Surprisingly for such a low-growth company operating in a mundane industry, this stock’s share price soared by 40% after received a takeover approach earlier this year. But rising borrowing costs could undermine the bid.
Turkey of the week: Domestic & General (DGG), rated as a BUY by Daniel Stewart
Unlike Computacenter, Domestic & General (D&G) looks like one of the many overvalued stocks currently being precariously propped up by takeover interest. D&G is the UK’s largest provider of post-sale extended warranties for domestic appliances such as TVs and washing machines. It manages the entire process, including underwriting, claims handling and repairs, covering around six million appliances in total. Most new business comes from direct marketing, such as email campaigns. Like most insurers, Domestic & General invests policy premiums in the financial markets, which accounted for 32% of group profits in 2006. Smaller operations include pet insurance and outsourced call-centre services. Its fledgling continental Europe business – although higher growth – presently accounts for just 5% of turnover.
Somewhat surprisingly for such a relatively low-growth company operating in a mundane industry, Domestic & General received a takeover approach in May from Homeserve, which helped lift its shares by 40%, and in turn triggered an auction process. However, if the dire state of the debt markets undermines the bids by driving up borrowing costs, then either the offers will be withdrawn or reduced in price. This would be likely to send the shares into a tail-spin.
There are also a number of worrying headwinds for the underlying business. Firstly, the need for extended warranties on domestic appliances is gradually falling as product costs go down and reliability improves. Secondly, valuations for many insurers are around ten times earnings, which is 45% below Domestic & General’s present rating. Meanwhile, the current jitters in the markets mean that the group’s near-term investment returns are also likely to be affected.
The City has pencilled in revenues and earnings per share of £329m and 78p for this year, rising to £362m and 86p next year – putting the shares on challenging p/e ratings of 17.6 and 16.3 respectively. Moreover, Domestic & General recently lost a lucrative call-centre contract with the Post Office that will blow a gaping £1.5m per year hole in future operating profits.
So what price should a buyer be prepared to pay? I’d value the group on a stand-alone basis at around 930p. As such, assuming a juicy 50% control premium is extracted from a strategic buyer, such as Homeserve, the stock might be worth up to 1,400p per share. This suggests there is minimal further upside from current levels, while there are substantial downside risks. And in fact, when the deal was originally announced, Homeserve’s approach for Domestic & General got a mixed reception from the City, with analysts questioning the logic of buying this low-growth business. If the deal falls through, the shares could rapidly head south towards 1,000p.
Recommendation: TAKE PROFITS at 1,360p
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