Winning new business has never been Direct Line’s strong suit, and managing alluring pricing with profitable underwriting has become an even finer balancing act. Policy numbers fell back again last year, as did gross written premiums. The main culprit? A hyper-competitive motor insurance market.
That’s been the case for a while, but a lower level of claims amid the pandemic and efforts to lure customers ahead of the Financial Conduct Authority’s market reforms meant pricing deflation last year.
Its answer? Launching an online platform for its Direct Line, Churchill and Privilege motor customers, which Penny James, chief executive, reckons will get more products to market faster and improve its policy pricing by giving it greater access to customer data and the ability to tweak those rates more quickly, depending on movements across the wider market.
The insurer has long argued that it prioritises value over volume. When average motor premiums across the market fell by 7 per cent over the second half of last year, Direct Line cut by only 2.5 per cent. Investors can give some credence to that approach. A return on tangible equity that has surpassed 19 per cent over the past five years is not too shabby and it has prompted generous cash returns for investors.
Last year was no exception, a dividend of 22.7p a share equates to a yield of 8.9 per cent at the current share price, or above 7 per cent prior to the market sell-off last month.
There are also plans for £100 million in share buybacks this year. Even after that the solvency capital position will be above its 140-160 per cent target range.
But Direct Line isn’t alone in doling out cash to shareholders, and investors place a lower value on companies that don’t show the promise of growth. That explains why Direct Line’s shares have lagged Admiral, Aviva and Legal & General in the past three years as pricing competition has ratcheted-up.
Direct Line insurance is an incumbent that has been playing catch-up against motor insurance rivals. Gross written premiums are 3 per cent lower than they were five years ago, versus a compound annual growth rate of 2.8 per cent for Admiral.
A bloated operating structure hasn’t helped the top line either. By cutting costs, primarily in its property footprint and digitising its back office functions, James, hopes to cut expenses to 20 per cent of its net earned premiums by next year, from 23.9 per cent last year. That could give the insurer the room to be more competitive on pricing.
Claims inflation, due to higher repair costs, should lead to higher premiums. But that depends on claims frequency post-pandemic. Peel Hunt, the broker, has forecast a higher rate of growth over the next two years, of 27 per cent. There’s a chance insurers such as Direct Line, that cut prices to a lesser extent, might gain favour with customers by not having to increase premiums to account for claims inflation, analyst Andreas van Embden says.
But reforms to the insurance market introduced this year, which mean companies will be barred from charging renewing customers a higher price than new customers, have made it harder for insurers to judge how far they can push pricing to potentially win market share, while remaining profitable.
Prices for new customers are rising and dropping for those renewing. Direct Line is, unsurprisingly, tight-lipped on the impact of the latter. A greater exposure to home insurance, where so-called price walking was more prevalent, could mean the reforms pinch harder.
Convincing investors it can break its stagnant spell won’t be easy.
ADVICE Hold
WHY The shares are worth holding for the dividend but deserve their lower valuation versus peers
Bakkavor
Rapidly rising inflation is an unavoidable foe for food producers such as Bakkavor, and one that is set to gain in strength this year. The London-based group, which specialises in freshly prepared food, reckons cost inflation will hit between 10 and 12 per cent this year as heightened labour, distribution, packaging and ingredient costs bite.
You would think investors would balk at the spectre of worsening cost inflation, but a forward earnings multiple of nine is in the same ballpark as prior to the pandemic. Why are investors not more nervous? Progress in fending off the impact of higher costs on the bottom line has been considerable. Automating more of its production and passing some of the inflationary pressures through to customers via price rises meant the adjusted operating margin increased to 5.4 per cent last year, against 4.7 per cent in 2020.
However, it is unlikely that the food manufacturer will be able to maintain that performance this year. War in Ukraine is expected to add to rising ingredient prices, which for Bakkavor will be felt to varying degrees via rises in flour and sunflower oil, as well as costlier energy. It is also spending on enhancing its manufacturing processes in the UK and US; this will weigh on the margin, which management reckons will reduce to 4.8 per cent this year, albeit roughly in line with the 2019 level.
As a manufacturer of fresh foods, less frequent grocery shopping hurt sales during the pandemic as consumers stocked up on products with a longer shelf life. But like-for-like revenue edged ahead of 2019 last year, thanks to a recovery in the UK and a leap forward in the US, which it sees as its big growth market. There is a risk that higher prices and the squeeze on the consumer purse holds back growth in sales volumes.
Investors can take succour in a leap forward in free cashflow and the reduction in leverage to back within its medium-term target range six months ahead of schedule. The result? A 10 per cent increase in the dividend against 2019 to 6.6p a share, equivalent to a dividend yield of 5.8 per cent at the current share price. That makes the shadow of further inflationary pressures worth putting up with.
ADVICE Hold
WHY Has shown a good ability to mitigate rising costs
