According to a range of headlines this week, car insurance premiums are set to soar. Normally, this would be great news for car insurers such as Direct Line (LON:DLG), but its shares slumped 7% on the news. The reason for this is a profit warning, brought about by a change to the discount rate which is applied to personal injury compensation payouts.
In my view, buying after a profit warning can be the perfect time to acquire a stock. Often, the market overreacts to negative news flow and this creates an opportunity to buy when a greater margin of safety is on offer.
Undoubtedly, the future prospects for Direct Line and any other company reporting a downgrade to guidance are unclear. However, I would argue that when it is an industry-wide cost which should be passed almost entirely on to consumers, as is the case with Direct Line, the outlook for the company remains sound. Therefore, as well as its high income return prospects, I think Direct Line could be a source of capital growth in the long run.
Profit warning challenges
The words ‘profit warning’ are enough to send a shiver down the spine of any investor. Normally, they result in a high-single or even double-digit percentage decline in a company’s share price. Often, the full impact of them takes time to be reflected in a company’s stock price. They can be followed by multiple warnings, especially if the company fails to address the reasons behind the downgrade to its financial outlook.
However, some profit warnings are worse than others. For companies which are experiencing internal or external challenges for which there is no obvious solution, things may get worse before they improve. In such a situation, a period of intense restructuring or reorganisation may be required, while a change in management or asset disposal may also be needed. In these scenarios, I think investors are often better off waiting for the green shoots of recovery before buying in. It can easily become a slippery slope for the company’s share price in such a situation.
In contrast, there are profit warnings for which there is a clear and easy-to-implement remedy. This could be an additional and unexpected cost which can be passed on to consumers. It could be an underperforming division which is sold off, or an exceptional event which by its very nature is unlikely to be repeated. In such a scenario, I believe a share price fall is an opportunity to buy what is otherwise a strong business.
The effect of a change to the discount rate
The news of a change to the discount rate in personal injury claims falls into the latter category in my opinion. I believe companies such as Direct Line will be able to pass the cost on to customers. All motor insurers will be hit by the additional costs, and this makes the chances of higher premiums across the industry relatively likely.
…the company’s strong financial standing and differentiated customer proposition mean it may surprise investors with the relative ease with which it passes on the higher costs to consumers.
The change in discount rate from 2.5% to minus 0.75% means accident victims will receive higher payouts from insurers. It has been estimated the change to the discount rate will mean an increase of £50-£75 per year on average for a comprehensive motor insurance policy. There will also be higher increases for younger and older drivers. Direct Line estimates this will reduce profit before tax by between £215 million and £230 million in 2016, while its combined operating ratio will increase by 6 percentage points and its Solvency II capital ratio will fall to towards the higher end of its target range.
Appealing investment
While I can understand why investors in Direct Line have reacted negatively to the news since its financial performance in 2016 will be affected, I believe the company will not be significantly worse off in the long run. Although car insurance is highly price elastic, I believe it will be an industry-wide price rise since the changes affect all insurers. I do not feel it will be sufficient to dissuade people from owning cars and due to car insurance being compulsory, industry-wide price rises are unlikely to hurt demand.
Direct Line’s margin of safety increased following the share price fall in my opinion. Its P/E ratio may be higher when using 2016 figures, but this assumes it will be unable to recoup the additional costs in future years. Other insurers seem confident that higher costs will be passed on to consumers, with Admiral stating ‘there will be no significant impact on future business and its profitability’. While the same cannot be guaranteed for Direct Line, the company’s strong financial standing and differentiated customer proposition mean it may surprise investors with the relative ease with which it passes on the higher costs to consumers.
In my opinion, it remains a highly appealing dividend stock. Its dividend for 2016 is unlikely to be affected by the news regarding the discount rate in my opinion, while I would expect the 2017 dividend to remain in line with guidance. This puts it on a prospective yield of 7.9%, which means it is among the highest yielding large-cap UK shares.
Outlook
Buying a stock right after a profit warning can lead to losses in the short run. Sometimes the problems it is facing turn out to be bigger than expected and they lead to further warnings as well as a deterioration in its outlook. However, I believe profit warnings are an opportunity to buy rather than a reason to panic. Provided there is a clear path to improvement and/or a strategy which means the company can overcome the challenges it faces, the greater margin of safety on offer increases the overall investment appeal.
In Direct Line’s case, I think the industry will adapt to the prospect of higher costs. It is obviously too late for 2016’s results to include higher premiums, but since the industry as a whole will be affected I believe consumers will end up covering the cost of the change to the discount rate. Consumers need car insurance and so if all premiums rise there is little alternative or substitute. Since Direct Line has a strong brand and sound finances, I think it will survive and prosper. In my view, its high yield and margin of safety mean the rewards from buying after its profit warning could be high.