LONDON -- Did you know that the insurer Direct Line is part of Royal Bank of Scotland (LSE: RBS.L)? Direct Line is, in fact, a group of companies providing insurance and related services. Other parts of the group include Churchill ("ohhhh yesh!") and Green Flag.
Following its bailout by the government, RBS was forced to sell some of its assets. RBS must dispose of its entire stake in Direct Line by the end of 2014.
RBS is selling between 25% and 30% of the company in one of the most closely watched IPOs of recent years.
Direct Line has committed to offering shares to investors in the range of 160-195 pence. This is a substantial reduction from what analysts were expecting a few months ago.
So have Direct Line's prospects changes materially? Were those analysts wrong, or is this a great opportunity to buy into a company at a discount price?
Recently, Direct Line issued its investment prospectus. This document provides a wealth of information to help investors appraise the opportunity. Insurance company accounts are notoriously difficult for private investors to understand. However, I have picked some of the key numbers.
Profits
The uppermost question in assessing a share has to be: is the company profitable? In the first six months of 2012, Direct Line made a pre-tax profit of 106.5 million pounds. However, 176 million pounds of this was investment income. This means that, currently, Direct Line is not making money from its insurance operations.
While this is a cause of some negativism, it is not unique in the sector. The income an insurer can make by investing premiums is a key part of the business.
Assets
What will investors get for their money? As of the last balance sheet date (30 June), Direct Line reported a net tangible asset value of 167.7 pence per share. As a rule of thumb, I've always believed that profit-making insurance companies should trade at a premium to their net tangible asset value. Since then, Direct Line has paid a 200 million pounds dividend to RBS. This dividend payment reduces what is left for new shareholders.
Dividend
In Direct Line's 2012 financial year, the company paid 800 million pounds to its owner RBS. However, it is clear that this level of payout will not be sustained. Instead, Direct Line plans to pay 50%-60% of profits out to shareholders in dividends. This suggests a dividend yield of 6%-7%.
Just because Direct Line is being sold, that doesn't mean that it is the only share you should consider buying. Below, I've compared Direct Line with some of its sector peers. The numbers for Direct Line are my estimates, based on the middle of the IPO range.
| Company | Price (pence) | Net asset value (pence) | P/E (historic) | Yield (historic, %) | P/E (forecast) | Yield forecast, %) | Market cap (million of pounds) |
|---|---|---|---|---|---|---|---|
| RSA | 111 | 102 | 7.9 | 8.3 | 9.3 | 8.5 | 3,940 |
| Admiral | 1066 | N/A* | 13.1 | 5.3 | 11.8 | 8.0 | 2,890 |
| Aviva | 324 | 395 | N/A** | 8.0 | 6.7 | 7.9 | 9,260 |
| Direct Line | 177.5 | 193.7 | 10.7 | 30.1 | 8.9 | 6.2 | 2,650 |
*Unable to obtain a figure. **Previously loss making.
Clearly, the entire sector is cheap. The price-to-earnings (P/E) ratio and yields available mean the shares above are all cheaper than the average FTSE 100 (UKX) stock.
Direct Line is clearly being priced at an asset and earnings discount to RSA and Admiral, its closest peers.
One problem, though, is the recently announced Office of Fair Trading (OFT) investigation of the motor insurance industry. The OFT has that it has "grounds for suspecting that there are features of the market that prevent, restrict or distort competition." An unfavorable ruling could damage the long-term profitability of the sector.
However, there is another factor that could mean that Direct Line is a great opportunity for a low-risk investment. It appears that Royal Bank of Scotland hopes to begin reducing the Government's stake in the bank by 2014. While it is possible some of Government's RBS shares may be bought back by the bank, it is likely a sale back into private hands will also be pursued. To help create an environment that makes such a rehabilitation possible, it is important that the Direct Line IPO is a success.
A good return for IPO investors will help foster the idea that buying bits of RBS is good for your wealth.
Private investors have until 9 October to take up the offer. The exact price will depend on demand for Direct Line shares. On 11 October, Direct Line is scheduled to announce the price that shares will begin trading at. Direct Line shares are expected to start trading on the Main Market of the London Stock Exchange on 16 October.
Investors considering taking up the Direct Line IPO will likely be deterred by other recent launches. Glencore came to the market in May 2011 at 530 pence; the shares now trade at 342 pence. Online grocery distributor Ocado shares can be bought for 66 pence, little more than two years after its launch at 180 pence. Despite falling recently, Supergroup has been a success (500 pence to 644 pence). The biggest of the lot, Facebook, has received an almighty thumbs-down. Since its IPO at $38, shares in the social network now trade for just $22.
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Further investment opportunities:
David does not own shares in any of the above companies.
