Direct Line: Avoid this tempting flotation

At first glance, shares in Direct Line look cheap ahead of the insurer's initial public offering (IPO). But they're not cheap enough, says Tim Bennett. Here's why.

After Facebook's colossal flop of a flotation in America earlier this year, you'd think most firms would desperately want to avoid trying to list on any stock exchange anywhere in the world right now. But not Direct Line.

Under pressure from the government, Royal Bank of Scotland the nationalised bank that actually owns the insurer is to sell shares in the firm. With the initial public offering (IPO) expected to value the company at around £2.6bn, it would be "London's biggest stockmarket launch of the year", as the Financial Times puts it.

The government hopes the sale will go well so that taxpayers can recoup some of the bail-out money that was poured into RBS when it was nationalised. But should you take the plunge and invest, or should you leave well alone?

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Why now?

The timing may seem odd, given the lacklustre state of the markets. Companies have raised just $1.5bn this year in London, compared with $15.6bn over the same period last year, according to Bloomberg. But the government has little choice. Under European Union rules on state aid, RBS must dump Direct Line as a condition of receiving £45bn in financial support from the government after the 2008 financial crisis.

The firm will be sold in chunks between now and the end of 2013, by which time RBS must have sold off at least 50% of the firm. The plan is to sell a tranche now (between about 25% and 33%, it seems), another next year and a final one in 2014. As such this is an unusual forced sale' usually IPO timings are determined solely by the seller.

What's on offer

Direct Line was started in 1985 from a single office in Croydon. Known primarily as a motor and home insurer, it owns brands such as Churchill and Privilege, plus the Green Flag vehicle recovery service. It boasts more than four million motor insurance customers and a similar number of home policyholders. It employs around 15,000 staff, although it has promised to cut 900 jobs to help save £100m by 2014. At £224m, profits rose 7% in the first half of 2012.

What's to like?

Bulls see this sale as a buying opportunity simply because the government and RBS will be desperate to see the first tranche fly off the shelves. After all, what hope is there for future sales if this one flops?

At first sight at least, Direct Line "does look pretty cheap compared with its obvious peers", Nick Johnson, insurance analyst at Numis, tells the FT. That's based on the firm being valued at between 1.04 and 1.26 times net tangible assets (the exact ratio won't be known until the share price is confirmed on the day), which is quite a bit lower than rival Royal Sun Alliance (RSA) on 1.7. Relative to earnings too, it looks as though Direct Line will be sold at a cheaper price/earnings (p/e) multiple than either RSA and Admiral.

The firm could also offer a yield of around 7.5%, if operating profit targets for 2012 are met, against a FTSE 100 average of more like 3.7%. It also plans to distribute 50%-60% of future after-tax profits, which bodes well for future yields. Sounds tempting.

The risks you should be aware of

However, there are several risks too. The insurance sector as a whole has several clouds hanging over it. Bad weather this year mainly flooding will squeeze margins in what Brewin Dolphin analyst Jonathan Newman calls a "mature and very competitive" sector.

Worse, the industry faces a probe from competition regulators over fears that consumers may have been overcharged. This enquiry could take two years. In the case of Direct Line, Shore Capital estimates that about 30% of its operating income comes from services such as providing replacement vehicles a key area being investigated.

More specifically, Direct Line isn't as profitable as its rivals, despite its size. A key ratio for insurers is the combined ratio of claims to premiums. Once this exceeds 100%, it means the insurer is losing money on underwriting. For the first half, Direct Line's was 101%, while Admiral's was a much healthier 95.2%. The firm has also already conceded that up to 7% of pre-tax profits could be at risk if a legal battle over how accident victims are compensated goes against it.

More fundamentally, it's hard to see how the firm will boost profits other than by cutting costs. Barriers to entry in key areas such as large-scale motor insurance are much lower than they used to be, which means rivals can easily steal market share. Direct Line also refuses to appear on comparison sites, which means it has to spend more on advertising, which is then recouped via higher premiums.

Unlike rivals such as RSA, which earns a decent chunk of profits from outside Britain, Direct Line gets around 85% of its revenues from the UK, meaning it is relatively undiversified. As for that yield, 7.5% looks good, until you compare it to 8.6% for RSA and 8.8% for Aviva.

No wonder, as Julian Chillingsworth from Rathbones puts it on Bloomberg, "there's a lack of enthusiasm (for Direct Line shares) unless it's very cheap". We don't think it will be cheap enough.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.