Venture: Mid-Cap Insurance

Issue 18;

Beep beep.

Direct Line (DLG)

“Direct Line Group is one of the largest insurance companies in the UK and home to several well-known insurance brands. Our mission is to be brilliant for customers every day. We have some of the strongest and most recognisable insurance brands including Direct Line, Churchill, Green Flag, NIG and Darwin. Through these trusted brands we offer a range of insurance products that help protect customers motors, homes, holidays, pets and businesses.”

DLG is the second largest car insurer in the UK (10.8%), behind Admiral (14%). Over the past decade, the number of insurance companies has fallen by 30%. An excellent overview of the industry has been done by Confused.com.

UK residents will remember DLG’s adverts selling car insurance back in the day, and it became a household name. Then things went wrong. There was regulatory creep, competition from the compare sites and, more recently, the pandemic and refunds to customers following an overcharging scandal.

The problem has been the divergence between premiums and claims. Looking at the surge in premiums, you might be surprised to hear that claims rose faster. The insurance companies have had to pay more to fix cars due to shortages of parts and such. My car was stuck with the dealer for an MOT for 10 weeks while waiting for a part that had previously been made in Russia. Add in the Suez Canal, the pandemic and so on, and it soon becomes clear how and why this has happened.

Insurance Premiums Have Surged

Direct Line recently hit a wall. Insurance companies live or die by their “combined ratio”. This measures the sum of the claims and costs divided by premiums received. A number above 100% shows losses, and a number below shows profits. After years of profitable underwriting, losses mounted after the supply chain disruptions, but at least we know how we got here.

Direct Line Combined Ratio

Insurance companies also generate investment income because they hold onto the premiums until the claims are made. With higher rates, that’s an important contributor. It hasn’t worked out yet because exceptional compensation payments have been made to customers. The bull case for DLG is this is peak bad news.

The good news is the supply chains are improving again, and the premiums ought to be high enough for the tide to turn. You can already see that DLG has seen a notable jump in earnings forecasts. The analysts’ consensus forecasts have called the trough. Of the 17 covering the stock, 10 are buyers, 7 holds, and one is sell (last update Sept ’23). Their target price is 200p against the current price of 164p. That’s not huge, but here’s the interesting bit.

Direct Line and Expected Profits

DLG also had a balance sheet or a regulatory capital problem. Following the disposal of a subsidiary called Regulatory Lines for £520 million, this has gone away, and the bond market is telling us that DLG is now a stable credit. Better still, this disposal was in a different area of the insurance market and so not a competitor.

As usual, I am attracted to the value on offer, which is appealing. The market cap is £2.1 billion, with cash of £1.6 billion and debt of £453 million. That’s an enterprise value of £1 billion for a company worth £5 billion a decade ago. Looking at its competitor, Admiral (ADM), life in the UK car insurance has been tough but has turned the corner.

Direct Line vs Admiral

DLG trades on 6.3x ’24 earnings. It may pay a dividend (10p, perhaps?) in April. The trading statement in November showed 27.6% growth in premiums, with claims in line with assumptions. Jon Greenwood, Acting CEO, commented:

"Throughout Q3 we have continued to address our three key priorities: to restore our capital resilience, improve our performance in Motor and maintain our performance in our other businesses… We are confident that the decisive actions we are taking sets the Group up for improved performance going forward."

If that’s true, these shares are undervalued. The next full-year update comes on 21 March, and that will be delivered by the new CEO, Adam Winslow, who was head of Aviva’s UK and Ireland general insurance business.

Finally, we ought to trust the charts. The 200-day moving average is positively sloping, which implies things may be improving.

On the shareholder register, it is reassuring to see good managers from Majedie, Liontrust and Polar Capital, who are experts on the insurance sector.

Risk

The problems stem from rising claims in recent years and increased regulatory scrutiny. With higher premiums, a repaired balance sheet, and the problems being addressed, that is the opportunity. But, to be clear, things could go wrong. The shares are liquid, with £5m trading per day. Volatility has been high but seems to be cooling. There are uncertainties, and I deem this to be high risk, although cheap, and see more upside than the analysts’ consensus.

Venture Update

Mobico (MCG) took a knock as it announced delayed results relating to its German subsidiary. This is deemed to be overdone. Speedy Hire (SDY) modestly lowered guidance, while Fisher (FSJ) was hit by a share sale from their charitable foundation. These have all been the worst performers. What they have in common is debt. I have looked at their balance sheets and deemed them to be highly likely survivors and, therefore, undervalued into a recovery. It is notable that the market is currently harsh on small and mid-caps with debt, even if they are able to support it.

No action, but it is a good reason to be even more conservative on balance sheets in future. Market conditions change, and sometimes, such as in 2009, weak balance sheets perform best.

Plus 500 (PLUS) posted good results. The gold stocks are ready to move on a firmer gold price, and I will be looking at oil stocks.

The pricing review for Venture has been under discussion, and we will be in touch soon. In the meantime, please carry on.

Please let me know your thoughts by emailing me at charlie.morris@bytetree.com or tweeting me @AtlasPulse.

Many thanks,

Charlie Morris

Editor, Venture