Stockwatch: Lock in 7.5% yield

Has Direct Line drifted too far? After floating four years ago, the FTSE 100 general insurer more-than-doubled from 200p to 414p by the end of 2015, but was down to 333p after the EU referendum and has not recovered like the other financials. The rise was fuelled by growth in its profits and special dividends, driven by cost-cutting.

At 355p the stock still offers a prospective yield of about 7.5% if based on a full pay-out (see table below) with consensus profit expectations down from about £570 million to £490 million. Consensus can be viewed as over-cautious, however, with there being scope to build the 2018/19 scenario stronger.

So the stock is in a sensitive area for risk/reward, well-supported and exposed to rise on any improvement in earnings expectations.

Morgan Stanley upgrades

Mind investment bank Morgan Stanley has commercial relations with Direct Line, although this can foster close insight. The analysts were positive after the early August interims, but the shares have since dropped from about 400p to around 350p in volatile trading.

The analysts reckon: "The market is missing the improving quality of earnings and resulting future dividend growth...with continued special dividends and a gradual rise in the pay-out ratio over our forecast period."

It derives from a strategic change underway towards own-brands rather than partnership business, helping customer retention and earnings quality. Falling commission costs should aid margins and overall return on equity is projected to rise from 16% this year to 17.2% by 2019.

Morgan Stanley increases its 2017 EPS forecast from 30.2p to 32.4p - 13.7% above consensusDirect Line is also updating and linking every separate IT system to optimise product offerings and trim expenses; one of the few European insurers investing so.

Morgan Stanley has upgraded its 2017 earnings per share (EPS) forecast from 30.2p to 32.4p - 13.7% ahead of consensus - based on higher motor premium rates and margin expansion, underpinned by improving customer retention and declining commission ratio.

Obviously the price/earnings (PE) multiple makes a big difference to any price target. These analysts reckon it's worth an earnings valuation of 14.4 times, substantially higher than the 8.3x to 11.6x average annual PE that Direct Line has sustained according to the Company REFS database/table.

Showing a measured view, the analysts also caution of longer-term disruption for UK motor insurance resulting from enhanced safety features on vehicles.

Anyway, their key strategic observation is worth noting when consensus already looks for a 7.5% yield, as stronger earning power would drive capital upside from this sensitive share price level.

Operational progress

The stock's 2016 volatility has probably been reinforced by mixed first-half results.

Encouragingly, gross written premium for ongoing operations rose 3.9% and a combined operating ratio - the sum of incurred losses/expenses divided by earned premium - of 89.6% was 0.2% better, despite a flooding levy impact of 1.6%.

Investment in brand differentiation helped home and motor own-brand sales up 3.0%Yet operating profit slipped £12.2 million to £323.6 million due to £18.5 million lower investment gains, and there was also a strong first half 2015 comparator.

With basic earnings per share up 4.2% to 17.2p, the board was confident enough with the strategic progress to raise the interim dividend per share from 4.6p to 4.9p and also pay a 10.0p special dividend.

Ongoing investment in brand differentiation helped home and motor own-brand sales up 3.0% with strong customer retention, and a partnership with RBS for home and private insurance was extended for another three years.

Strategic progress

The medium-term goal is to be a "great retailer, smart and efficient manufacturer, and to lead and disrupt the market".

Reflecting Morgan Stanley's point about enhancing own-brands, a new three-hour emergency plumbing service was introduced for Home Plus customers, along with a seven-day car repair and guaranteed hire car on comprehensive motor policies. Policy amendment fees have also been removed.

The group's commercial side, as opposed to personal, only represented 4% of 2015 profitsAdmittedly, some of this may be needed just to maintain competitiveness, the share price effectively saying it will be guided only by financial results.

Own-brands are also enjoying more business from price comparison websites after improving capabilities there.

Meanwhile the joint arrangements continue to be worthwhile, with Direct Line having "a strong shared heritage with RBS" in home and private insurance and its travel insurance with Nationwide extended to end-2018.

The group's commercial side - as opposed to personal - only represented 4% of 2015 profits, but appears to have evolved well.

A new e-trading platform for broker business has been launched and there has been 17% growth in telematics policies, where Direct Line is building partnerships with the car industry, aiming to spearhead this market. So the operations' development story reads well.

Derivatives explain lower investment returns

The sense is that lower bond/cash returns are affecting insurers, however Direct Line's interim accounts show fairly stable income from debt securities and investment property. The impact comes instead from a £15.9 million loss in derivatives, albeit reducing from £34.5 million in the first half of 2015.

Such losses were half-offset by net realised gains in debt securities, and while this doesn't ease the discomfort surrounding the use of derivatives' - given their potential for introducing volatility - at least it shows the operating profit hit as exceptional and possibly implies consensus 2016 profit/earnings forecasts are over-cautious.

A forward PE in the mid-teens may not be justified, but the risk/reward favours capital upsideIn stock price terms, Direct Line has significantly underperformed its peers this year, but the group is getting stronger intrinsically.

I'd hesitate to assume this justifies a forward PE in the mid-teens, as Morgan Stanley contends, but indeed the risk/reward profile favours capital upside and you can also currently lock in a high yield that's uncommon for a sound business.

A section on "dividends and capital management" within the interims did note that special dividends will henceforth be considered only with the full-year results, but reassured that solvency remains ample for the group's risk appetite.

Improved trading and higher than expected prior-year reserve releases should also benefit the combined operating ratio in the second half.

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This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.