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Direct Line - share buybacks suspended

Emilie Stevens, Equity Analyst | 19 March 2020 | A A A
Direct Line - share buybacks suspended

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Direct Line Insurance Group plc Ordinary

Sell: 268.80 | Buy: 269.00 | Change -1.10 (-0.41%)
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Direct line has suspended its share buyback program in light of the COVID-19 pandemic. The group estimates its solvency capital ratio at about 163%, down from 165% on 31 December 2019.

The group will still pay its regular final dividend of 14.4p per share.

The shares were down 4.9% in early trading.

View the latest Direct Line share price and how to deal

Our view

Personal insurance can be a tough industry.

It's highly competitive, and with rivals offering pretty generic products, few companies can maintain any semblance of pricing power. That tends to have negative consequences for combined operating ratios (the percentage of premiums that are paid out as claims or expenses) as companies are forced to cut prices to attract customers. Price comparison websites have only exacerbated the problem.

Nor is that the only headwind. The industry at large has struggled with technical changes to the way personal injury claims are valued, increasing the reserves insurers need to hold.

Against this backdrop, CEO Penny James has updated the market with a strategy firmly focused on cutting costs and leveraging recent investments in technology. The goal is to bring the group's operating costs down to 20% of premiums by the end of 2023, compared to 23.2% last year. While the cost of the IT upgrade will weigh in profits, James reckons lower capital spending going forward and £50m of cost cutting can generate an extra £100m of capital each year.

In recent years profits have been flattered by the release of prior years' reserves. Insurers must set aside a portion of the premiums they receive to meet future claims, called reserves. But, if claims turn out to be lower than expected or the rules around how much must be set aside change, the excess can be released as profit.

That's unsustainable in the long run, and James wants more profit to come from current year underwriting, driven by lower costs, better underwriting and some growth. That could prove easier said than done though, as better underwriting often means higher prices, which would make growth a challenge.

Direct Line does have a few key advantages. The first is the brand, which has helped it price more aggressively than competitors. The second is scale, because the new, leaner cost base can be spread across more policies. The new technology infrastructure should also help the group compete on price comparison sites, and may improve underwriting accuracy for the direct brands.

Direct Line's recent move to favour share buybacks over special dividends will significantly reduce the prospective yield. However, it does make it easier for management flex total shareholder returns, which is exactly what the group has done in response to the coronavirus pandemic. On the bright side, buybacks could provide some support to the share price over time. The share's currently offer a prospective yield of 8.7%.

Overall we think Direct Line's targets are ambitious but not unachievable - although a lot's riding on the new technology investments living up to their billing. The PE ratio of 10.2 prior to the announcement is below above the long run average.

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Update on share buyback programme

Direct Line has completed £29m of its recently launched £150m share buyback program. The group will keep the situation under review, and CFO Tim Harris said "We hope to be able to resume the share buybacks in due course".

The group anticipates lower Motor claims as the UK government discourages unnecessary travel. Travel claims related to the COVID-19 pandemic increased to £5m on 15 March, up from around £1m on 3 March. Further claims are expected, although it's too early to estimate the final impact. Direct Line has reinsurance cover of £18.5m for Travel claims.

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Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.