Broker tips: Direct Line, Micro Focus, Rio Tinto

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 inflexion 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%.

Micro Focus got a boost on Wednesday as Goldman Sachs upped the stock to 'buy' from 'neutral' and lifted the price target to 1,700p from 1,300p as it said the risk/reward is now skewed to the upside.

GS said that following a period of significant M&A execution risks which led to turbulent sales growth in FY18, the dust is starting to settle at Micro Focus.

"We see early indications that the business is stabilising after an in-line trading update implying that revenue declines are not deteriorating any further which we view as a positive," the bank said.

In addition, it highlighted a number of positive indicators, among them the appointment of Jon Hunter, an industry veteran in the mature infrastructure space, to the executive management team. GS said he could be key in steadying the ship over the medium term.

The bank also noted the fact that management is incentivised to maximise shareholder returns, with management remuneration heavily geared to an increase in share price and total shareholder return.

"Having said this, recent management turnover (CEO & CFO leaving in 2018) might raise some concerns amongst investors," it added.

Iron ore indicators are looking "shaky" and steel prices are faltering, said Liberum, as it downgraded Rio Tinto to 'sell' from 'hold' and cut the price target to 3,350p from 3,600p.

The brokerage noted that Rio shares have bounced back 10% from their September lows following a third-quarter revival in Chinese steel and benchmark iron ore prices. However, steel prices are now faltering and mill profitability is declining.

Liberum said demand weakness looks set to continue based on its analysis of previous credit cycles, confirmed yesterday by another weak print of Chinese credit growth. Chinese exports of aluminium are also rising as domestic demand slows, putting pressure on prices.

"Our base case is that demand weakness will continue to erode Chinese steel mill profitability and ultimately drive iron ore grade premiums lower - the relationship between these two factors has remained broadly intact throughout this cycle, although this is dislocating again now.

"Continued weakness in spot mill profitability in China should see prices for benchmark (62%) and premium grades (65%) of iron ore move back towards lower (58%) grades, currently $52/t. The growth in higher grade and lower alumina volumes form the S11D ramp-up and the resumption of Minas Rio at the end of the year should aid in this process."