What Does Direct Line Tell Us About Lloyds And RBS?

LONDON -- Since its float in October at 175 pence, Direct Line (LSE: DLG.L  ) shares have performed well. They are now 194 pence. That's a handy 10% gain since the IPO.

It is possible that the public will be invited to buy into an even larger offering in the future: the sale of the government's stake in Lloyds Banking (LSE: LLOY.L  ) (NYSE: LYG  ) and RBS (LSE: RBS.L  ) (NYSE: RBS  ) .

Unlike Direct Line before IPO, you can buy shares in Lloyds and RBS today. I've run the rule over all three shares.

Company

Price (pence)

P/E (forecast)

Yield (forecast, %)

Market cap (millions of pounds)

Direct Line 194 12.6 4.1 2,920
Lloyds Banking 44 18.0 0 30,970
Royal Bank of Scotland 280 16.2 0 16,691

1. Lloyds Banking
Currently, Lloyds is 40% owned by the U.K. taxpayer. These shares were purchased at an average price of 70 pence.

Lloyds' share price is up 69.8% so far this year. Another similar rise in the next 12 months would take the government well into profit. Though that might sound optimistic, I don't remember anyone at the start of the year saying that they expected Lloyds shares to rise almost 70%.

Lloyds has three problems: the huge amounts it has had to pay to meet Payment Protections Insurance (PPI) misselling claims; impairments (borrowers failing to pay their debts or asset values falling); and the weak U.K. economy. Anyone who hopes the Lloyds share price will one day be back above 70 pence needs the company to put these three issues behind it.

In a recent trading statement, Lloyds announced that over £2bn had been set aside to address PPI. Impairments for nine months totaled 4.4 billion pounds.

Impairments are falling. In the third quarter, impairment was down 40% on the amount suffered in the same period last year. If that trend continues, then Lloyds' profits will accelerate.

Lloyds' market cap today is 31 billion pounds. Analyst forecasts are for 3.7 pence of EPS (earnings per share) in 2013.

2. Royal Bank of Scotland
Like Lloyds, RBS has also been hit by PPI costs. The damage at RBS has been less, under than half what Lloyds has set aside.

With bank investment, its seems that every silver lining has a cloud. Unlike Lloyds, RBS is more implicated in the Libor scandal. That's bad for its shareholders as a fine may be on the way.

The taxpayer owns 83% of RBS. Today, RBS shares trade at 280 pence -- a whopping 75% below the average price the government paid in the bailout. RBS shares are up 37.5% this year. Yet they still remain well below the company's net asset value per share of 476 pence.

In the past, banks shares usually traded at a premium to this figure. If RBS can convince investors that it deserves a premium, the government could move into profit on its stake.

Whenever a sale of the taxpayer's stake comes about, I expect that the government of the time will encounter pressure to sell RBS shares to the public at an attractive discount to the market price.

3. Direct Line
Direct Line is still majority-owned by RBS. Direct Line owns the huge general insurance brands Churchill and Direct Line. The company also owns breakdown recovery specialist Green Flag.

At IPO, 35% of Direct Line was sold to the public. The rest is expected to be sold in another two tranches in the future. My expectation is that this might be 2014. By that time, Direct Line will have over a year's independent trading behind it. The company will also likely be paying a higher dividend -- this will make further share sales far easier.

Direct Line cheered the market with its recent trading statement. The key statistic for any insurer is the combined ratio: a measure of payouts versus premiums received. In the first nine months of the year, this came in under 100%. This means that Direct Line is now making more from insurance premiums than it is paying out to meet claims.

Measures were announced that would see the company achieve significant cost savings. Direct Line's international division also delivered decent growth.

All this adds up to convince the market of two things. First, that Direct Line will be more profitable in the future. Second, management is on course to meet the promises they were making at IPO.

Frequently, the difference between a low share price and a fair one is confidence. So far, Direct Line management are delivering. Analysts expect 12.6 pence of EPS for 2012, rising to 18.5 pence for 2013. An 8.0 pence dividend is expected for 2012, rising to 12.6 pence in 2013.

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David owns shares in Lloyds Banking and RBS, but not in Direct Line. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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