Monday, April 17, 2006

BMO NB Preview of Life Insurance Co Q1 2006 Earnings

BMO Nesbitt Burns, 17 April 2006

The life insurers kick off Q1/06 reporting next Thursday, April 27, 2006 with Sun Life, followed by the other three Canadian lifecos the week of May 1, 2006 (see scorecard at the end of this comment). Overall, we estimate EPS growth of 10-13%, with Manulife expected to generate the highest growth in Q1/06 and for all of 2006.

On balance the macroeconomic conditions remain favourable for the sector. Strong growth in the Canadian equity markets, up 25% versus the same quarter last year, and respectable results from the S&P500, an increase of 8% versus Q1/05, augur well for the wealth management operations at the lifecos (see Table 1). Partially mitigating the strong equity markets is the 6% rise in the Canadian dollar versus the same quarter last year. While we remain sensitive to the strength of the Canadian dollar, earnings from the two largest life insurers- Manulife and Sun Life- have grown nicely over the last four years, despite the dramatic rise of the Canadian dollar. However, Great-West's results are expected to be negatively impacted by the lack of currency hedge (last year GWO hedged U.S. earnings at 1.32 versus the current rate of 1.17).

In addition to good equity markets, conditions in the credit market remain quite favourable. Spreads on 'BBB,' 'BB,' and 'B'-rated securities have been stable over the last few years. In fact, spread trends continue to remain historically low.

The interest rate environment also appears to be improving. The yield on the U.S. 10-year has risen above 5% and in Canada the yield on the 10-year has risen to 4.45% from under 4% a few months ago. Relatively higher long-term interest rates and a steeper yield curve should all be positive for the life insurers, as outlined in our research report entitled 'Interest Rates and Life Insurance: A Triple Triple,' released on January 20, 2006.

Sun Life reports on Thursday, April 27, 2006, and we are projecting EPS of $0.85, up 10% from $0.77 in Q1/05 and versus consensus of $0.86. We expect results to be driven by good equity markets, strong credit quality and continued strength from the Canadian operations, specifically Canadian group businesses. MFS should have another solid quarter and while we expect total net inflows to be positive, the net flows into retail mutual fund operations should continue to be negative. Of particular interest to us in the quarter will be the status of the share repurchase program, margins at MFS and sales results in Canadian individual life and U.S. annuities. Margins at MFS have been below peer group average as it absorbed costs related to the SEC investigation(s), which are nearing completion, and an expanded international platform to meet expected global growth requirements. Canadian individual life sales growth is expected to remain positive. Sales of U.S. variable annuities are expected to remain in net redemptions; however, recently announced new distribution arrangements may improve the outlook for variable annuity sales. Sun Life remains Outperform rated.

Manulife reports on Thursday May 4, 2006, and we are projecting EPS of $1.16 versus consensus of $1.18 and $1.03 in Q1/05. Once again, we would expect Manulife to show the strongest results not only in terms of earnings growth but also in terms of new sales, particularly in the U.S. and Japan. While the JHF acquisition is complete, we will continue to monitor the growth in Funds Under Management in the U.S. individual life and variable annuity operations- the two key U.S. segments for Manulife. We also expect to see further growth of wealth management sales from the company's Asian operations, and results from Hong Kong appeared to be improving over the last two quarters and we hope to see further evidence of this turnaround in term of insurance sales and growth in the sales force. Rising long-term interest rates in Japan should help results in that country. We would expect to see MFC's gross impaired loans to continue to grow, albeit at a very modest pace, given the size of the block of assets purchased from JHF. While the current credit market conditions are very favourable, the trend is also unsustainable. Accordingly, we expect credit to be a primary concern of Manulife investors in the event of adverse credit developments. Lastly, we will continue to monitor the company's buyback activity, which appears to have been more modest in the first quarter versus the last three quarters. Manulife remains extremely well capitalized, with excess capital in excess of $4 billion, in our view. We do not believe that Manulife is interested in any large transactions but it is clearly open to relatively smaller bolt-on acquisitions in the U.S. Manulife could entertain more ambitious acquisitions in Asia given the growth opportunities in those markets. However, we do not believe that a transaction is imminent. Manulife remains Outperform rated.

Great-West LifeCo also reports on Thursday, May 4, 2006 and we project EPS of $0.53 (consensus is $0.52), an increase of 12.8% versus $0.47 in the same quarter last year. Our estimate for GWO may be too optimistic given management's guidance during the Q4/05 conference call that EPS growth in 2006 is likely to be lower than growth in 2005 of 10%. The slowing trend is due to the absence of a favourable currency hedge (discussed above) and unsustainably high earnings growth, over 20%, in Canada over the last few years since the Canada Life acquisition. We expect the U.S. operations to remain the focus of investor attention, specifically the U.S. health care. While net new participants in the health care segment may range from 0-50,000, the debate is more focused on the company's strategic intentions in this segment. GWO shares have lagged the group over the last 12 months and we believe this situation reflects concerns on the currency hedge and the strategic direction of the U.S. operations discussed above. Over the last four years, GWO's shares have gone from trading at a 20% P/E premium to the group to a 15% discount to the life insurance group. This shift largely reflects the strong share price performance from Manulife as GWO's absolute valuation has remained relatively stable. Nonetheless, we doubt that GWO shares can reverse its relative valuation discount without greater clarity on the strategic direction of the U.S. operations. GWO is rated Market Perform.

Industrial Alliance, which is rated Outperform, reports Q1/06 results on Tuesday, May 2, 2006. We project that IAG will generate EPS of $0.61, largely driven by the wealth management operations. Forecast EPS growth of 13% in Q1/06 is above management's guidance of roughly 10% for 2006. Management effectively reduced EPS guidance to 10% from 10-12% during the Q4/05 conference call largely due to concerns on low interest rates and the impact that this may have on new business strain. While we sympathize with this view, we do believe that the strong equity markets, good credit experience and acquisitions should help mitigate the higher sales strain. Key issues during the quarter will be the growth in in-force business in individual life and an update on the Clarington acquisition. At some point in the future, we expect IAG to repurchase some, or all, of the $63 million in subordinated debt at Clarington used to finance commissions when it was an independent company. The repurchase of subordinate debt is likely to have a one-time impact on IAG's financial results. The appropriate allocation of this cost would be to the purchase price of Clarington. Longer term, the key issue is the sustainability of mutual fund net flows at Clarington and we believe that the evidence thus far is inconclusive except to say that Clarington did consistently generate net sales, despite as an independent entity in the face of volatile markets and relatively poor performance by some sub-advisors. The central issue focuses on whether IAG can keep the sales results positive with a change in ownership. We remain cautiously optimistic on this front; however, quarterly results over the next six months should be instructive.

Price Targets for Life Insurance Companies, as at February 2006