Insurance company Direct Line (DLG) sparked a more than 25% drop in its share price after announcing (11 January) it wouldn’t pay a final dividend due to poor trading which has put pressure on its balance sheet.

Direct Line was hit by a combination of extreme weather and higher motor claims inflation which dented profit and caused the company to reassess what it needed to do with its cash.

What is most surprising about the missed payout is that the firm has built a reputation as a steady dividend payer and regularly paid a special dividend on top.

While Direct Line’s problems appear company-specific, in this article we highlight potential income disappointments which may be brewing elsewhere in the UK.

AN IMPRESSIVE TRACK RECORD

Since listing on the market in 2012 at a price of 175p per share Direct Line has paid out 269p to shareholders in regular and special dividends. It is therefore understandable why shareholders might have considered the firm a solid income payer.

Looking through the accounts and trading updates there are signs the company may have been too generous to shareholders at the expense of financial prudence.

The estimated 2022 dividend was uncovered by earnings according to Refintiv data. In addition, the 20.9p per share dividend which had been forecast for its 2022 financial year represented a yield of 9.2% which looked high, suggesting the market was sceptical on the level of the anticipated payout.

Direct Line was also in the process of a £100 million share buyback programme equivalent to around 3% of the company’s market cap before the trading update. In effect, this was equivalent to paying shareholders a combined yield of 12% – too good to be true.

Finally, first half results (2 August) showed the company’s capital cushion had dropped significantly with the solvency ratio shrinking from 176% to 152%.

Despite this management said it was ‘confident in the sustainability of our regular dividends as we look ahead to the full year and beyond’.

The solvency ratio measures the amount of capital a company has relative to the minimum regulatory capital. To its credit, the firm did cancel the remaining £50 million left in the share buyback plan in the summer.

IS THERE ANY READ ACROSS FOR ADMIRAL?

Fellow insurer Admiral (ADM) has also been a prodigious income payer over the years as the chart shows.

Admiral’s solvency ratio shrunk by the same percentage points as Direct Line’s in the first half of 2022, but, crucially, from a higher starting point. The solvency ratio of 185% suggests the company has sufficient capital for the dividend not to be under threat.

Analysts have pencilled in 168p per share of total dividends for 2022 which at the current share price gives a yield of 8%.

OTHER POTENTIAL INCOME DISAPPOINTMENTS

It might be a good idea for investors to have a good look at their portfolios to see if there are any high yielding stocks which are not supported by earnings.

While the UK economy has avoided a recession so far, there are heightened risks for the rest of the year as consumer spending (roughly two thirds of the economy) comes under increasing pressure.

Using Stockopedia software Shares has created a screen to identify stocks which have historic yields above 7% and dividend cover (earnings per share divided by dividend per share) below one. It is only a guide but may throw up some interesting results.

Notably Direct Line makes the list, but there are other insurance firms that qualify too, including Sabre Insurance (SBRE).

Sabre is involved in similar lines of business to Direct Line, and it reported a solvency ratio of 163% in the first nine months of its financial year, notably above the top of the company’s target range. Sabre doesn’t have any debts.

HOUSEBUILDER DIVIDENDS MAYBE AT RISK

Housebuilder Persimmon (PSN) appears on the screen which may look surprising at first glance given its large net cash position.

In November the company announced a new conservative capital allocation policy and scrapped plans for a special dividend.

Recent trading updates across the sector suggest companies are planning to retrench land purchases and focus on conserving cash through efficiencies and the slow release of work in progress.

Analyst Andy Lammin at Investec believes the whole sector is at risk if earnings fall because many housebuilders link their payouts to earnings growth.

Lammin said, ‘There is an increasing risk that dividends are cut further as we potentially see further earnings downgrades come through on a weakening housing market.’

Investment director at AJ Bell, Russ Mould commented: ‘Aggregate consensus estimates for the FTSE 100 and FTSE 250 housebuilders suggest net profits will fall by a third to £2 billion and that dividend payments will drop by more than a fifth to £1.5 billion in 2023.’

Disclaimer: Financial services company AJ Bell referenced in this article owns Shares magazine. The author (Martin Gamble) and editor (Tom Sieber) of the article own shares in AJ Bell.

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