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Morningstar | DLG Updated Forecasts and Estimates from 20 May 2019

Direct Line Insurance Group reported full-year results with profit before tax of GBP 583 million, slightly above our full-year estimate. This is higher than the GBP 539 million of the prior year. Gross written premium was down at GBP 3.2 billion versus GBP 3.4 billion, but the business achieved 180-basis-point growth in gross written premium coming from its own brands. We will maintain our fair value estimate for the time being while we roll our valuation model, but we think there are some warning signs coming out of these results. We maintain our no-moat rating.

The final dividend being proposed is GBX 14.0 with a GBX 8.3 special. Combined with the GBX 7.0 interim, the normal dividends give the stock a near 6.0% dividend yield. While the business is entering a phase of rollout of the latest generation of IT systems for personal lines, following the launch of these systems for small businesses in 2018, Direct Line management continues to target a 93.0%-95.0% combined ratio over the medium term across the group. Operating profit declined by GBP 43.6 million as the group had lower prior-year reserve releases. The 2018 period also benefited from GBP 55 million from moving to an assumed zero percent Ogden rate, which means that core operating profit was down by close to GBP 100 million. What we basically have is a flattened profit before tax because of improved financing costs.

Full-year results also demonstrated a decline in underwriting profit, from GBP 288 million to GBP 255 million. That near 12% decline has been buoyed by a 7% rise in instalment and other operating income. The loss ratio has deteriorated from 56.0% to 61.8%. This overall deterioration in underwriting profitability, beyond the 5.0% reduction in gross written premium, is being masked within the movement of the combined ratio from 90.8% to 91.7% by a significant improvement in the commission ratio from 910 basis points to 650. The expense ratio has also dropped by 150 basis points. We find the movement in these metrics a bit worrying: They say that the business is making less money from its core of underwriting and is having to make up for this with expense reductions and lower commissions, both of which we think have an end point. Net asset value per share is down to GBX 188.6, with tangible a bit lower at GBX 147.0.

Gross written premiums in motor were broadly stable at GBP 1.67 billion, but this was on the back of a 190-basis-point rise in policies in force. This indicates a decline in the quality of pricing. While motor risk-adjusted pricing was up 0.6%, the risk mix reduced average premiums by 150 basis points. This reduction primarily reflects the promotion of free motor legal protection cover to Churchill aggregator (price comparison website) customers, who typically have lower average premiums. While investors might be tempted to assign these promotions as one-offs, look at risk-adjusted pricing, and believe the pricing will therefore rise again in the near future, we think this will likely become a more normal than a more abnormal set of circumstances as the market becomes increasingly competitive.

Home has suffered a bit in these results because of the exit from the Nationwide and Sainsbury’s partnerships. But the combined operating ratio came in at 92% versus 94% a year prior, and this year's results included GBP 65 million of weather-related claims. Volume was slower in the second half as, according to management, shopping levels slowed following the anniversary of the introduction of new rules requiring the previous year's premium to be included on renewal documents. Management basically implied that Direct Line is the most competitive offer in the market with this statement. Home saw 350-basis-point price increases that more than offset a reduced mix shift. This GBP 80 million is decent in the context of historical profits for this division, but we don't think a 92% combined ratio is sustainable, and additionally, home only contributes 12% to group operating profit.

Rescue and other was relatively uneventful, with operating profit stable. In-force policies fell by 270 basis points to 7.5 million.

The commercial business does not look a lot better than motor, in our opinion, with operating profit down nearly 20%, though weather has returned to more normal levels. The commercial business is made up of two main businesses. Direct Line for Business serves van and landlords with motor and home insurance. NIG is a similar operation but delivered entirely through brokers.

One of the overarching themes we are concerned about in this sector, and where we have thought Direct Line may be more defensible, is price comparison websites. However, the business is forced into this. Management sees a "real opportunity in strengthening [its] capabilities in price comparison websites." The team has made some "tactical pricing changes," and this has helped increase premiums by nearly 20% within Churchill and Privilege motor insurance. This speaks volumes to us, and this is where the market is being driven. The only way to offset this will be expenses and alternative sources of profit. We think these cost savings will be finite. Over the last five years, management already reduced marketing spending by 30%, the number of Direct Line sites by half, and annual rental costs by nearly 40%. We see instalment and other income becoming an increasingly important part of Direct Line’s income statement, and in light of the combination with price comparison websites, this is something we are not a fan of.