Direct Line to return capital

Shareholders in Direct Line (DLG) should welcome news that the group's Italian and German operations are being sold to Spain’s Mapfre (ES:MAP) for €550m (£430m). Management expects to return "substantially all" of the net proceeds to shareholders, which points to a special dividend of up to 26p a share.

But enough uncertainties still face the motor market - Direct Line generates around two-fifths of its premiums from selling car insurance - to merit caution. First, premium rates have been under pressure: the most recent Tower Watson/Confused.com price index reported that motor rates had slumped 15 per cent in the second quarter. Admittedly, Direct Line is doing rather better than that: its rates were down a modest 2 per cent at the half-year stage. There's some optimism that the market could turn, too. Admiral (ADM) sees signs that motor rates may have stopped falling, while esure (ESUR) reckons pricing could even begin to firm up in the first quarter of next year.

Second, regulatory tinkering remains a worry. Earlier this month, the Competition & Markets Authority banned exclusive pricing deals between motor insurers and price comparison websites. While that will probably deliver just a small boost to competition, it certainly won’t support pricing, either. Moreover, HM Treasury is concerned about the price increases that usually accompany renewals, and has also flagged concerns about insurers charging more to allow customers to pay premiums by instalment.

Canaccord Genuity says...

Buy. Direct Line has agreed a good price for the sale of its international operations. The associated capital return - implying a prospective yield of around 15 per cent - is certainly attractive. There could be further capital-related upside next year, too, once the group’s capital requirements under the Solvency II rules become clearer. We also anticipate more good news from the group’s own self-help measures. The shares trade on about twice book value, but on an earnings basis they aren’t overly expensive, trading at a discount to those of rival Admiral, for instance. Prior to the disposal we were forecasting EPS of 23.2p for 2014, rising to 25.5p in 2015.

Deutsche Bank says...

Buy. Though the sale of the international arm was anticipated, the price is substantially higher than our £225m estimate. Looking forward, we remain positive. Our basic forecasts continue to assume special dividends of 18p, 15p and 12.5p in 2014, 2015 and 2016, respectively. This gives a total yield - over and above the capital return due as a result of the disposal - of 10.5 per cent this year and 9.7 per cent next year. We also see considerable potential above current earnings estimates from factors like cost savings. Moreover, a one-point hike in UK interest rates should boost earnings by 16 per cent. Our price target is 333p, with EPS of 23.9p forecast for 2014.