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How Will Direct Line Insurance Group Plc Fare In 2014?

direct line

For most shares on the London stock market, 2013 was a good year and investors have likely enjoyed capital gains and rising dividend income.

That makes me nervous about investing for 2014 and beyond, and I’m going to work hard to adhere to the first tenet of money management: preserve capital.

To help me avoid losses whilst pursuing gains, I’m examining companies from three important angles:

  • Prospects;
  • Risks;
  • Valuation.

Today, I’m looking at general insurer Direct Line Insurance Group (LSE: DLG).

Track record

With the shares at 262p, Direct Line’s market cap. is £3,937 million.

This table summarises the firm’s recent financial record:

Year to December 2012
Revenue (£m) 4,049
Net cash from operations (£m) 1,039
Adjusted earnings per share 21.8p
Dividend per share 8p

1) Prospects

In 2009, the European Commission arm locked Royal Bank of Scotland into promising to give up its insurance business, in return for state aid. That must have hurt, because the eventual outcome was the 2012 divestment of Direct Line Insurance Group, which now proudly stands as a PLC in its own right within the FTSE 250 index.

RBS backed the creation of Direct Line in 1985 and it’s hard to deny the popularity of the insurance business’s offering. Today, most will either have used, or at least heard of, the firm’s brands such as Churchill, Privilege, Green Flag and, of course, Direct Line, with its iconic advertising emblems: the wheeled, red telephone and computer mouse. In the early days, the firm’s innovative telephone-sales model was a great success and Direct Line has now emerged as an independent with a hefty looking market capitalisation of almost £4 billion.

In 2012, the firm turned over 44% of its net earned premium from motor insurance, 26% from home, 10% from rescue and other personal lines, 11% from commercial and 9% from international markets. The combined operating ratio (COR) came in at 99.2% that year, a 2.6% improvement marking a return to underwriting profit. With the third-quarter results released in the autumn the good news continued with a 20% increase in operating profit compared to the year-ago figure and an improved COR running at 95.4%.

Going forward, I’m optimistic that the firm’s strong brands and on-going ‘transformation’ programme can keep the business profitable.

2) Risks

So, it seems that Direct Line has been turning around from a position of underwriting loss. Can we expect further improvements in the figures for 2014 and beyond? Maybe, but there are headwinds.

The firm warns that all personal insurance markets are competitive with the UK motor insurance industry particularly cut throat. In answer, Direct Line is targeting margin over volume, but that strategy could become more difficult to apply because of what the company calls ‘substantial regulatory change’ on the horizon. Issues in the motor-insurance market such as referral and legal fees, the increase in whiplash claims, and the implementation of a gender directive all seem to be driving the changes.

In common with other insurers, Direct Line relies on investment returns to balance the books. The firm mainly invests in bonds, and returns have been low. The directors describe the investing environment as ‘tough’. There’s every chance that it could remain so.

Whatever the eventual outcome, 2013 looks like being a good year for the firm. We’ll find out more with full-year results due on 26 February.

3) Valuation

City analysts following the firm reckon 2015 earnings will be up by about 13%. On that basis, the forward P/E rating is running at about 10, which looks tempting when compared to a dividend yield predicted to be about 5.6%. Those forward earnings will cover the dividend payout around 1.7 times if the analysts are right.

What now?

Tempting though that valuation seems I’m mindful of the cyclicality of the insurance industry. Direct Line appears to be more of a cyclical turnaround situation than out-and-out growth. That inclines me to caution, as to my reading of the situation, this turnaround has essentially already turned.

That's why I'm looking at potential investments with consistent cash flows and without major operational challenges. I've found some in a Motley Fool report prepared by our top analysts. The report highlights five shares with the kind of dependable all-season stalwart-like characteristics that Direct Line has struggled to achieve in the past.  

These evergreen stock market stalwarts deserve consideration for any investor aiming to build wealth in the long run. The report is available now so, to download your copy, click here.

> Kevin does not own shares in Direct Line Insurance Group or in Royal Bank of Scotland.