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Investors’ Chronicle: Phoenix Group, Ferrexpo, Direct Line

BUY: Phoenix Group (PHNX)

The damage from the LDI debacle weighed heavily on the share price but the recovery continues, writes Julian Hofmann.

Phoenix Group endured a difficult autumn as traders took aim at any company with even a tangential connection to servicing or originating swaps for the liability-driven investment (LDI) industry.

With that bad memory now fading, these results were a chance to move on and showcase the dividend attraction that forms a major part of the company’s investment case. Phoenix delivered a modest rise in the payout against a background of complex market movements, making the income statement difficult to interpret — a life insurer’s primary concern is to hedge its Solvency II base, rather than protect the reported income statement from wild asset swings. Therefore, the results require a certain amount of interpretation.

The IFRS-adjusted operating profit looked more coherent at a profit of £1.22bn, which was basically flat on 2021. At these levels, even small changes in interest rates can have a broadly positive impact, and rising rates made themselves felt with interest income nearly £250mn higher at £2.88bn generated by the company’s asset base. This included a notable third-party contribution from related entities — interest income here rose from £1mn to £21mn for the year on the back of better rates.

In terms of the outlook, management seemed coy about forecasting specifics other than that the economic outlook might be difficult. However, with interest rates underpinning the viability of defined-benefit schemes, and about £470bn of heritage business to complete, Phoenix should have a decent pipeline of de-risking business this year as pension funds offload liabilities.

There is barely a sliver of paper between valuations for the big life insurers, which is reflected in Phoenix’s forward price/earnings ratio of 10.6 for 2023 and its 8.5 per cent dividend yield. An important income share given the high inflation background.

HOLD: Ferrexpo (FXPO)

The iron ore miner has managed to reopen some production capacity recently, and beat cash profit forecasts for 2022, writes Alex Hamer.

Ukrainian iron ore miner Ferrexpo’s 2022 results are not like those of most other companies listed in the UK. The standout figure, far more than Ebitda or the final dividend, is the 20 workers killed while defending Ukraine from the Russian invasion. That the company has been operating at all is a significant result.

Since the war started in February 2022, its export capabilities have been severely constrained, while the inconsistent power supply has also cut the company’s ability to turn the high-grade iron ore it mines into pellets.

“Operationally, our assets have produced in line with accessible markets, with the closure of Ukraine’s access to the Black Sea placing a significant impediment in our ability to access seaborne markets,” said company chair Luca Genovese.

Exports to European customers continued, and the company kept sales above $1bn (£820mn), on pellet production of 6mn tonnes, a 46 per cent drop on 2021. Sales to Europe only fell 23 per cent, however, as supply lines were more accessible.

There have been some positive updates recently — Ferrexpo reported last month that it had restarted another pelletiser line, meaning it is running at half capacity.

Ben Davis, an analyst at house broker Liberum, said he was optimistic about an agreement over iron ore exports being made with Russia, like the grain corridor deal. And failing that the “success of Ukraine’s expected counter offensive in the summer will ultimately lead to a withdrawal of Russia’s navy from the Black Sea”. Perhaps a forecast to be taken with a pinch of salt, however, given Liberum’s experience is in equities research rather than conflict strategy.

Amid the difficult operating conditions (to put it mildly), there was a positive surprise for shareholders in these results — Ferrexpo managed to top consensus estimates for cash profits of $730mn, with its $765mn final figure. Liberum forecasts a significant decline this year, however, to $323mn. Alongside the war, global trading conditions knocked earnings as the iron ore price came down by around a quarter. Ferrexpo also brings in a ‘pellet premium’ on top of the 65 per cent Fe market price, and this climbed to $72 a tonne from $60 a tonne in 2021.

The company has had corporate governance issues in the year — 49.5 per cent shareholder Kostyantin Zhevago sells the company spare parts, insurance, advertising and other services, racking up $23mn in related-party transactions in the year. He quit the board in December after being arrested in France on Ukrainian charges.

We have previously recommended selling Ferrexpo off the back of its ownership structure. Now the war is the determining factor in its performance and we are neutral given the uncertainty there.

HOLD: Direct Line (DLG)

The insurer, in keeping with peers, has taken a bath on motor pricing assumptions, writes Mark Robinson.

As foreshadowed in January’s trading update, Direct Line will not be paying a full-year dividend due to its deteriorating solvency ratio — a measure of the insurer’s ability to meet its long-term financial obligations.

It was perhaps the degree of the fall rather than the resultant metric — 29 percentage points to 147 per cent — that caught the eye. The metric (post-dividend and share buyback) fell towards the lower end of the risk-appetite range, although it is worth mentioning that the ratio had increased by around five percentage points by the end of February, partly due to positive movements on the bond portfolio. The reversal was driven by lower profits, together with losses on investments held, with the latter point of greater interest given current events in the specialist banking sector.

As we’ve witnessed recently with industry peers, claims inflation had an outsize impact on the motor segment, where inflation was 14 per cent above the insurer’s pricing assumptions. This not only points to the underwriting challenge posed by the return of regular motoring volumes as the pandemic restrictions dissipated, but it also reflects wider price pressures in the economy. Supply chain disruption fed through to delays in third party claims, so the cumulative impact of these factors saw the segment’s combined operating ratio — incurred losses divided by earned premium — rise from 92.4 to 114.7 per cent year-on-year.

Management notes that pricing in the insurer’s other business segments kept pace with claims inflation, with combined operating ratios broadly in line with expectations, albeit when they’re “normalised for weather”. Indeed, Direct Line had to contend with weather event claims of £149mn, more than double the original budget assumption, with the lion’s share brought about by lengthy periods of sub-zero temperatures across Scotland and north-west England.

The 64.9 per cent contraction in investment income also contributed to Direct Line’s slump to a statutory loss, along with a marked reduction in prior-year reserve releases. But perhaps the most salient detail was the 16.3 per cent increase in the overall loss ratio.

FactSet consensus gives a combined ratio of 97.5 per cent for 2023, falling to 95.6 per cent in the following year.

The market outlook had dimmed by July, when the board decided not to launch the second £50mn tranche of Direct Line’s £100mn share buyback programme. Looking ahead, heightened macroeconomic uncertainties, not least of which those linked to debt markets, and “higher than assumed claims inflation on motor business written during 2022 and in early 2023″, are forecast to weigh on earnings. But we think share price performance over the past year adequately reflects the negative outlook.

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