Stockwatch: Insider buying underlines US potential and special divi

Does insider buying in emergency home repairs business Homeserve flag value? Four non-executive directors have snapped up £363,331 of shares at prices from about 419.5p to 435.3p, versus 426p currently. That rates as genuine "cluster buying" which is more meaningful as director buying goes; i.e. not a case of executives buying to make subsequent big grants of share options look acceptable, or get free bonus shares.

The non-execs are facing risk on the same basis as outside investors, unlike with options. Their buying comes now Homeserve is out of its closed period for 2014/15 prelims, and after the Mid-250 shares have risen 30% this year. Despite the chart showing a three-year recovery from 138p, clearly the non-execs sense upside, and technically the stock is 19% below its 2011 high. A special payout of 30p per share this July will be one motivating factor, but the underling prospects also look good.

Turnaround from a major mis-selling scandal

Homeserve is achieving a major transformation after a glaring verdict on mis-selling. After a lengthy investigation, in February 2014 the company was issued with the largest-ever fine for using hard-sell tactics and misleading information. Consumers were persuaded to buy policies they may not have needed, complaints were not examined adequately, and compliance issues and risks to customers were overlooked. Staff had been motivated to achieve sales regardless whether the policies they sold covered what they claimed. Including restitution to customers the total cost was in the order of £70 million.

Yet the forecast profits recovery (see table) implies the market's savaging of the shares from 532p to 138p in 2011/12 was overdone; the UK business has lost far fewer customers than feared. Indeed, the chief executive says: "We have transformed the business, rebuilding and strengthening the management team, retraining staff and restructuring systems and controls". Customer reviews at the likes of Trustpilot have substantially improved to score an overall 7.7 out of 10 helping these insurance policies prove resilient versus independent plumbers/electricians.

Clearly, enough people prefer the peace of mind of a services contract than seek out independent traders - especially in case of emergency. Moreover, the much bigger US market has had no reputational hurdle to overcome and management looks to have its act together. The stockmarket is, therefore, steadily gaining a sense of "New Homeserve" as the business overcomes caution.

Earnings' rating is up with events; but the US offers significant upside

At first sight the rating looks high enough: a forward price/earnings (P/E) multiple of 22 reducing to 19, versus earnings growth in the mid-teens percentages; and a modest ordinary dividend yield of 2.7% covered 1.8 times by earnings. Annual average P/E's have been lower: Company REFS cites 9/11/17 over 2012/13/14 respectively, albeit when the earnings trend was disrupted. Homeserve made over £100 million pre-tax profit as recently as 2011 and 2012 and overseas prospects are now stronger with 67% of customers now in the US and continental Europe, quite the opposite of the split just a few years ago.

Prelims to end-March 2015 showed moderate progress, while increasing marketing investment in the USA by £12 million equivalent. Homeserve's marketing significantly depends on "affinity partners" with utilities and similar. Total customers rose from 5.5 million to 6.3 million with net debt rising from £42.3 million to £64.1 million, although this involved a reduction in cash rather than increased borrowings. Performance is flat overall in the UK which had the same 2.1 million customers at the financial year-end and a retention rate of 83%, representing 64% of group operating profit.

More positively, US customers rose 26% to 2.0 million helped by 12 new utility partnerships and test marketing with AARP, a lifestyle improvement group for the over-fifties that has been a new partner since last November and offers 22 million households' potential. This progress is encouraging given the scale of US market opportunity - the business development team has been doubled to 20 and will increase further to cover 1,445 prospective utilities. The pipeline of potential new partnerships is described as strong, and an 82% customer retention rate is similar to the UK.

Trading is mixed if generally good in continental Europe. In France, customer numbers edged up 3% and profits by 11% in local currency, helped by a continued high retention rate of 89%. An affinity partnership with Lyonnaise des Eaux this last March provides access to 5.3 million households, a potential boost. Spanish operating profit nearly doubled, but margins are only a third of those in France, hence comparatively lower operating profit.

Investment in "new markets" such as Italy will continue at about £6 million annually, although Italian business is small as yet and the German business is being exited to prioritise Homeserve Alliance, a UK franchise network of independent heating installation and repair businesses - based from a digital hub in London. Altogether the new markets division continues at an operating loss near £6 million. IT systems are being upgraded to improve customer offerings and efficiency, meaning capital investment will increase this year then normalise at about £25 million in 2018.

Special dividend of 30p a share this July

Given the ongoing investment and reduction in balance sheet cash from £96.2 million to £74.7 million, returning £97.0 million cash can look excessive. A return was entertained at last November's interims but only quantified at prelims. Equivalent to 30p a share, this alone represents a 7% gross yield so is an attractive lure - and likely why the shares twice traded up to 437p after the 19 May prelims, but have settled back possibly as the P/E is also considered.

Personally, I prefer better ordinary dividends and special payouts to apply chiefly once an investment programme matures to throw off excess cash. Special payouts are soon forgotten whereas a higher ordinary dividend keeps new investors interested and establishes more of a prop to the shares - mitigating volatility. The board explains its policy in terms of increasing leverage for "a more efficient capital structure" and says this will increase the annual interest cost (there already being £137.6 million bank debt) only by about £2 million. Last year's finance cost was £2.6 million versus £79.1 million operating profit, with only £0.2 million income on cash-at-bank, so the financial statements can take this change. A share consolidation is also proposed.

For more information see: homeserveplc.com.