2023-03-18 04:33:13 ET
Summary
- Direct Line is an U.K. insurance company, with a business profile heavily geared to the motor segment.
- In 2022, its operating performance was quite bad as the company suffered from higher inflation, bad weather, and lower investment income.
- While its valuation is much cheaper than compared to its history, this is justified by its fundamentals woes.
Direct Line (DIISY) had a terrible performance during 2022 due to several issues that are largely outside of its control, which does not bode well for its fundamentals ahead, thus there are better alternatives within the European insurance sector.
Company Overview
Direct Line is an insurance company operating in the U.K. Property & Casualty (P&C) market, with a strong presence in the auto insurance segment. Its current market value is about $2.5 billion, being therefore a relatively small company by this measure within the European insurance sector, and trades in the U.S. on the over-the-counter market.
The company was founded in 1985 and was part of Royal Bank of Scotland's financial group until 2012, and has been listed since 2012 and operated as an independent company since then. The British bank sold entirely its stake in 2014, and Direct Line's current major shareholders are financial institutions, such as BlackRock (BLK) or T. Rowe Price (TROW).
The company is one of the leading insurance companies in its domestic market, having a strong market share in the motor segment, while it also has some exposure to commercial insurance lines. Its business model is to operate under a multi-brand, multi-product approach, offering its products and services through several distribution channels. Nevertheless, Direct Line's main brands sell their insurance products mainly through direct channels, being a distinctive factor to its closest peers, such as Admiral Group (AMIGF) or Aviva (AVVIY).
As shown in the next graph, Direct Line is the second-largest insurance company in the U.K. motor segment by market share (around 11%), after Admiral Group. However, the market is somewhat fragmented, as the largest three companies hold some 35% of total written premiums, thus pricing power may be rather low given that to a large extent insurance is a commoditized product, plus smaller competitors may offer more competitive pricing compared to larger players in order to gain market share.
Motoris the company's largest segment and the biggest driver of its top-line and earnings performance, representing close to half of its net premiums written, while other segments have smaller weights, including home, commercial, and other personal insurance lines. Going forward, the company's growth strategy is not expected to change much, focusing mainly on organic initiatives, while acquisitions aren't ruled out but should be mainly small bolt-on deals.
Business profile (Direct Line)
Financial Overview
Regarding its financial performance , while historically Direct Line has reported a relatively stable performance and good levels of profitability, measured by its double-digit return on equity ratio achieved over the past few years, this has changed dramatically during 2022. Indeed, the company was hit by a perfect storm of higher inflation, lower investment income, and weather events that led to a collapse in its profitability.
Due to weaker capital markets, Direct Line's investment income declined considerably during the past year, mainly related to losses on U.S. credit and lower property valuations. While its investment income increased due to higher interest rates, leading to an increase in its net investment yield to 2.2% (versus 1.7% in 2021, this was not enough to offset lower asset values across the credit and real estate markets. The company's investment return declined by 65% YoY, to only £51 million, being a drag for its overall earnings.
Investors should note that Direct Line's investment allocation can be considered conservative, as most of its investments are allocated to investment grade bonds with high credit ratings, and doesn't have any exposure to equities. If the company would have a more risky allocation its investment return during the past year would be even lower, as the stock market was quite weak during the past year, thus most likely Direct Line will maintain a conservative asset allocation in the near future.
Investment allocation (Direct Line)
Another negative factor for its earnings in 2022 was bad weather in the U.K., which led to higher claim costs than expected in its home and commercial insurance segments, being the worst year for the company related to weather claims since its IPO. As shown in the next graph, Direct Line's weather event claims amounted to £149 million during 2012, while the company's claims budget was only £73 million, having a negative impact on its underwriting profit.
Beyond lower investment return and higher weather claims, what had the most negative impact on Direct Line's underwriting profit during the last year was higher motor claims, justified by higher inflation that led to increased costs related to auto repairs and increasing prices for used cars.
While other insurance segments were able to report an underwriting profit, motor experienced a sharp increase in claims costs, which led to a combined ratio of close to 115% (a ratio below 100% means a profit) in this business segment. Given that motor has a strong weight on Direct Line's business, its overall combined ratio was above 100%, which is naturally above its internal target, and much higher than its combined ratio of 91% reported in 2021.
Combined ratio (Direct Line)
As I've said before, the motor market is quite fragmented and pricing power is not great even for the larger companies in the market, thus Direct Line was not able to pass to customers higher costs, explaining why its underwriting profitability deteriorated markedly.
While average motor premiums in new business increased compared to the company's overall average premium, the company's efforts to maintain acceptable retention rates led to a decrease of 6% YoY on insurance renewals. Despite this effort, Direct Line's retention rate was only 82% in 2022, showing that customer churn is somewhat high, and if the company increases prices it will certainly lead to lower policies renewals.
The combination of these negative effects regarding claim costs, plus lightly lower gross premiums written during the year to £2.97 billion (-3.2% YoY), led to an underwriting loss of £167 million in the year (compared to a profit of £301 million in 2021). As Investment return also declined considerably, Direct Line's operating profit was only £32 million in 2022, a decline of 94% YoY. Its bottom-line was a loss of £40 million (vs. a profit of £344 million in the previous year and a return on tangible equity of 23%), showing that Direct Line's operating performance collapsed rapidly during 2022.
While the company is taking some steps to improve profitability in the short-term, its negative performance in recent quarters was to a large extent outside of Direct Line's management control, not boding well for its earnings in the near future. The company acknowledges this situation and is not expecting a rapid turnaround in its earnings, expecting 2023 to be another challenging year that, it believes, does not reflect the company's earnings potential.
This happens because the motor segment is expected to remain a drag on the group's overall earnings, as tough pricing conditions are expected to remain and, most likely, will continue to not offset rising claims costs. Despite this backdrop, current market expectations are for a net profit above £300 million in 2023, which may be too optimistic considering current macroeconomic headwinds and inflationary pressures in the U.K.
B alance Sheet & Dividends
While historically Direct Line has a cash generative business, allowing it to distribute a good part of earnings to shareholder through dividends and share buybacks, its recent negative operating performance changed this landscape and the company decided to suspend its final dividend related to 2022 earnings.
This decision is explained by the collapse in its earnings, but also due to a capitalization that is weaker than compared to its peers in the insurance sector. Indeed, at the end of 2022, Direct Line's solvency ratio was only 147%, representing a decline of 14 percentage points during the year. The company is taking some measures to restore its capitalization, expecting to generate capital organically by moving its business more toward non-motor business lines, but its solvency ratio should remain much lower than compared to its closest peers, such as Admiral that had a solvency ratio of 180% at the end of 2022, and Aviva was above 200%.
This clearly shows that Direct Line is undercapitalized and is not likely to resume dividend payments in the short term, even though its guidance is to update its dividend outlook in the summer, when it is expected to report half-year results. However, as the company's business concentration in the motor segment is significant and rapid rebound in this market seems unlikely, I think it's not probable that Direct Line will pay dividends related to 2023 earnings.
Conclusion
Direct Line was hit by a perfect storm during 2022 which impacted its earnings considerably and a rapid rebound doesn't seem likely. While in the past it offered an attractive dividend yield, and that was one of the most attractive features of its investment case, this is no longer the case.
Reflecting its woes, Direct Line's current valuation is naturally low right now compared to its own history (0.9x book value vs. average 14.x book value over the past five years), but this is quite close to Aviva's valuation, and its competitor offers a high-dividend yield above 7% as I've analyzed here, thus Direct Line is a stock to avoid right now as better value seems to exist elsewhere.
For further details see:
Direct Line: There Is Better Value Elsewhere