Will Direct Line Soar At IPO?

Published in Company Comment on 3 October 2012

Direct Line is being spun out of Royal Bank of Scotland (LSE: RBS). Is this a great opportunity to profit from an IPO?

Did you know that the insurer Direct Line is part of Royal Bank of Scotland (LSE:  RBS)? Direct Line is, in fact, a group of companies providing insurance and related services. Other parts of the group include Churchill ("ohhhh yesh!") and Green Flag.

Following its bailout by the government, RBS was forced to sell some of its assets. RBS must dispose of its entire stake in Direct Line by the end of 2014.

RBS is selling between 25% and 30% of the company in one of the most closely watched IPOs of recent years.

Direct Line has committed to offering shares to investors in the range 160p-195p. This is a substantial reduction on what analysts were expecting a few months ago.

So have Direct Line's prospects changes materially? Were those analysts wrong, or is this a great opportunity to buy into a company at a discount price?

Recently, Direct Line issued its investment prospectus. This document provides a wealth of information to help investors appraise the opportunity. Insurance company accounts are notoriously difficult for private investors to understand. However, I have picked some of the key numbers.

Profits

The uppermost question in assessing a share has to be: is the company profitable? In the first six months of 2012, Direct Line made a pre-tax profit of £106.5m. However, £176m of this was investment income. This means that, currently, Direct Line is not making money from its insurance operations.

While this is a cause of some negativism, it is not unique in the sector. The income an insurer can make by investing premiums is a key part of the business.

Assets

What will investors get for their money? As of the last balance sheet date (30 June), Direct Line reported a net tangible asset value of 167.7p per share. As a rule of thumb, I've always believed that profit-making insurance companies should trade at a premium to their net tangible asset value. Since then, Direct Line has paid a £200m dividend to RBS. This dividend payment reduces what is left for new shareholders.

Dividend

In Direct Line's 2012 financial year, the company paid £800m to its owner RBS. However, it is clear that this level of payout will not be sustained. Instead, Direct Line plans to pay 50-60% of profits out to shareholders in dividends. This suggests a dividend yield of 6-7%.

Just because Direct Line is being sold, that doesn't mean that it is the only share you should consider buying. Below, I've compared Direct Line with some of its sector peers. The numbers for Direct Line are my estimates, based on the middle of the IPO range.

CompanyPrice (p)Net asset value (p)P/E (historic)Yield (historic, %)P/E (forecast)Yield forecast, %)Market cap (£m)
RSA (LSE: RSA)1111027.98.39.38.53,940
Admiral (LSE: ADM)1066N/A*13.15.311.88.02,890
Aviva (LSE: AV)324395N/A**8.06.77.99,260
Direct Line177.5193.710.730.18.96.22,650

* unable to obtain a figure

** previously loss making

Clearly, the entire sector is cheap. The price-to-earnings (P/E) ratio and yields available mean the shares above are all cheaper than the average FTSE 100 (UKX) stock.

Direct Line is clearly being priced at an asset and earnings discount to RSA and Admiral, its closest peers.

One problem, though, is the recently announced Office of Fair Trading (OFT) investigation of the motor insurance industry. The OFT has that it has "grounds for suspecting that there are features of the market that prevent, restrict or distort competition". An unfavourable ruling could damage the long-term profitability of the sector.

However, there is another factor that could mean that Direct Line is a great opportunity for a low-risk investment. It appears that Royal Bank of Scotland hopes to begin reducing the Government's stake in the bank by 2014. While it is possible some of Government's RBS shares may be bought back by the bank, it is likely a sale back into private hands will also be pursued. To help create an environment that makes such a rehabilitation possible, it is important that the Direct Line IPO is a success.

A good return for IPO investors will help foster the idea that buying bits of RBS is good for your wealth.

Private investors have got until 9 October to take up the offer. The exact price will depend on demand for Direct Line shares. On 11 October, Direct Line is scheduled to announce the price that shares will begin trading at. Direct Line shares are expected to start trading on the Main Market of the London Stock Exchange on 16 October.

Investors considering taking up the Direct Line IPO will likely be deterred by other recent launches. Glencore (LSE: GLEN) came to the market in May 2011 at 530p; the shares now trade at 342p. Online grocery distributor Ocado (LSE: OCDO) shares can be bought for 66p, little more than two years after its launch at 180p. Despite falling recently, Supergroup (LSE: SGP) has been a success (500p to 644p). The biggest of the lot, Facebook (NASDAQ: FB.US), has received an almighty thumbs-down. Since its IPO at $38, shares in the social network now trade for just $22.

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> David does not own shares in any of the above companies.

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Comments

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goodlifer 03 Oct 2012 , 4:37pm

FWIW, my hunch is they'll be available cheap after a week or two.
Perhaps worth buying then, they're not a bad company.

goodlifer 04 Oct 2012 , 10:39am

"Investors will likely be deterred by other recent launches.".

Including FCSS.

F958B 04 Oct 2012 , 11:24am

My general view of new flotations is:

"If it's such a good business, with good prospects; why is someone wanting to sell it and why haven't the venture capitalists snapped it up?".

apprenticeDRL 04 Oct 2012 , 2:34pm

F958B I dont think that RBS want to sell Direct Line, I believe it is a forced sell in response to reciept of Government aid during the banking crisis.

F958B 04 Oct 2012 , 3:22pm

But why doesn't anyone higher up the food chain want it, if it's being sold so cheaply?
Private investors are at the bottom of the list of priorities - only when nobody else higher up the food chain wants to take on an investment (other financials, venture capital, wealthy individuals/syndicates, pension funds etc), will be be offered to the general public.

Like the big money; I'll pass on this one.

I am also very cautious on the financial outlook for 2013-14; I've been using gearing very profitably for the last three years, but I've been selling quite heavily recently in order to raise cash to pay-down the gearing ahead of what I believe could be a very turbulent period for financial markets.
I wonder if RBS also see turbulence ahead and are choosing to sell what they can, while they still can?

F958B 04 Oct 2012 , 3:26pm

If the overall market is going to experience turbulence, it's not RBS' fault if private investors who purchased DL shares take a hit.

"Unforseen adverse market conditions" would be RBS' get-out clause.

ANuvver 04 Oct 2012 , 4:17pm

Think I'll be passing on this one too.

If there was going to be a guaranteed tranche allotted to private investors large enough to foster demand in the wider market, I might feel differently. Absent that prospect and there's no clear benefit from getting in on day one, to my thinking.

apprenticeDRL 04 Oct 2012 , 5:32pm

I commented on another direct line article published today. Principally although I have registered for the IPO I think I am going to wait a couple of months and see which way the share price heads after listing before making a decission.

Personally if the markets sink a bit in the comming year then for me I would look at the buying opportunities rather than seeing this as necessarily negative.

I do take on board your thoughts about institutional investors buying the majority of the shares, but I thought this was going to be the case? as there only appear to be a couple of brokers handling the IPO for for PI's. I have had to register with a different broker than the one I normally use in order to have the option to purchase through the IPO.

ANuvver 04 Oct 2012 , 6:08pm

apprDRL:

You might have put your finger on it. My main broker (TDW) dangled it, and I know a few others have, but RBS don't seem to have gone out of their way to make it available to the public. More of a "Don't Tell Sid" attitude.

Problematic partial forced privatisation. Wow. I think I'd better think it out again...

The corollary of this is that the thing is bound to gatecrash the FTSE100 immediately, so it would seem to make sense to allocate heavily to institutional buyers. Who may be reluctant, but for various reasons will have to buy.

The vintage 1980s privatisations offered almost guaranteed stagging profits (mostly), because big players would have to come after your little allocation. This doesn't seem to be the same kind of situation at all. In the current climate, RBS has to be seen to be getting the best price it can from the spin-off. Granted, they'll subsequently be disposing of more over the next year or so, so some kind of price planning is essential, but it'll be carefully balanced.

The lure to private investors seems to be a promise of a progressive dividend policy. Which is very hard to value or trust, when DL is being spun out of a major bank's accounts.

Far too many imponderables, and not much margin for the little fish. I reckon.

F958B 04 Oct 2012 , 6:24pm

apprenticeDRL

If you are not sure about when to buy an investment, consider buying half now and half at a later date.
You neither "miss out" on an uptrend, nor are "all in" just before a share price slump.

goodlifer 04 Oct 2012 , 7:42pm

apprenticeDRL
"I don't think that RBS want to sell Direct Line, I believe it is a forced sell in response to receipt of Government aid during the banking crisis."

If you're right - and I believe you are - that's a good reason for expecting the issue to flop.
If I were trying to organise an IPO I'd only ever do it in a sellers' market, which is not exactly what we've got today.

goodlifer 04 Oct 2012 , 7:53pm

ANuvver,

If I remember correctly, you forecast the market was going to deep-six in September.

Just one more disappointment - what's the latest thinking?

goodlifer 04 Oct 2012 , 8:05pm

When the family silver was sold off the eighties, it was a totally different, historically unique, unrepeatable exercise.

A voters' benefit, part of an election campaign.
It was like finding money in the road - those were the days!

F958B 04 Oct 2012 , 8:57pm

Hi goodlifer.

I gave my view on the market outlook here:

http://boards.fool.co.uk/ive-been-suggesting-for-a-while-that-markets-have-12641126.aspx

Since making the above and related postings, my gearing-reduction strategy has accelerated. As I stated in the above link: my portfolio is now only around 10% geared; down from about 20% a few months ago and 35% about a year ago.

goodlifer 04 Oct 2012 , 9:57pm

Thanks F958B,

I can hardly wait.

ANuvver 05 Oct 2012 , 12:52am

goodlifer:

ANuvver 05 Oct 2012 , 1:04am

I said I thought there will be a serious downturn during Sept/Oct.
So I was wrong.

I still think this IPO should be treated with a bargepole.

goodlifer 05 Oct 2012 , 12:44pm

ANuvver
Thanks,
But what's the latest thinking?

"I still think this IPO should be treated with a bargepole."

Could hardly agree more.

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