Broker tips: Direct Line, Sainsbury's, builders merchants
Direct Line Insurance Group’s shares declined on Thursday after Macquarie Research downgraded the stock to ‘underperform’ from ‘neutral’ and cut the target price to 345p from 295p.
The downgrade comes as the government is due on 31 January to announce a decision on the interest rate used to calculate discounts applied to personal injury compensation.
The Chancellor is expected to lower the current Ogden discount rate of 2.5% which is considered by many to be too high as it penalises claimants.
Macquarie said it understands Direct Line carries a margin covering the cost of a 100 basis reduction in the rate to 1.5%.
“However, we expect the Lord Chancellor to set the rate between 1% and 1.5%,” Macquarie said.
“Thus if the rate falls to below 1.5% then Direct Line’s reserves may require strengthening.”
Macquarie predicts the new rate will cost the company £90m, in excess of the reserve margin the bank expects it currently holds.
More importantly, the use of this margin in large bodily injury reserves will mean reduced reserve releases in the future, the bank added.
“Currently we expect that Direct Line has benefitted from releasing the excess margin between 1.5% and 2.5% when a claim is settled. This will potentially not be available in the future.”
Direct Line is “especially sensitive” to changes in reserve releases as the group depends on this source of earnings for 70% of its operating profits.
Macquarie’s earnings forecasts for the company are 16% below consensus in 2017 and 26% below consensus in 2018. The bank expects consensus forecasts to fall should the discount rate reduce.
“With a negative catalyst looming for Direct Line, we expect Direct Line to underperform the wider non-life insurance sector at least until the new Ogden discount rate is announced,” the bank said.
“As such, we reduce our price target from 345p to 295p, as we factor in the increased uncertainty into our valuation through a higher cost of equity.”
J Sainsbury was on the back foot on Thursday as HSBC reiterated a ‘reduce’ rating but raised its target price to 205p from 185p following the supermarket’s third quarter trading update.
The company on Wednesday reported total group sales for the 15 weeks to 7 January rose 0.8%, with group like-for-like sales up 1.0% as weak LFL growth from the supermarkets business of 0.1% was offset by a 4% gain from recently acquired Argos.
HSBC said the total sales and Sainsbury’s sales growth were broadly in line with expectations. “The surprise was 4% LFL growth from Argos vs consensus of 1% and came despite disruption and increased competition,” the bank said.
While Argos did well, HSBC stressed that the core supermarket chain is key and remains under pressure.
The bank also warned that Sainsbury’s faces further competition from its recovering rival Tesco.
“As Tesco continues to recover it is likely to win more sales back from Sainsbury than any other retailer. Sainsbury lacks scale compared to Tesco and will find it harder to compete as Tesco utilises its scale more effectively,” HSBC said.
“We continue to believe that in the long term Argos is in a weak position and will prove a distraction to the core business. Sainsbury needs a strong food business.”
HSBC updated its forecasts on pre-tax profits for fiscal year 2016/17 to £570m from £560m to reflect Sainsbury’s guidance of £573m. The bank raised its target price to 205p from 185p to reflect the profit increase and a reduction in the beta, a measure of volatility, to 1.3 from 1.5.
Against the backdrop of a "patchy" construction sector, broker Liberum highlighted Howden Joinery as its top pick and downgraded building materials suppliers Wolseley to 'hold' and SIG and 'sell' on valuation grounds.
Liberum felt the stock market appeared overly pessimistic on builders merchants, "as it may be overestimating operational leverage".
"RMI [repair, maintenance, improvement] has fallen out of favour but we believe that the degree of pentup demand that exists, and banks’ appetites to lend, may mean that a 2017 slowdown may be shorter and shallower than feared," the broker.
Howden was picked as offering around 30% share price upside to a target price of 500p, as while concerns of a Brexit-driven slowdown are understandable, the company's management has a good track record of cutting overheads in slower markets.
"We see this as an excellent opportunity to pick up shares in a long established category-killer with a very strong balance sheet," analysts wrote.
Others with a 'buy' rating including air conditioning and ventilation specialist Volution, "a highly cash generative leader with profitable reinvestment opportunities and structural growth" with a target price of 206p; Travis Perkins on the momentum from its self-help strategy, with a target of 1,650p.
Safestyle was a 'buy' with a 335p target, for its growing market share; and Tyman too, targeting 327p, as it is "well placed" for renewed US residential growth and continues improving its businesses.
Even though the shares are trading on a low valuation, SIG was moved down from 'hold' with a target price of 88p, as "risks endure" and analysts remain concerned that margin pressure will continue due to competitive pressures from Travis Perkins and Saint-Gobain - "we wonder how much losing scale will impact the group's offer".
Wolseley, with a target price of 4,975p, was downgraded on valuation grounds even displaying attractive characteristics of good leadership, business improvement and US exposure.