Direct Line: Still in “Too Hard” Bucket After H1, Despite <10x P/E

Company Update (DLG LN) (Neutral)

Highlights

• Shares rebounded 20% in 2 days but are still down 35% from 2021

• Mgmt. believes they are now writing Motor policies with a 10% margin

• Solvency Ratio is significantly above target after an asset sale

• With shares at 180.75p, run-rate revenues alone imply a P/E of <10x

• However, past mis-steps suggest more fundamental problems. Avoid.

Introduction

We review our Neutral rating on U.K. general insurer Direct Line after the company released H1 2023 results on Thursday (September 7). Shares have risen 20.4% in the subsequent two days:

Direct Line Share Price (Last 1 Year)

Source: Google Finance (08-Sep-23).

Direct Line’s share price remains 35% down from 2021 year-end and has fallen 44% in the past 5 years.

We have followed U.K. insurance stocks for close to a decade, with Admiral being our preferred pick in the sector in recent years (see our June article for a recap of our investment case). We wrote about Direct Line in March after 2022 results, taking the view that it had too much uncertainty and should be avoided. Since then Direct Line has underperformed Admiral (gaining 19% vs. Admiral’s 28%, including dividends), though the rebound in the last two days means Direct Line shares have outperformed Admiral shares by 17% this week.

There are arguments that Direct Line stock is cheap even after the rebound. Management stated that they are now writing new U.K. Motor policies at a 10% Net Insurance Margin, also their “ambition over time” for the group. H1 run-rate net revenues alone imply a normalized P/E of just 10x, before the new Motability business, further price increases and higher investment income. Solvency Ratio will be 10 ppt higher than the top-end of the 140-180% range once an agreed asset sale is completed, and will rise further from reserve releases and potential earn-outs. The dividend is likely to be re-instated in Q2 2024.

However, limited reserve releases may hinder the Net Insurance Margin until 2026. Direct Line’s recent record also suggests more fundamental problems. Motor Claims Ratio was 30.5% worse year-on-year, as management did not raise prices sufficiently until later in 2023, had under-reserved for some 2022 claims, and has two ongoing reviews about regulatory breaches. The estimated cost of one of these breaches has already had to be revised upwards less than 3 months after the original announcement. With insurance being a highly-levered business, we are uncertain that targets will be met and uncomfortable with the potential downside.

For Admiral, the read-across is positive. Direct Line was the main threat and is clearly weakened. Direct Line’s Motor claim cost inflation in 2022 is now unquestionably worse than Admiral’s, reaffirming the latter’s cost advantage. Moderating claim cost inflation and continuing price increases in 2023, as well as the admission that Direct Line had only belatedly priced its policies correctly, all support our view that Admiral will resume volume growth soon.

Direct Line H1 Results Headlines

Direct Line lost money in H1 2023, with a negative Net Insurance Margin of -6.4% and an Operating Loss of -£78.3m:

Direct Line Results Headlines (H1 2023 vs. Prior Periods)

NB. Prior-period figures restated under IFRS17. Source: Direct Line results release (H1 2023).

The core Motor business caused the loss, with a negative Insurance Service Result of -£183.8m, worse both year-on-year and half-on-half. Net Insurance Margin was a negative -26% for Motor but a positive 12% for the rest of the group. Net Investment Income also improved by 46.7% year-on-year, largely thanks to higher interest rates.

However, reported H1 2023 results reflect the outcomes of insurance policies written in the past 12 months as well as historic claims, which means they do not fully reflect current underwriting performance. Management made this point repeatedly on the earnings call, for example with CFO Neil Manser stating that:

“The key point to note here (in Motor) is that the first half earnings are not representative of the profit of the business we are writing today.”

There is certainly a time lag between the decision to raise prices and the entire customer base (mostly on annual contracts) being repriced upwards. (This dynamic is a key part of our Admiral investment case and materialized as expected in its H1 2023 results.) In Direct Line’s case, even though inflation started to accelerate significantly after Russia invaded Ukraine in late February 2022 and Direct Line has been raising its prices as policies are written, their average earned premium in Motor in fact continued falling until Q4 2022:

Direct Line Motor Written vs. Earned Average Premium (Since Q2 2022)

Source: Direct Line results presentation (H1 2023).

Management believes Direct Line has improved its Written Loss Ratio by 18 ppt between Q2 2022 and Q2 2023, reaching a Written Loss Ratio of slightly over 80% as of the latest quarter:

Direct Line Motor Predicted Written Loss Ratio vs. Average Written Premium

Source: Direct Line results presentation (H1 2023).

Including expenses and other revenues, management believes the Motor business is “now writing at loss ratios consistent with a 10% Net Insurance Margin” under IFRS17. This compares with a 11.3% margin for H1 2022 (restated under IFRS17), which was described as “challenged” with “uniquely complex motor market conditions” at the time.

Management comments indicate the Motor P&L will report a 10% Net Insurance Margin in around Q2 2024, because by then all the in-force policies will have been written at the pricing level reached during Q2 2023, believed to enable a 10% Net Insurance Margin. As shown above, however, the average earned premium in Q2 2024 (£472) is still expected to be around 4% lower than the average written premium (£492) in Q2 2023.

Management “have an ambition over time to generate a net insurance margin of above 10%” for each of the areas in the group. If they achieve this, then Direct Line may have a normalized P/E of just 10x on run-rate net revenues alone.

Run-Rate Revenues Imply 10x P/E

We attempt to estimate Direct Line’s normalized run-rate earnings based on management comments.

For H1 2023, Direct Line had a Net Insurance Revenue of £1.45bn and an Insurance Service Result of £93.4m (implying a Net Insurance Margin of -6.4%) on an ongoing basis; this gave an Operating Loss of £78.3m:

Direct Line P&L (H1 2023 vs. Prior Year)

Source: Direct Line results release (H1 2023).

Applying a 10% Net Insurance Margin and other simplistic assumptions (including keeping all other P&L numbers the same as in H1 2023 but omitting one-off items), we arrive at a run-rate Profit After Tax of £228m, implying a P/E of around 10x (relative to the current market capitalization of £2.38bn):

Direct Line Run-Rate Earnings Estimate (H1 2023)

Source: Direct Line company filings, Librarian Capital estimates.

The £228m figure is likely to be a significant underestimate, because of a number of factors not included:

• The new Motability business is expected to go live on September 1. Direct Line expects this to bring 700k customers and to generate around £700m of gross premiums annually. The business will be 80% reinsured.

• Further price increases will follow each month as Direct Line continues to adjust prices in line with claim cost inflation, still expected to be in high-single-digits in 2023.

• Investment income will increase again in 2023 as the income yield on the investment portfolio continues to rise with higher rates, from 3.2% in H1 2023 to an expected 3.4-3.5% for the full year

Partially offsetting these, Direct Line finished H1 2023 with 3.2% fewer in-force policies across the group (including 4.2% fewer in Motor) than at the end of 2022. Overall, it is clear that normalized earnings will imply a P/E of 10x or less.

Solvency Ratio Above Target After Asset Sale

Direct Line has repaired its Solvency Ratio by agreeing to sell its brokered commercial insurance business (NIG), which is expected to generate an initial uplift of around 45 ppts, pushing the ratio to above 190% (vs. 140-180% targeted):

Direct Line Solvency Ratio Walk (2023 YTD)

Source: Direct Line results presentation (H1 2023).

The 45 ppt benefit reflects the upfront consideration of £520m and capital relief from selling the front book. Management expects “further benefits of around 10 ppt over time from the natural paydown of existing claims reserves as well as the prospective earnout” (of “up to £30m”). If Direct Line also sells the back book to the same buyer (Intact-owned RSA), which it has not done for now for practical reasons, the claims reserved will be released even faster.

Dividend Likely to Return in Q2 2024

The dividend, suspended since the profit warning in January 2023, seems set to be restarted in Q2 2024, as CFO Neil Manser explained on the call:

“We've set two conditions for restarting dividends. The first is to restore capital resilience which has been met by the proposed sale of NIG. The second is a return to organic capital generation in Motor. Now we've made good progress on a written basis, and the Board will review how this business develops over the second half of 2023 and early 2024 before deciding whether this condition has been met.”

Given the Solvency Ratio will be 10 ppt higher than the 140-180% targeted once the NIG sale has been completed, the intent to not restart dividends until 2024 appears to be motivated by the desire to see the 10% Net Insurance Margin actually materializing in the P&L instead of merely being predicted. Restating the dividend in Q2 2024 would also follow the scheduled Q1 2024 arrival of new CEO Adam Winslow, currently head of Aviva’s U.K. & Ireland business.

10% Margin Target vs. Track Record

The 10% Net Insurance Margin target is probably realistic over time but may not be achieved until 2026.

A 10% Net Insurance Margin under IFRS17 is likely to be equivalent to a 97% Combined Operating Ratio (“COR”) under IFRS4. While no reconciliation between the two figures is available, CFO Neil Manser stated that the Net Insurance Margin figure was probably around 7 ppt better overall. Also, restated H1 2022 results under IFRS7 had a Net Insurance Margin of 11.3% while original results under IFRS4 had a Combined Ratio of 96.5%, indicating an 8 ppt benefit).

Direct Line’s COR was around 92% in pre-COVID 2018 and 2019, and around 90% in 2020 and 2021:

Direct Line Combined Operating Ratios (2018-22)

NB. 2021 figures restated to exclude run-off partnerships. Not pro forma agreed NIG sale. Source: Direct Line company filings.

(We believe historic Group COR figures are broadly comparable despite subsequent disposals and exits. Run-off partnerships were only 3% of 2021 Net Earned Premiums, and their exclusion only flattered the COR by 0.6 ppt. The Commercial segment was 23% of Net Earned Premium in 2022, but historically reported slightly worse COR than the group, and about 30% of the segment will be excluded from the NIG sale.)

While these figures superficially suggest Direct Line’s new target is realistic, the reality may be different because of reserve releases. Reserve releases contributed substantially to the COR figures and, excluding reserve releases, COR exceeded 100% in both 2018 and 2019. Reserve releases shrunk in 2020-21, which was why Direct Line’s COR was only 1-3 ppt better during the years most helped by COVID-19. (By contrast, Admiral’s U.K. Motor COR was 11 ppt better than 2019 in 2020, and still 7 ppt better in 2021.) After the bad underwriting during 2022 and much of 2023 (more below), management now “expect prior year releases to be minimal in the short term“.

Reserve releases may not start recovering until 2025 (on the back of H2 2023 and 2024 underwriting) and only return to normal in 2026, in which case the 10% Net Insurance Margin may not be achieved under 2026.

Mis-Steps Suggest Fundamental Problems

Direct Line’s multiple mis-steps also suggests more fundamental problems, which may prevent the 10% Net Insurance Margin target from being achieved.

The Net Claims Ratio in the Motor business was 30.5% worse year-on-year, an almost unprecedented deterioration. This consists of a 14.2 ppt worsening in the Current Year Loss Ratio and a 16.3 ppt reversal in reserve releases (from a 7.9% benefit to an 8.4% cost), and highlights a number of execution mis-steps:

Direct Line Motor Ratios (H1 2023 vs. Prior Year)

Source: Direct Line results presentation (H1 2023).

Direct Line did not raise prices sufficiently until later in 2023. CFO Neil Manser acknowledged that losses in Motor “primarily reflects the earning through of the unprofitable business written in 2022 and earlier this year (our emphasis)”. Average written premium in Motor showed a sharp acceleration in Q2 of 2023, implying a belated catch-up:

Direct Line New Business Premium vs. Market (Since Q2 2022)

Source: Direct Line results presentation (H1 2023).

As shown in one of the charts above, Direct Line is predicting a Written Loss Ratio of 80% for policies written in Q2 2023 and one of 90% for Q1. If an 80% Written Loss Ratio implies a 10% Net Insurance Margin, then the 90% figure for Q2 implies that polices written in that quarter were just breaking even.

Management had also under-reserved for some 2022 Motor claims. As part of H1 2023 results, £60m had to be added to reserves to reflect “some adverse development on damage claims, particularly in the last quarter of 2022”.

Direct Line also has two ongoing reviews about regulatory breaches, one on the amount of compensation paid for “total loss” Motor claims, and the other on overcharging renewing Motor and Home customers compared to new customers (FCA Pricing Practices Review regulations require both to be treated the same). These are expected to cost £40m and £30m respectively. £30m had to be added to reserves in H1 2023 to reflect these, including a “modest” increase in the “total loss” remediation costs less than 3 months after they were described as fully reserved for (on June 29).

The multiple mis-steps suggest a company that has been over-aggressive in pricing, reserving and estimating costs, indicating potential problems in culture, processes and/or information flows. These can be fatal to any investment case because, with insurance being a highly-levered business, any mistakes will have an outsized financial impact.

New CEO Unlikely to Make Much Difference

We do not believe incoming CEO Adam Winslow will make a dramatic difference to Direct Line’s model or performance.

While the Aviva U.K. business he been running since May 2021 has a solid reputation, Aviva has traditionally operated with quality-focused model, very different from the price-focused, cost-conscious model at Admiral and Direct Line. Similar comments can be said about his experience at AIG during 2014-20, mostly involved in their life and health insurance businesses.

In any case, a company’s culture can only be changed so much by a new CEO. Direct Line’s previous CEO, Penny James, was originally hired as CFO in 2017 following two years as a non-executive director at Admiral, likely an effort to replicate the latter’s success. Under her leadership, Direct Line embarked on major changes to their cost structure and IT systems, seemingly with negative results that included multiple profit warnings and ultimately her exit.

Conclusion: In the “Too Hard” Bucket

Overall, we are uncomfortable with the level of uncertainty associated with Direct Line.

While it is possible that Direct Line will achieve its new 10% Net Insurance Margin target and delivered outsized returns relative to the current valuation, the potential downside can also be substantial, in the form of a prolonged period of poor profitability, higher-than-expected regulatory remediation costs and other currently-unknown problems. We therefore put the stock in our “too hard” bucket – it may deliver a positive outcome but is too speculative.

We reiterate our Neutral rating on Direct Line. Avoid.

Positive Read-Across for Admiral

For Admiral, the read-across is positive.

Direct Line’s comments around inflation moderating and their plans to continue increase prices indicate a benign competitive environment for Admiral. In particular, that Direct Line had not raised its Motor prices sufficiently until later in H1 2023 helps explain Admiral’s 7.4% year-on-year volume decline in H1, and supported the latter’s expectations to resume market share gains in the near future.

We had regarded Direct Line as the most credible competitive threat to Admiral because of its size and price-focused business model. Direct Line’s multiple problems reflect the weakening of a key competitor.

Direct Line’s U.K. Motor claim cost inflation in 2022 is believed to be 17%, unquestionably worse than Admiral’s estimated 11%, reaffirming the latter’s cost advantage. (For 2023, Direct Line is expecting high-single-digits claim cost inflation, vs. Admiral’s 10%.)

We have a Buy rating on Admiral and it continues to be one of our core holdings.

Ends

Stocks mentioned: ADM LN, DLG LN. We are long Admiral.

Disclaimer: This article consists of personal opinions, based on information believed to be correct at the time of writing, but not guaranteed. We undertake no responsibility in updating content in this article. Nothing published here should be taken as financial advice.