Homeserve: special situation or falling knife?

It's hard to make money in a crowded stock market. Good companies with growing profits are usually popular, and priced accordingly.

Value investors prefer to shun the crowd and look for shares with lots of sellers and few buyers, but potential for making a comeback in the longer run. Scandals and litigation can often create such situations, where investors flee a stock in the short term, leaving longer-term investors a chance to profit when the problems are resolved.

But spotting such opportunities isn't easy. Take Homeserve, the UK's largest provider of home emergency insurance. It is currently embroiled in a mis-selling scandal. Its shares have tanked as a result.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Is this a temporary blip presenting a rare profit opportunity for investors? Or is this the beginning of the end?

Why Homeserve shares have crashed

Homeserve shares were trading as high as 532p during the middle of last year. Something of a stock market darling, the business had consistently delivered profits growth and promised more to come. Many investors were excited by the potential profits that could come from taking its business model to the US.

Last October it had some bad news for the City. Apparently some customers had complained that they were being sold products they didn't understand. Homeserve, to its credit, investigated. It agreed that its marketing practices weren't up to scratch. Memories of the banks' payment protection insurance (PPI) scandal came flooding back. Investors panicked and sold the shares.

On Wednesday, Homeserve updated the market on its progress. Putting its UK business back on the right track is taking longer than expected. It is also losing more customers that it thought it would. Next year's profits will be lower. The shares ended the day at 240p 55% below last year's peak.

Is Homeserve a good business?

So is it a buying opportunity? Or a value trap? Let's take a closer look at the business.

As anyone who has ever suffered a burst pipe or a broken-down boiler will know, it's not easy to find reliable trades people, particularly at short notice. Homeserve aims to take the worry out of these sorts of home emergencies. It sells insurance policies to cover these problems and promises to look after everything in the event of an emergency. It also has a manufacturer warranty business, fixing household appliances.

The bulk of its profits come from the UK business, so we'll focus on that. The UK business hasthree million customers with 7.7 million policies. This business is extremely profitable. For the year to March 2011, it made £104.3m of profit on sales of £317m a whopping profit margin of 32.9%.

What's interesting here is that British Gas has a similar home services business. In 2010, it made £241m of profit on sales of £1,464m a margin of 16.5% - roughly half of what Homeserve makes. Why is this?

The most likely explanation is thatthey have different types of customer. Over half (54%) of British Gas's policies are central heating contracts. This business is very labour intensive, especially during the winter months and could be the main reason for its lower operating margins.

By contrast, more than half (56%) of Homeserve's policies relate to water. This includes policies for plumbing and drainage problems, and also the insurance of a water supply pipe the pipe from the stopcock to the house boundary. This water pipe cover currently costs £3.50 per month, or £42 per year. The level of claims on these policies is probably a lot lower than on central heating - this may be the major reason behind Homeserve's big profits.

The big threat to Homeserve investors

Sounds good. But what if customers don't really need this type of insurance? Perhaps they are already covered on an existing house insurance policy. Has this sort of policy been mis-sold? If so, then Homeserve's business is nowhere near as good as it looks.

At the moment, the Financial Services Authority (FSA) has not announced any intention to investigate Homeserve, but that doesn't mean that it won't (remember PPI). Investors must not underestimate this threat.

The key thing to remember is that Homeserve has a lot of fixed costs. This means that its profits are very sensitive to changes in revenue. This is good when sales are rising, but deadly when sales fall.

By way of a basic example, if all of Homeserve's 4.3 million water policies included water supply pipe insurance at £42 a year, this would equate to £180m of revenues (4.3m x £42) more than half the total revenue of the UK business. A big reduction in policy numbers here could have a very large negative impact on profits, as the ability to cut costs in response is limited.

Analysts don't yet expect a profit collapse

According to Bloomberg, City analysts expect pre-tax profits of £126m for the year to March 2012, falling to £116m in 2013. This puts the shares on just overnine times 2013 earnings with a prospective dividend yield of 4.8%.

That's not expensive - but it's not desperately cheap either. And what if analysts are still too optimistic? What's the longer-term outlook past next year?

Even without an FSA investigation, Homeserve's high profit margins are a bit of a red flag. Either rivals will spot the money to be made here, enter the market, and drive down margins across the sector, or customers will wake up to the fact that these policies offer poor value for money in risk/reward terms.

In short, far from being a value investor's dream, Homeserve looks more like a falling knife. Do not catch it.