It was not so long ago that insurer Direct Line (LSE: DLG) had a monster dividend. Even at the start of last year, the Direct Line dividend yield was well into double digits in percentage terms.
A shock profit warning revealed that the business was struggling more than the City had realised. It axed the dividend.
But the business has a customer base in the millions, a well-known brand, and operates in a market that should see resilient long-term demand.
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It reinstated its dividend this year. For now though, it remains a shadow of its former self. Could things get better in future?
A common investing mistake
One mistake that a lot of investors make is paying too much attention to how a company has done in the past as a basis for estimating what it may be capable of achieving in the future.
Looking at the past Direct Line dividend, the current share price could seem like a bargain. If the company paid out the same dividends (both ordinary and special) next year that it did for 2020, its prospective dividend yield would be a mouth-watering 17.5%. That would certainly grab my attention!
But just because the business did that well in the past does not mean it will do so again.
Direct Line has seen significant changes in senior leadership since the start of last year. That could help improve performance, but it also brings a risk of internal disruption to the business as any management change does.
Weak business performance
Even more alarming for me as an investor is the source of last year’s profit warning. Basically Direct Line pointed the finger for its poor performance at events such as unusually bad storms pushing up the cost of claims.
But exceptional events are unexceptional in the business of insurance. Estimating risks and pricing them properly is the bread and butter of a general insurer such as Direct Line.
Its rivals faced the same conditions last year but did not seem to trip up in the same way. That makes me concerned about how tight Direct Line’s underwriting standards have been over the past few years and whether that could lead to any more nasty surprises in future.
Room for dividend growth
On the positive side, the dividend is back and I think there is substantial room for future growth.
At 4p per share, it is less than a third of what it had been two years before. But the company has a sizeable business – revenues last year came in at a record £3.6bn.
If it can convert revenue growth to earnings growth, there could be scope for a bigger dividend in future.
The first quarter of this year saw year-on-year percentage revenue growth in double digits. That is good, but reflects higher pricing rather than business growth: the number of policies in force fell 2% from the same quarter a year ago.
The Direct Line dividend may yet scale its old heights. But if it ever does, I do not expect it to happen for a long time. The business performance simply could not sustain such a high payout at the moment, in my view. I have no plans to buy the shares.
