its historical average over the past five years of about 1.22x book value, but close to its historical average based on earnings, which seems to be justified by the company’s recent weak operating performance and much lower profitability than compared to its history.
Compared to its closest peers, including Admiral Group (OTCPK:AMIGF), Direct Line is also trading at a discount based on book value (peer group at close to 2x book value) and earnings (16x forward earnings), showing that Direct Line may have significant upside potential if its turnaround program is successful in improving its operating and financial performance ahead.
Conclusion
Direct Line has improved somewhat its operating performance in recent months due to its pricing actions and measures to improve efficiency, but its turnaround program still has significant execution risk and how much its profitability eventually improves over the next few years is quite uncertain. While its shares continue to trade at a discount to its historical average and its peer group, I still don’t see the risk-return profile attractive enough for long-term investors.
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