2023-04-21 15:52:08 ET
Summary
- Direct Line shares have sold-off significantly over the past twelve months, as poor underwriting results led to a FY 2022 loss and the suspension of its dividend.
- Although some elements like higher weather-related claims will resolve on their own, weak Motor performance will take longer to correct. Management has downgraded financial targets as a result.
- Despite the uncertainty, these shares look very cheap on rebounding profit and dividend potential over the next two years.
Direct Line ( DIISF )( DIISY ) shareholders have been hit hard recently, with shares of the UK general insurer down around 35% over the past 12 months.
Direct Line Share Price (price in GBX)
Operating conditions explain much of that decline: claims inflation led to a large FY 2022 operating loss in its Motor line, with that coming alongside significant weather-related claims hitting home insurance profit. As a result, the company's bottom line swung into the red for the first time since its IPO in 2012.
Although the weak financial performance reflects industry-wide issues, certain company-specific factors have aggravated this, which is why these shares have materially underperformed those of peer Admiral Group ( AMIGY )( AMIGF ) over the same period:
Admiral Group Share Price ((GBX))
With the shares falling as much as they have, Direct Line now offers considerable value, albeit I do think that comes with a "warts and all" qualifier given the uncertainty in its near-term outlook. Every stock has its price, though, and this one now looks too cheap based on rebounding profit potential and a restoration of the dividend in FY 2023 and FY 2024. I rate it a buy.
Tough Motor Environment Made Worse By Operational Misstep
Direct Line is pretty much your run-of-the-mill general insurer. Its lines are Motor ( ~48% of gross written premium ), Commercial ( ~25 % ), Home ( ~ 17% ) and Rescue & Other ( ~ 9% ) , which includes pet insurance, travel insurance and so on. Last year the company reported 9.7 million in-force policies and GWP of £2.97 billion.
As per above, motor insurance represents almost half of its total GWP, and the operating environment was a tough one last year. In 2020 and 2021, car insurers benefitted from the sharp reduction in traffic brought about by strict COVID-containment measures. Less traffic meant fewer accidents, which meant less cash paid out in claims. Claims frequency began to normalize again last year with the return of normalized traffic levels, but with the kicker that inflation also sent the cost of claims sharply higher:
The first thing to note is that the -- is that 2021 benefited from the lower claims frequency that we saw during the COVID lockdowns. This accounted for around 5 points of the loss ratio deterioration. The remaining 13-point increase was principally due to two main factors.
The first of these was severity inflation, which throughout 2022, was tracking substantially above the levels assumed in our pricing. Our long-term average expectation for severity inflation was 3% to 5%. Actual severity inflation was around 14%.
Jonathan Greenwood , Acting CEO
Ideally, management would respond to the above with offsetting price hikes, but in trying to balance inflation with customer retention it ended up sacrificing earnings. Retention increased 5 points to 82%, but average Motor premiums actually fell by low single-digits despite significant claims cost inflation. In-force Motor policies also fell by 3.4% to 3.836 million, with GWP down a little over 8%.
The net result was a sharp deterioration in underwriting profitability and earnings. Motor combined operating ratio ("COR") was 114.7% last year versus 92.4% in FY 2021 and 87.7% in FY 2020, with the segment posting an underwriting loss of £207m versus a £112m profit the year before.
Weather Makes For A Perfect Storm
An extremely weak Motor result was compounded by weather-related weakness elsewhere in the business. Storms early in the year and extreme cold weather toward the end of it resulted in weather-related claims of £149m - more than double the weather budget for the year.
As a result, the Home segment swung into an underwriting loss of £36m versus a £110m profit in 2021, with Home COR coming in at 106.9%. Home in-force policies also fell by 6.2%, to just over 2.5m, with GWP down over 10% to £518m.
Commercial fared better, with higher weather claims offset by a 14.7% rise in GWP off a 6.5% increase in in-force policies. This remains a relatively small part of Direct Line's business, though, with Commercial underwriting profit landing at just under £40m in 2022.
All said and done, the above contributed to a statutory loss for the year of £39.5m (versus a profit of £343.7m in 2021), with the aforementioned underwriting loss made worse by lower investment income due to realized and unrealized losses in its investment portfolio.
Dividend Scrapped, Targets Lowered
Weak capital generation led to a large drop in the company's Solvency Ratio, which ended the year at 147% - slightly above the lower end of management's 140-180% target range. Management decided to suspend the final FY 2022 dividend to support this.
Previously, Direct Line was what you could call a yield stock. Profits had been relatively flat since IPO and so dividends accounted for a large share of total return. The suspension of the dividend therefore likely explains a large portion of the stock's recent decline. Management hasn't indicated when it will return but will instead review the payout after H1 FY 2023 results.
Direct Line EPS and DPS (includes special dividends)
Alongside the suspension of the dividend, future profitability targets have been downgraded, with management now aiming for a 10% net insurance margin (which equates to a 96% combined COR). Previously, the target was set at a 93-95% combined COR "throughout the medium term".
At a group level, our ambition is to reach earnings consistent with a 10% net insurance margin, but this will clearly take time given -- to achieve given the headwinds in Motor.
Neil Manser , CFO
The softening of financial targets incorporates a weak near-term Motor outlook, and it's possible management could be sandbagging a little beyond that. Nevertheless, it should be noted that targets have been changed under an acting CEO (the previous permanent CEO, Penny James, resigned following the company's poor 2022 performance). This adds an extra layer of uncertainty as any new permanent appointment may not feel bound by prior financial targets.
Shares Now Too Cheap
At 170.55p in London trading, Direct Line shares have fallen 35% over the past 12 months. The extent of the share price decline likely reflects the factors outlined above - namely an FY 2022 statutory loss, uncertainty regarding future profitability and financial targets (including an unfilled permanent CEO position) and the suspension of the dividend, which previously accounted for a large share of the stock's total return.
Despite the uncertainty in Direct Line's outlook, I do think these shares are just too cheap right now. Motor will continue to be a drag this year on high single-digit cost inflation, while management's goal of prioritizing margin will probably lead to a more pronounced drop in in-force policies. Still, improving group COR and higher investment income should lead the company back into the black, with the higher interest rate environment boosting the latter.
With that, I'm tentatively penciling in FY 2023 net income of around £240m (~£0.181 per share), which I see rising to around £320m (~£0.246 per share) in FY 2024 as group COR moves closer to management's target. On an 8x EPS multiple that gets me to a two-year share price target of just over £1.95. Assuming a 70% average dividend payout ratio would add a further £0.30 per share in cumulative distributions, leading to a circa 33% implied total return over the next two years or so. Buy.
For further details see:
Direct Line Insurance: Too Cheap, Warts And All