 Since two major UK insurance companies announced takeover terms on 6 December – a “possible̶1; offer for Direct Line Insurance Group
DLG
0.65%
by Aviva
AV.
0.79%
becoming a full offer by Christmas – it is curious how Direct Line shares are trading at 247p, a 10.5% discount to the offer price.
Is this a fair reflection of risks surrounding a deal consummating, or an opportunity to buy into or raise one’s holding in Aviva by discounted means? Aviva has been a popular share for income-seekers, and consensus forecasts imply an 8% dividend yield with roughly 1.2x earnings cover. Mind, its free cash-flow profile – what counts most for payouts – has seen historic volatility.
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Recommended terms are 275p per Direct Line share comprising 129.7p in cash (Aviva can fund from internal resources) and 0.2867 new Aviva shares, also a dividend up to 5p from Direct Line. A dividend may be necessary anyway if the competition regulator much delays completion of the deal.
With Aviva trading at 475p, the share-based element values Direct Line at 136p, hence around 5p of the possible offer discount is explained by Aviva falling from 483p since the news broke:
Aviva chart performance
Source: TradingView. Past performance is not a guide to future performance.
Otherwise, that still leaves the discount just over 10% as if the market sees risks.
The chances of Aviva backing off look low
Aviva would have modelled its financial resource within a range of possible offers before it initially mooted a 250p per Direct Line share on 28 November.
Digital Line Insurance Group performance chart
Source: TradingView. Past performance is not a guide to future performance.
Given Direct Line floated at 175p in 2012, it would seem its strategy and execution has been lacking, although there have been substantial dividends (including special payouts) over the years.
Direct Line Insurance Group - financial summary
Year end 31 Dec
2014 2015 2016 2017 2018 2019 2020 2021 2022 2023
Turnover (£ million) 3,349 3,253 3,321 3,496 3,427 3,284 3,202 3,230 3,229 3,602
Operating margin (%) 13.6 15.4 10.4 15.2 16.8 15.4 14.0 13.6 -7.0 3.8
Operating profit (£m) 457 500 345 531 577 506 447 441 -226 137
Net profit (£m) 373 580 279 434 472 420 367 344 -232 223
Reported EPS (p) 26.0 27.6 20.2 31.5 32.9 29.2 25.5 24.1 -19.1 15.9
Normalised EPS (p) 26.7 26.5 24.1 33.6 33.0 29.9 28.2 30.0 -19.1 15.7
Earnings per share growth (%) 1.8 -0.8 -8.9 39.4 -1.7 -9.4 -5.7 6.4 -163 176
Operating cashflow/share (p) 51.4 37.6 62.4 39.6 35.6 33.4 42.5 32.4 61.6 30.9
Capex/share (p) 13.9 9.9 9.5 6.9 11.3 13.6 11.7 10.2 9.2 30.4
Free cashflow/share (p) 37.5 27.7 53.0 32.7 24.3 19.9 30.8 22.2 52.4 0.5
Ordinary dividend per share (p) 12.6 13.8 14.6 20.4 21.0 21.6 22.1 22.7 7.6 4.0
Covered by earnings (x) 1.8 2.0 1.4 1.5 1.6 1.4 1.2 1.1 -0.6 4.0
Special dividend per share (p) 14.0 27.5 10.0 15.0 8.3 0.0 14.4 0.0 0.0 0.0
Cash (£m) 880 964 1,166 1,359 1,154 949 1,220 956 1,004 1,772
Net debt (£m) -284 -381 -571 -523 -319 -126 -153 -897 -939 -1,584
Net assets/share (p) 205 191 185 198 187 193 200 194 176 183
Source: historic company REFS and company accounts
Aviva will have judged a takeover as strategically sound and earnings-enhancing, with scope to take out costs and achieve synergies.
Raising its offer terms may also include an aspect of hope that more can be released from Direct Line’s claims reserves and which may only involve tweaking the discount rate applied. But this is going to need closer examination – as is likely happening right now.
Even in a worst-case scenario of skeletons, there would seem more likely a modest adjustment on price. Most Direct Line holders will be even more relieved finally to have a chance to move on.
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A latest note from broker Jefferies cites their concern that Direct Line’s IT systems may be problematic to integrate after a recent investment programme. “It is unclear which system Aviva ought to decommission; however, as Aviva’s book is performing better, it might be safer to write off Direct Line’s investment and move that book to Aviva, even if the systems are older.”
All-considered as to execution risk, I see this favouring Aviva consummating a deal. Its recent strategy has been to divest non-core and overseas interests, but the fact its shares are priced for an 8% yield suggests the market sees few capital growth prospects. A substantive UK acquisition starts to address that.
Aviva - financial summary
Year-end 31 Dec
2016 2017 2018 2019 2020 2021 2022 2023
Operating profit (£m) 1,833 2,374 1,734 3,916 1,895 877 -2,138 1,793
Net profit (£m) 703 1,497 1,568 2,548 2,798 1,966 -1,051 1,085
Reported EPS (p) 19.9 45.0 49.7 82.4 43.7 8.3 -34.7 37.7
Normalised EPS (p) 23.6 46.6 48.0 83.4 47.2 8.2 -34.6 37.8
Earnings per share growth (%) -46.5 97.1 3.2 73.6 -43.4 -82.7
Return on capital (%) 0.4 0.5 0.4 0.9 0.4 0.2 -0.7 0.5
Operating cashflow/share (p) 153 249 177 200 -82.8 7.4 508 -99.6
Capex/share (p) 6.0 5.7 5.0 4.0 4.6 3.6 3.2 12.8
Free cashflow/share (p) 147 243 172 196 -87.4 3.8 505 -112
Dividend per share (p) 30.7 36.1 39.5 20.4 27.6 29.0 31.0 33.4
Covered by earnings (x) 0.6 1.3 1.3 4.0 1.6 0.3 -1.1 1.1
Cash (£m) 29,834 13,377 8,355 11,171 10,345 12,485 22,505 17,273
Net debt (£m) -17,858 -2,360 2,359 -190 780 -5,141 -14,435 -9,906
Net assets (£m) 16,803 16,969 16,558 17,008 19,354 16,238 9,704 9,082
Net assets/share (p) 544 557 559 571 649 569 348 334
Source: historic company REFS and company accounts.
Jefferies regard Aviva shares as “inexpensive below a 10x 2025 P/E”, hence reiterate “buy” and raise their target price to 560p from 550p. If a fair view, then it sweetens the exit for Direct Line shareholders, hence intrigue whether to add currently.
There must, however, be two valuation scenarios based on whether or not the takeover happens, given Aviva’s motivation to do so is based on enhancing earnings.
Longevity of regulatory examination is key uncertainty
Some Direct Line holders argue the 5 December approval by the Competition & Markets Authority (CMA) of the takeover of Three by Vodafone Group
VOD
0.41%
, implies this insurance takeover is most likely to happen.
Estimates differ but combining Aviva with Direct Line could possibly result in a 20% share of the UK motor insurance market, yet the CMA waved through Vodafone and Three with 20% and 15% of the UK mobile market respectively. That will, however, still lag Virgin 02 with 38%, if ahead of BT Group
BT.A
0.27%
with 27%.
Unpacking some of the contrasting claims:
Data from Confused.com, a UK financial services comparison platform, suggests a combination would result in a market share over 20% in motor insurance - Aviva currently with 11% and Direct Line just over 10.2% - ahead of Admiral Group
ADM
0.65%
with 11% then Hastings just below 7%.
Shareholders have to hope Confused is indeed so. On 2 December, Statistica cited Admiral leading with 13% and Aviva/Direct Line combined accounting for 12%. The top 10 motor insurers in the UK hold 75% of the total UK market. It would seem the difference is based on Statistica using first-half-2024 figures for motor premiums.
Apparently, the combination will lead to the UK’s largest home insurer.
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Precedent exists: when Aviva initiated its £460 million purchase of AIG’s UK protection side, the CMA investigated how the merged entity would become the biggest operator with a share over 20%, ahead of Legal & General and various others. It approved the combination given the two businesses’ services were different enough to have separate rivals.
Yet with Aviva/Direct Line, both target the mass market and tend to sell direct rather than use intermediaries. So, it rather depends how the CMA wants to regard a strengthening of such approach.
The competition regulator is accountable to government where a House of Commons report has cited UK car insurance prices rising by 82% from May 2021 to June 2024; although Covid lockdowns did reduce premiums shortly beforehand. I treat this inflation claim with a pinch of salt for it may not be wholly real if based on renewal prices. All insurers seem to try and fleece customers this way, but if you compare the market and go back negotiate, they usually cave in.
Not surprisingly then, Aviva is already pitching that the takeover will create efficiencies able to lower premium costs.
From customer review boards on Direct Line, some people do protest at high prices/increases while others praise its customer service.
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Optimists on this takeover also cite the CMA’s CEO declaring last month it “should play a critical part in the success of the government’s growth mission”.
Following the US election result, it is easy to assume this means a loosening of regulation, the platform on which Donald Trump stood, his strong victory prompting US stocks to surge.
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Yet the CMA boss meant competition as an “engine for unlocking opportunities and growth...we must stay true to our mandate from Parliament: to promote competition, for the benefit of consumers”. That implies a toughening of approach, at least to examine change where it creates greater concentration of power.
The CMA launched its investigation into Vodafone/Three on 26 January. While the outcome could be similar here, there is an obvious time value for uncertainty.
Double-digit discount does make sense
You can take your view, but reasons exist why this takeover – even if formally proposed before the Christmas deadline – could drag on.
Direct Line shares may respond positively, but I would expect at least a 5% discount to offer terms to continue. If and when the CMA shows its hand, this valuation gap could widen again.
Obtaining Aviva shares still appears an attractive prospect. Recent consensus forecasts (which ought not to factor in the takeover) imply its forward earnings growth prospect divided by the price/earnings ratio is 0.7, hence a “buy” according to this PEG ratio. Mind, these numbers may benefit from recent underlying momentum; if that is sustainable then why assume the risk of a big takeover?
Reasons therefore exist to continue holding both shares. As to any “arbitrageR21; opportunity, buying Direct Line, it first needs a confirmed offer, then see what the CMA’s response is – tricky to predict.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor. |
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