5 Reasons To Buy Direct Line

Published in Investing on 4 October 2012

The IPO of RBS's insurance arm is a good opportunity.

Should you invest in the flotation of Direct Line, the insurance subsidiary of Royal Bank of Scotland (LSE: RBS)? "Oh yes!", would no doubt be the answer from Churchill, the lugubrious nodding dog that is the mascot of Direct Line's principal brand.

And I'm inclined to agree. A recent survey showed more young people recognise pictures of the canine Churchill than they do the wartime leader of the same name, underlining just some of the value in the company and its brands.

Cheap

And it's being sold on the cheap. The published price range is lower even that most pundits had forecast, valuing the company in the range £2.4bn to £2.9bn. That's for a business RBS tried -- although admittedly failed -- to sell for £7bn in 2008.

The difference isn't explained by the level of the market. Since mid-2008, the FTSE 100 (UKX) is up 5% while nearest rivals RSA Insurance (LSE: RSA) and Admiral (LSE: ADM) are down 13% and up 32% respectively. And in the meantime, a new management team that took over Direct Line in 2009 has done much to improve its performance, all but eliminating the company's underwriting losses. Direct Line is being sold at between 1.0 and 1.3 times its net tangible assets, compared to the 1.7 time RSA trades at.

Punishment

The company is being sold cheaply because RBS is a forced seller up against a deadline. As punishment for taking state aid in 2009, the European Commission required it to cede control of Direct Line by the end of 2013 and divest fully by end 2014. This first tranche of 25-30% has to be sold successfully for RBS to have any chance of floating the whole operation in that time.

It's a dire time to float a company. Volumes of new issues are as low as they were at the height of the financial crisis and there have been several poor flotations, from Ocado (LSE: OCDO) in the UK to Facebook (NASDAQ: FB.US) in the US. That saps confidence.

If you're an RBS shareholder, you should be fuming. The £4bn or so difference between the £7bn valuation and the top of the pricing range is a significant loss of value set against RBS's £16bn market cap. But RBS's opportunity loss is a potential gain for Direct Line investors.

Good reasons

Cheapness is one attraction of the float. Entry level is important. But it's not sufficient. So here are five good reasons to invest:

1. Yield. General insurers traditionally pay high yields. RSA and Admiral are yielding around 7% to 8%, and Direct Line looks like it will be on a par with these;

2. Strong market position. Direct Line is the market leader in UK motor insurance and home insurance, with 19% and 18% market shares respectively. Its scale and multi-brand, multi-product, multi-channel distribution positioning gives it market power and strength to defend its market. The industry is unattractive: it's mature, highly competitive and over-regulated. There is to be another competition enquiry into the motor insurance industry, which contributes 60% of Direct Line's operating profit. Struggling to make money from underwriting, insurers have sought to top up their profits with kick-backs from lawyers and repairers. But you can still do a lot with a leading market position in a mature industry;

3. Operational improvement. Direct Line's management have done much to rationalise the business since late 2009, but they clearly believe there is further to go. They are targeting £100m in annualised savings (which will take some time to come through as the one-off cost of implementation is also £100m). RSA's earlier turnaround shows what good management can do in the sector;

4. Cyclical recovery. The insurance industry in inherently cyclical, and with insurers' profits so dependent on investment performance, low interest rates are especially painful. Industry profitability should eventually improve;

5. Growth opportunities. Direct Line has operations in the German and Italian motor insurance sectors, the largest and second largest in Europe. (The UK is fourth largest: presumably the Italians have fewer cars but more accidents). Both are less sophisticated than the UK, with direct-to-consumer and price comparison channels growing strongly. There is nothing in the prospectus to suggest it but my hunch is that, freed of RBS, Direct Line's management might explore such growth opportunities more aggressively.

Risks

Of course, there are plenty of things that can go wrong. There are two specific risks that make me uncomfortable:

1. Markets crater. That's bad enough in itself, but because of RBS's forced sales timetable, it could have to offload the remaining shares in even worse circumstances. If that meant selling a 30%-plus stake to an industry or private equity buyer, shareholders could find themselves compulsorily bought out at below the original offer price;

2. Dependence on RBS. RBS will still initially be controlling shareholder, and Direct Line's credit rating will depend on RBS's. The transitional arrangements to transfer IT and other operations from RBS to Direct Line carry a lot of operational risk, and RBS is no stranger to IT meltdowns.

But financial investors are paid to take risks, and I think the positives outweigh the negatives. If you agree, you must act fast. Subscriptions close on 9 October.

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> Tony does not own any other shares mentioned in this article.

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Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

apprenticeDRL 04 Oct 2012 , 2:26pm

I have registered for the IPO but in my mind the jury is still out. I have an instinctive dislike of purchasing IPO's at point of issue as I have seen so many go down in value recently post issue. I may wait a couple of months and see whcih direction the share price is headed.

I am also not sure about investing in motor insurance at the moment. Plus I remember reading somewhere that the operating costs of Churchill are much higher than the equivelent costs from Admiral. I still need a bit of convincing before I commit

giveaholic 04 Oct 2012 , 7:11pm

I'm in. Better to have loved and lost....

I think the insurance industry will come good in the long run. Meanwhile the dividends are great at the moment. However I haven't ruled out taking a quick profit if the opportunity presents.

goodlifer 04 Oct 2012 , 7:30pm

FWIW, my hunch is they'll be available much cheaper over the next month or two,
A pretty good company though.

goodlifer 04 Oct 2012 , 9:33pm

giveaholic

Better to have loved and lost....

...than never to have lost at all.

SmudgeButt 05 Oct 2012 , 10:50am

And will this make RBS a better prospect and if so when?

TrafficCop 05 Oct 2012 , 11:47am

I think this article ignores soon of the negative aspects of this IPO (which is when the promoters tend to only push the positive attributes). This is what I said on the ShareSoc blog recently:

Direct Line, the personal insurance operation of RBS, is being partly sold via an IPO. Individual shareholders can participate via their brokers. Having studied the prospectus (all 350 pages of it, with of course endless warnings about the risks associated with the shares), it is worth making a few comments.

Like all insurance companies, the accounts are complex, so I’ll just pick out a few highlights. Only the last three years of revenue and profits are supplied. Revenue in that period was effectively static, and profits variable. Operating profit ranged from £166m in 2009, thru a loss of £206m in 2010 to a profit of £422m in 2011. Averaging those out, you can see that net margins as a percentage are quite low and hence are vulnerable to market swings.

If one looks back into the history of this company, it obviously grew rapidly historically when the old “broker” sales channel model to retail customers was superseded by phone and internet direct operations (as pioneered to a certain extent by Direct Line itself). But now price comparison sites are taking more of the business and eroding insurers control over their sales channels.

56% of revenue comes from motor insurance (if one includes the German and Italian operations), which is a notoriously cyclical insurance sector. In the UK it is now subject to a Government inquiry and fraud is an increasing problem (false “whiplash” claims, and fake accidents). The activities of claims management companies have also increased costs rapidly.

The overall Combined Ratio shows that the company actually makes a small loss on insurance underwriting and the profits therefore only arise from other activities (such as the return on investment activity of the retained premiums). It is a particular problem in the motor insurance area.

Return on equity, one of the key performance ratios for any business, only reached 10% in the good year of 2011.

So in summary, it looks like an ex-growth business with some strategic and market challenges. But there is a price for everything, and analysts are suggesting that the anticipated price range of between 160p and 195p may make it look quite cheap on a multiple of net assets basis in comparison with other insurers. It is also expected to pay a relatively high dividend.

But RBS is only selling a part of the business initially with the rest to be placed later (as it needs to dispose of it completely by the end of 2014).

For private investors, you may want to stand on the sidelines until any “share overhang” arising from the large stake yet to be disposed of by RBS is out of the way. It is always tricky when there is one dominant and major shareholder in a public company. Or if you want a stake in this kind of business, simply compare it to other general insurers such as Aviva or RSA, which are both on high dividend yields, before deciding.

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