Direct Line Group: Divestment dilemma

The divestment of Direct Line Group is undoubtedly the industry's current major talking point, and the anticipation surrounding the expected flotation seems to exceed that whipped up by Admiral's initial public offering in 2004.

As DLG owner Royal Bank of Scotland prepares a prospectus capable of propelling the group's market capitalisation ahead of the IPO, it can only that hope history does not repeat itself.

In April 2008, RBS said it had identified a "possible whole or partial disposal" of its insurance arm, which includes Churchill, Direct Line, NIG and Green Flag, as a means of strengthening its balance sheet when it unveiled a £12bn rights issue.

Big-name insurers including Axa, Allianz, AIG and Generali were considered potential buyers, and the sale was tipped to fetch up to £5bn. But, six months later came the first multi-billion pound government bailout, which would eventually total £45bn.

By February 2009, interest had cooled, and group chief executive Stephen Hester conceded that it was in shareholders' best interests to retain the insurance business.
 
He said at the time: "Given RBS' broader considerations, it was important to test the market for this business, which has demonstrated that a sale on terms currently available would destroy value for RBS' shareholders."

Despite continued ‘not-for-sale' pronouncements, speculation remained strong in the months to come that RBS still needed to sell all or part of its insurance business to bolster its balance sheet and appease European competition commissioner Neelie Kroes.

By October that year, the European Commission confirmed that it was investigating state-owned banks over competition issues.

Following the investigations, the Commission demanded that RBS sell its insurance assets, and the bank agreed to divest the majority of the unit by the end of 2013, with the entire sale to be completed by the end of 2014.

It was widely reported that RBS had considered selling its insurance arm to private equity houses, engaging in talks with Bain Capital, KKR and Blackstone Group earlier this year.

But ever since reporting its 2010 full-year results in March 2011, DLG chief executive Paul Geddes' public position has been that a flotation in tranches, starting in the second half of 2012, is his preferred option, subject to market conditions.

Analyst speculation
However, this has not stopped analysts speculating that a private equity bid will still emerge, even when DLG formally confirmed its intention to float this month.

On 14 September, Geddes claimed that, after de-risking the portfolio, exiting unprofitable business, and improving pricing and claims, the group was "in great shape and ready to go to market" with a prospectus expected imminently.

But, the same day, some insurance analysts suggested that it might be in DLG's best interests to take a private equity offer now, given the uncertainty in the equity markets.

It has been widely speculated that DLG's market capitalisation will be pitched anywhere between £1bn and £4bn, some analysts suggesting that the highest value can only be gained through an IPO.

Panmure Gordon insurance analyst Barrie Cornes agrees. "An IPO would gain a better valuation and return rate. We think DLG is roughly worth £3bn, but it could float at a higher price because it is backed by large investment houses," he says.

Keith Williams, head of financial services at Altium Capital, believes that a phased IPO would allow for market recovery in between floats, possibly pushing up the share price.

"An IPO is probably the most sensible position for RBS given that it is a forced seller and it has already tried and failed a PE exit," he says.

"RBS will look to sell only a small minority tranche on IPO this year and then sell further tranches in 2013 and 2014.

"By doing this, it has the opportunity to maximise return to shareholders by allowing for the possibility of market recovery and the improved trading performance of DLG."

Sale not precluded
Analysts are confident that RBS could still put DLG up for sale even if the float is unsuccessful.

"Launching an IPO means RBS can test the market's appetite. The fact it is doing a partial float now does not preclude a sale," says a market source.

"If the market doesn't take to DLG and the share price is very low, a sale could still take place afterwards and the buyer could buy any shares already on the stock exchange.

"A partial float sets a market value for DLG. If the shareholder price is not good enough on the market, RBS can always sell it. That is a reasonable strategy."

The source adds that insurers keen to expand their UK footprint, could make an offer for DLG after assessing market sentiment during the initial minority float, and may pay over the odds.

"When the prospectus is published, prospective bidders will assess the business. If the float is unsuccessful, they may decide they can add value to it over and above the market's expectations, and make an offer that would surpass the stock market value," the source says.

"America, Australia, Germany and China based insurers could all be interested. Pension funds could also invest."

One analyst, who wishes to remain anonymous, says that an IPO is the preferable option because PE houses, known for buying businesses, turning them around and then selling them off, would not know how to grow the group.

"DLG is a big personal lines motor insurance company. It produces a good dividend. You can't do much more with it than that," he says.

"You can't sell off many assets because they are all quite small, and you can't merge it with anything else because it is a big motor insurance group and there would be competition issues if you did."

The source adds: "Brit is the most recent insurer to enter into a PE-backed deal. There aren't many more around, and that is not a ringing endorsement.

"PE buyers are not big on insurance carriers. They are keen on insurance distribution and suppliers to the insurance industry.

"PE houses either buy a big company, break it down into its respective parts and sell for more than they paid; buy a small business, merge it with something bigger and then sell it off; or buy a company at a knock-down price and wait for it to accrue value before selling.

"I can't see a PE backer buying a high-profile group such as Direct Line and selling it off in a relatively short period of time."

However, Williams believes there are some drawbacks to the IPO process, highlighting the failed floats of social media network Facebook and online retailer Ocado.

When Ocado listed on the London Stock Exchange in July 2010 it had high hopes of reaching 275p per share, but on the first day's trading it fell to 167p.

Similarly, when Facebook launched its IPO in May, trading opened at $42 (£25) per share but finished the first day's trading at $25.87.

"By floating now, I don't think they will achieve maximum value. Investor sentiment is pretty weak and everyone knows there will be a large overhang of RBS-owned shares. This will affect investor sentiment and impact the share price," said Williams.

In his opinion, the company's capitalisation on the stock market will depend on how it is compared with its peers.

"The most recent high-profile IPOs have not performed well, and institutions will be wary of this," said Williams.

"Listed institutions will look at other personal lines insurers such as Admiral and ask themselves: ‘Why would I invest in DLG as opposed to placing an order for a block of shares in Admiral or another insurer?'

"If DLG is positioned appropriately and priced correctly, there should be a good appetite from institutions. But if it tries to push the boundaries on pricing, institutions are unlikely to be interested.

"Direct Line, and the personal lines market itself, has a chequered past and was loss-making in 2010. There is also significant market pressure on pricing premiums, as well as the ongoing thorny topics of fraud and the costs of claims management to contend with. Institutions will consider such risks associated with DLG."

PE possibility?
Some analysts, hedging their bets, believe that a PE sale is still possible, citing German insurer Talanx, which initially decided to abandon an IPO after the company valuations it received from the market were significantly lower than expected.

Aweek later, however, owing to "encouraging unsolicited responses" from the market, Talanx decided to resume the IPO.

Implying that any route to market is conceivable, Cornes said in an analyst note: "We think there is a good (50:50) chance that a PE bid may still emerge for DLG.

"Given the uncertainty of equity markets, RBS may be better off going for a firm PE bid for the business now, rather than waiting to see how markets fare over the next two years knowing that it has to divest fully by 2014."

Williams adds that a PE sale would mark the end of an era and a fresh start for RBS, while an IPO would herald the start of a long and anxious task for the bank to build up stock value for another two years.

"This IPO does not give RBS as much certainty on price on exit as a PE offering. With a PE exit, RBS would be divesting 100%. With an IPO, it is not going to be a clean exit, it will be a staggered one," he says.

However, Williams warns that RBS risks selling DLG for a lower price to a PE house or other investor than it could receive on the stock market, explaining that a typical PE buy out structure uses a considerable amount of debt to help finance the acquisition.

One consequence of DLG falling under the regulation of the Financial Services Authority is that the body scrutinises any financing package that is part of a PE buyout structure.

The FSA will allow only "a suitable amount of debt" to be used, which Williams adds will typically be less than most PE buyout structures would like.

"As a result, PE firms have to put more of their own cash into the funding structure, which lowers their overall returns, "he explains.

"Consequently, in order to meet their minimum hurdle return requirements, the price they can afford to pay is significantly reduced. I suspect this is one reason why PE houses have not been able to meet the circa £4bn price tag."

Sale strategy
As the date for divestment draws closer, DLG has pulled out all the stops to boost its market capitalisation and share price.

As well as rebranding, the group has completed its 2010 efficiency drive to cut 2000 jobs, a strategy that has seen it shut six offices, with a further three to be closed over the coming weeks.

And earlier this month, DLG launched the second phase of its business transformation plan, a series of initiatives to achieve £100m of gross annual cost savings by 2014, including cutting 891 jobs and offshoring a "limited number" of chief operating office and sales, service and partnership roles.

Williams says: "Part of the pre-sale grooming process is about ensuring a business is operating with the appropriate cost structure in this environment.

"The £100m cost savings will all inevitably improve profitability in 2013 and beyond, and RBS must be thinking that it would help improve the share price of DLG post-IPO, which it would directly benefit from if it looked to sell its shareholding in tranches.

"IPO is a positive news story for RBS. It says DLG is in good order, has good management, is in charge of costs and knows how to grow the business to maximise shareholder value. Some of the identified cost savings will go straight to valuation, and this will help support the flotation case."

But commentators are inclined to believe that neither a PE sale nor a float will achieve the valuation DLG had when RBS first tried to sell it.

"Market conditions have changed. The state of the economy has worsened, and people's perceptions of motor insurance have changed too," one commentator notes.

"Four years ago periodical payment orders and personal injury claims inflation were not issues. Now they are."

Direct Line Group in numbers

£45bn
Amount the government paid to bail out Royal Bank of Scotland

£4bn
Analysts' top-end valuation of Direct Line Group on the London Stock Exchange

891
The number of DLG redundancies likely under plans to achieve £100m of gross annual cost savings by 2014

82
Percentage of the bank owned by taxpayers immediately following the 2008 bailout

2009
The year the European Commission ordered RBS to divest of its insurance arm