Stockwatch: This high-yielding share is special

Is a soaring share price rational for FTSE 100-listed insurer Direct Line Insurance Group, or another example of markets becoming exuberant once again? After Direct Line floated at 175p in October 2012, it bumped along in a 200p to 250p range during 2013 and analysts at Shore Capital have kept issuing 'sell' advice.

Admittedly UK insurance - especially home and motor - is a highly competitive area lacking the "moats" conducive to long-term investment returns. They are expected to alternate between periods of price deflation and stability. Yet, when I drew attention to Direct Line as its price tested 200p in November 2012, it appeared to me that the stock offered a prospective yield of 5-6% twice covered by expected earnings. Management was also vigorously taking out costs, therefore its risk/reward profile was attractive.

The chart has shown excellent if quite jagged progress to 342p, with some investors wary. Hence, it was possible to draw attention at 206p in May 2013 and again in October 2013 at 208p after two brokers advised 'sell' despite the prospective yield edging up to 6.5%. I suggested this ought to be a prop and the subsequent 64% re-rating (before substantial dividends) shows how the dynamics of equity yield situations can be dramatic also for capital gain.

Third of 2012 IPO price already returned to shareholders

Such has been the strength of dividend payouts - regular and special - that £836 million or 31.9% of the initial public offering price has already been returned to shareholders. To some extent this has resulted from restructuring/cost cuts, but two special dividends followed from surplus capital "in part reflecting the group's disciplined approach to underwriting over the last few years."

Last September's sale of the international division for £430.1 million implies another special dividend ahead, pending one outstanding regulatory approval expected to complete in the first half of this year.

So it's possible the stock has risen over 20% since last year partly due to institutional buyers chasing this next bumper payout - also considering they don't pay tax, whereas individuals could get hit at the top rate. The total sale price implies something near 29p a share, if just a ballpark figure.

Company REFS' statistics (see table) are bitty and quote only one recent forecast - on 9 February from Numis Securities which is an independent broker. It implies a price/earnings multiple over 14 times and total dividends of 62.5p expected for 2015 - an alluring near-term scenario worth holding for. With fresh money, however, it becomes necessary to consider where the ongoing business will stand, and the yield credentials for its shares. Total "regular" dividends for 2014 were 13.2p "in line with the group's policy to increase the dividend annually in real terms" - so, assuming a medium-term prospect of about 15p then the yield is about 4.4%, i.e. pretty supportive.

If markets crash in a Crispin Odey conflagrationthen yes there is downside risk; otherwise the stock can be bought for the next special dividend with reasonable confidence, and returns thereafter.

What's special about Direct Line's insurance business?

Management proclaims a strategy of making insurance much easier and better value for customers - a respectable if somewhat vague quality whose upshot can only be judged by way of revenue trends. Prelims have confirmed 2014 gross written premium from ongoing operations, 3.8% lower, said due to more judicious underwriting of motor and home premiums. The trend improved through the year, rising 0.4% like-for-like in the final quarter. More definitive revenue progress is really needed and it’s worth appreciating the current context.

New websites have been launched for example in motor, the "quote to buy" process via PC's, smartphones or tablets making buying easier; also the claims service has been improved and telematics evolved with a self-install device. Data generated this way has helped inform pricing decisions, enabling Direct Line to reward its customers for better driving.

Regarding claims, smartphone feedback via photos and video has speeded up settlement and reduced fraud. Other improvements include faster car repair times, sourcing a replacement car in the event of total loss, and providing household goods' replacements in eight hours. On a group level, costs have been cut by 5.6% and changes in IT infrastructure are expected to complete this year leading to further efficiencies. So, despite lower 2014 premiums having been written, a combination of factors hints at good underlying progress. The year also saw a strategy review to ensure Direct Line is attuned to its continually changing environment, which affirmed its priorities and also the UK as its core market.

Sound progress since listing, not stripping for cash

The company has met or exceeded all its efficiency targets and says it has also invested to support future profitability. For 2014 the "combined operating ratio" improved 0.2% to 95.0% - this ratio compares claims' costs, commission and expenses versus net premium generated. It enabled the ongoing operations to deliver stable operating profit of £506 million versus £509.9 million for 2013 while their pre-tax profit rose 12.2% to £456.8 million.

Total dividends for 2014 were 27.2p, up 32% on the year and representing an historic yield over 10% (assuming a median 2014 share price). So when also considering the special dividend scope for 2015, understandably this stock is in demand. As a "financial" it will remain quite sensitive to market volatility, hence worth watching in months ahead - say if any of the risks from Greece to Russia or China, prompt another bout of falls. Direct Line's dividend credentials ought to provide a back-stop, with an ongoing supportive yield as management continues to improve efficiency.

For more information see directlinegroup.com.