LONDON -- Should you invest in the flotation of Direct Line, the insurance subsidiary of Royal Bank of Scotland (LSE: RBS.L ) ? "Oh yes!" would no doubt be the answer from Churchill, the lugubrious nodding dog that is the mascot of Direct Line's principal brand.
And I'm inclined to agree. A recent survey showed more young people recognize pictures of the canine Churchill than they do the wartime leader of the same name, underlining just some of the value in the company and its brands.
And it's being sold on the cheap. The published price range is lower even that most pundits had forecast, valuing the company in the range 2.4 billion pounds to 2.9 billion pounds. That's for a business RBS tried -- although admittedly failed -- to sell for 7 billion pounds in 2008.
The difference isn't explained by the level of the market. Since mid-2008, the FTSE 100 (UKX) is up 5% while nearest rivals RSA Insurance and Admiral are down 13% and up 32% respectively. And in the meantime, a new management team that took over Direct Line in 2009 has done much to improve its performance, all but eliminating the company's underwriting losses. Direct Line is being sold at between 1.0 and 1.3 times its net tangible assets, compared to the 1.7 time RSA trades at.
The company is being sold cheaply because RBS is a forced seller up against a deadline. As punishment for taking state aid in 2009, the European Commission required it to cede control of Direct Line by the end of 2013 and divest fully by end 2014. This first tranche of 25%-30% has to be sold successfully for RBS to have any chance of floating the whole operation in that time.
It's a dire time to float a company. Volumes of new issues are as low as they were at the height of the financial crisis, and there have been several poor flotations, from Ocado in the U.K. to Facebook in the U.S. That saps confidence.
If you're an RBS shareholder, you should be fuming. The 4 billion or so difference between the 7 billion pound valuation and the top of the pricing range is a significant loss of value set against RBS' 16 billion pound market cap. But RBS' opportunity loss is a potential gain for Direct Line investors.
Cheapness is one attraction of the float. Entry level is important. But it's not sufficient. So here are five good reasons to invest:
1. Yield. General insurers traditionally pay high yields. RSA and Admiral are yielding around 7% to 8%, and Direct Line looks like it will be on a par with these.
2. Strong market position. Direct Line is the market leader in U.K. motor insurance and home insurance, with 19% and 18% market shares respectively. Its scale and multi-brand, multi-product, multi-channel distribution positioning gives it market power and strength to defend its market. The industry is unattractive: It's mature, highly competitive and over-regulated. There is to be another competition enquiry into the motor insurance industry, which contributes 60% of Direct Line's operating profit. Struggling to make money from underwriting, insurers have sought to top up their profits with kick-backs from lawyers and repairers. But you can still do a lot with a leading market position in a mature industry.
3. Operational improvement. Direct Line's management have done much to rationalize the business since late 2009, but they clearly believe there is further to go. They are targeting 100 million pounds in annualized savings (which will take some time to come through as the one-off cost of implementation is also 100 million pounds). RSA's earlier turnaround shows what good management can do in the sector.
4. Cyclical recovery. The insurance industry in inherently cyclical, and with insurers' profits so dependent on investment performance, low interest rates are especially painful. Industry profitability should eventually improve.
5. Growth opportunities. Direct Line has operations in the German and Italian motor insurance sectors, the largest and second largest in Europe. (The U.K. is fourth largest: presumably the Italians have fewer cars but more accidents). Both are less sophisticated than the U.K., with direct-to-consumer and price comparison channels growing strongly. There is nothing in the prospectus to suggest it but my hunch is that, freed of RBS, Direct Line's management might explore such growth opportunities more aggressively.
Of course, there are plenty of things that can go wrong. There are two specific risks that make me uncomfortable:
1. Markets crater. That's bad enough in itself, but because of RBS' forced sales timetable, it could have to offload the remaining shares in even worse circumstances. If that meant selling a 30%-plus stake to an industry or private equity buyer, shareholders could find themselves compulsorily bought out at below the original offer price.
2. Dependence on RBS. RBS will still initially be controlling shareholder, and Direct Line's credit rating will depend on RBS'. The transitional arrangements to transfer IT and other operations from RBS to Direct Line carry a lot of operational risk, and RBS is no stranger to IT meltdowns.
But financial investors are paid to take risks, and I think the positives outweigh the negatives. If you agree, you must act fast. Subscriptions close on 9 October.
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Tony does not own any other shares mentioned in this article.