LONDON (ShareCast) - (Sharecast News) - Deutsche Bank downgraded its stance on Direct Line to 'hold' from 'buy' on Wednesday and cut the price target to 370p from 390p as it reduced its earnings estimates on the back of higher-than-expected claims inflation, resulting in greater compression in margins.
In a broader note about motor insurance pricing, the bank said the latest data showed a 0.1% month-on-month increase in UK motor insurance prices in October versus a 0.7% increase the month before.

This stabilisation is consistent with DB's view that prices are at an inflection point and are likely to rise gently from here.

"On the other hand, at the 1H18 results, motor insurance companies commented that claims inflation was returning to a more 'normalised' level of 3-5%, and subsequently at the 3Q18 stage, indicated to be at the top end of this range. This therefore represents a bigger gap between price increases and claims inflation, indicating a bigger compression in margins than we initially expected."

The bank, which upped Direct Line to 'buy' just last month citing an attractive valuation and the potential for EPS downgrades to bottom out, said the company's third-quarter trading statement has weakened some of these arguments.

"In summary, the combination of higher inflation and greater-than-expected reduction in risk mix results in our EPS estimates declining by 6% for FY18, 5% for FY19 and 4% for FY20. On top of that, we suspect that motor insurers' margins will temporarily come under further pressure in 2H19 as the industry starts to pass the benefit of the whiplash reforms ahead of the associated benefit being realised only from April 2020."

As a result, DB now expects the group's combined operating ratio in FY19 - ex-Ogden impact - to be at the worse end of the medium-term guidance of 93% to 95%.

"Admittedly the dividend yield on Direct Line still looks attractive (circa 8.8% per annum on average for the next three years); however, we now believe this is outweighed by the risk of consensus earnings downgrades - therefore, we lower our rating," it said.

At 1350 GMT, the shares were up 0.5% to 325.80p.

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