Challenges ahead for Direct Line

After much speculation about insurer Direct Line's (DLG) final flotation price, its shares finally began trading earlier this month (11 October) at 175p - a shade above the group’s reported net tangible asset (NTA) value of 168p a share. That’s not pricey by insurance sector standards but, with plenty of trading challenges ahead, such undemanding pricing was probably needed to make the flotation a success.

After all, Direct Line is hardly the sector’s best performer. At the half-year stage it reported a combined ratio (of claims to premiums) of 101.1 per cent - which means underwriting losses. In contrast, core UK rivals RSA and Admiral are both profitable at the underwriting level with 95 per cent combined ratios. What’s more, 41 per cent of the book is in motor cover and premium rates there are dropping fast. Reversing that trend will prove hard going, too, now that the Competition Commission has launched a probe into the motor market that could take two years to complete.

Still, that weak earnings outlook may be mitigated by self-help measures - management plans to cut £100m of fat from the cost base by end-2012 and a return on NTA of 15 per cent is also targeted. The group’s investment portfolio, focused on cash and bonds, isn’t in bad shape either - that delivered a 3.4 per cent return at the half-year stage.

Panmure Gordon & Co says

Reasonably priced. We’ve yet to issue a formal recommendation - but believe that the shares are reasonably priced at current levels. The initial public offering (IPO) was priced at a level to make it successful and that objective has been achieved. We also think that the company will be able to achieve its cost savings and return on net tangible assets targets - which are not, in any case, that demanding. But, with over 40 per cent of the book in UK motor cover, the real concern is the trading environment - motor rates are falling and the Competition Commission’s probe into the motor sector won’t help sentiment.

Numis Securities says

Add. To focus on the restricted growth prospects implied by Direct Line’s large UK market share is to miss the point that significant profit upside can be delivered from actions to improve margins. The shares currently trade on 9.2 times our 2013 earnings estimate of 20.6p, and on 1.17 times June 2012’s net tangible asset. That PE ratio represents a 20 per cent discount to Admiral’s ratio - yet we see Direct Line's near-term earnings growth prospects as similar to those of Admiral and therefore think there is a strong case for Direct Line's shares to trade at a similar PE ratio multiple. Expect pre-tax profit of £284m for end-2012, giving EPS of 21.8p and a dividend of 12p. Our price target is 215p.