Stockwatch: Attractive for stellar income

Is it onwards and upwards for shares in FTSE 100 non-life insurer Direct Line, or are they due a period of consolidation? Might they also still be attractive for income? The chart shows strong, if quite volatile, progress since flotation at 175p in October 2012. 

Interestingly, when I first drew attention near 200p that November, it was along a rationale of offering "a respectable yield, 5-6% prospectively, about twice covered by earnings, where the board probably feels it must pay a progressive dividend to attract support and the market prices it low enough for a generous yield to compensate for low capital growth prospects".

In practice, this has been a 53% return by way of accumulated dividends alone, on 200p, with the stock also up 105% to about 410p currently (having reached 416p after the latest results). In a highly competitive industry, Direct Line appeared mainly a yield situation back then, but management has succeeded both in eliminating costs and driving growth - enabling capital value to transform, besides declaring special dividends. 

One key question, fundamentally, is how much longer they can sustain such an attractive mix after three years. It may be early days to assert a resistance level, but, technically, the stock has now twice tested an all-time high of about 415p this year, then slipped.

Robust cash flow helps dividend growth

The 1 March prelims show end-2015 cash of £963.7 million, despite affirming a total 36.3p in special dividends, additional to a 4.5% increase in the total dividend to 13.8p.  The cash flow statement clarifies £327.1 million deriving from disposals (the sale of the international division in September 2014).

It generated £42.1 million from operations versus £410.6 million absorbed in 2014, while cash generated from insurance assets more than halved to £503.1 million. So mind that the cash flow profile is lumpy year-on-year. A relatively modest £67.9 million was spent on property/plant/equipment and £75.5 million buying intangible assets, down 20% despite management saying it has been actively updating capabilities including digital in pursuit of growth. 

Motor insurance enjoyed 7.1% fourth-quarter growth, with Direct Line the UK's largest motor insurerWith only £61.3 million bank borrowings, the cash position at least underwrites medium-term growth in ordinary dividends.

Mind also that, in context of £2,630 million equity, there are £521.1 million "subordinated liabilities", clarified in note 11 as £500 million fixed-rate 9.25% notes generating £37.6 million interest expense - expensive debt, relative to £545.1 million operating profit. These were issued in April 2012 and nowadays look askance in context, although the balance sheet is strong enough to support them.  

Analysts' dividend forecasts vary from 14.6p to 26.8p per share for 2016, relative to a 22.3p consensus in the table, and 20.3p to 27.7p for 2017 against a 24.5p consensus.  These median values alone imply an attractive 5.5% to 6.0% prospective yield, the top-range projections coming from Numis Securities on 16 February.

Together with the group cash flow profile suggesting a business strongly placed for payouts, this makes Direct Line attractive for income and provides intrinsic support. 

Profits boosted by recoverable claims

Another positive is return on tangible equity up from 16.8% to 18.5% year-on-year, as pre-tax profit rose 11% to £507.5 million, ahead of analysts' expectations. However, the consolidated income statement shows this can be interpreted as resulting from £162.4 million "insurance claims recoverable from reinsurers" which jumped from £51.2 million in 2014. Such are the variations in a large, complex insurance group. 

This aspect rescued profits growth - otherwise the income statement shows total income slipping 2.4% to £3,269.8 million versus total expenses down 6.4% to £1,057.8 million. 

The broad upshot is a modest growth scenario, as befits a highly competitive industryWithin a 1.7% rise in gross written premium from continuing operations, to £3,152.4 million, motor insurance enjoyed 7.1% growth in the fourth quarter and 4.8% for 2015 as a whole, helped by premium rates increasing (amid rising claims costs also) - Direct Line being the UK's largest motor insurer. The home insurance market has seen deflation in premiums albeit stable underlying pricing in fourth-quarter. Rescue and commercial markets were more competitive during the year. 

So, the broad upshot is a modest growth scenario, as befits a highly competitive industry, and it's fair to question what further costs can be extracted after management has done this all the while since listing. 

Direct Line says it wants to make insurance much easier and better value - "to lead and disrupt the market" - although, despite high-profile advertising, I've not personally found Direct Line policies to be attractive value. With regard to income credentials, however, dividends are projected 1.2 times covered by earnings, against no great investment needs.

Scope for more special dividends

Direct Line and other financial stocks are poised for volatility, should European Union (EU) referendum opinion polls swing towards a 'Leave' vote. The chief financial officer expects instability from group investments in a Brexit scenario: "We have a large portfolio - sterling might weaken, gilts might weaken." 

In a yield-conscious climate, Direct Line remains attractive despite EU referendum uncertaintySuch a change could also affect European Solvency II capital rules for insurers, effective this January. Direct Line recently had a strong solvency capital ratio of 147.4% under the standard approach, where a figure of 100% implies an insurer's capital aligns with its underwriting, investment and operational risks. 

Analysts at Barclays reckon Direct Line's internal model is more rigorous than the new approach, hence scope for a Solvency II-related special dividend. The 2015 prelim statement doesn't entertain this, yet under-promising and over-delivering is wise financial PR.

Shareholders rotate from growth to income

Company REFS cites the annual average price/earnings multiple having risen from 8-9 times during 2013/14, to 11.4 in 2015. The latest consensus forecast implies 14-15 times - i.e. pricey for a major insurer. In a yield-conscious climate however, Direct Line remains attractive, despite uncertainties linked to the EU Referendum. The likely upshot therefore is growth-oriented investors tending to lock in gains, with dips providing an opportunity for income-seekers.

For more information see their website.

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.