Friday, April 28, 2006

Sun Life Q1 2006 Earnings

Scotia Capital, 28 April 2006

Q1/06 - Slight miss due to unfavourable claims experience

• Sun Life reported Q1/06 operating EPS (f.d.) of $0.84 vs $0.77 for 9% YOY growth, $0.02 below our estimate, and $0.02 below consensus. Given the favourable economic "tail winds" (buoyant markets, excellent credit environment, rising long term rates) we believe the "miss," largely due to modestly unfavourable claims experience in both the U.S. and Canadian group insurance segments, was somewhat disappointing.

• Mixed results. What was likely needed to boost the stock just wasn't there this quarter. We believe Sun Life needs to have, amongst other things, exceptionally better-than-industry sales growth in U.S. variable annuity, positive net flows in U.S. variable annuity, increasingly positive net flows at MFS and significant margin improvement at MFS before we can ascribe an increasing multiple (relative to the group) to the stock. Unfortunately this wasn't the case in Q1/06.

• But relatively favourable macro-environment and hint of increasing buy-back activity should continue to provide support. The combined impact of rising interest rates, which help to mitigate spread compression concerns, buoyant markets, good credit, lots of buyback support, and a payout ratio still at the low end of the targeted 30%-40% range, should continue to provide support. Management indicated the company would likely increase the pace of share buybacks going forward (from the 2 million shares in Q1/06, most of which were in March), suggesting the company definitely will meet if not exceed its targeted $500 million spend on annual share buybacks.

• Still a "show me story" - and not showing positive net sales in either U.S. variable annuity or U.S. mutual funds, and showing no significant improvement in U.S. variable annuity market share. Although we find the 24% increase in U.S. variable annuity (VA) sales encouraging (after increasing 10% at Q4/05), we expect only very modest market share improvement at best, especially given that exceptional results from other U.S. lifecos so far this quarter (Ameriprise's U.S. VA sales were up 70%, Genworth's were up 50%, MetLife's were up 57% and Harford's were flat, after declining sharply for several quarters). With total sales growth from these five players, including Sun Life, up 25% (we would expect this figure to increase when we include traditional players such as Prudential, Lincoln and Manulife) we expect the company will gain little in the way of market share in the U.S. VA market, despite the $10 million spent in expanding its distribution. More importantly, net sales continue to be negative, and, with a large block of single manager variable annuity business with a current duration of 5-7 years, we expect this trend to continue, despite the improvement in gross sales. Finally, weaker-than-expected net sales in both retail mutual funds and institutional business, largely due to a "poor" January per management, contributed to a disappointing negative US$300 million in net sales at MFS. Management indicated flows at MFS were positive in February and March of 2006.

• Margin improvement at MFS due in part to the transfer of money losing retirement services operation from MFS to U.S. annuities. The company noted that pre-tax margins at MFS (10% of SLF's bottom line) improved 300 bps, with about 150 bps due to the transfer of a retirement services operation from MFS to SLF's U.S. annuity segment, and another 150 bps due to operational improvements. The retirement services operation, which lost US$4 million in Q1/06, includes roughly US$6 million in revenue and US$10 million in expenses in the quarter, and about US$15 billion in assets. While the transfer of this retirement services business makes MFS look better (we look for 18% CAGR earnings growth, ex f/x through 2007), the only way for a meaningful impact on SLF's bottom line is for the company's U.S. annuity segment to turn this business around. With little experience in the retirement services business, we remain somewhat sceptical.

• Canadian segment (50% of bottom line) reported a disappointing 4% YOY decline in earnings over a strong Q1/05 due to unfavourable group claims experience. Group long term disability claims experience, an often volatile business, contributed, in part, to the decline, as did a slight decline in the earnings contribution from SLF's 34% interest in CI funds. The 12% CAGR the Canadian operations had from 2003 through 2005 certainly benefited from CI's 38% CAGR over the same period. Excluding CI, earnings for Sun Life's Canadian division grew 9% (CAGR) over the same period, and just 6% in 2005. We expect 7% growth in 2006 and 10% growth in 2007, respectively, for the segment, assuming a return to a more "normal" claims experience in the group insurance segment.

• For the U.S. division we look for steady 11% growth (CAGR, ex fx) through 2007. Despite the somewhat mixed outlook for average asset growth in the U.S. annuity segment (for a business in which average assets increased ex f/x just 1% CAGR from 2002 through 2005, we forecast just 2% CAGR through 2007 largely due to continued negative net flows) we expect rising interest rates and continued buoyant markets to allow for margin improvement. Whether it be a yield pick-up program for the company's U.S. fixed annuity business (by investing at longer durations than the liability portfolio) or an innovative "surplus" type funding of U.S. individual AXXX reserves (whereby the company uses internal funds rather than bank letters of credit (LOC) to fund these reserve requirements thus generating additional yield and saving the LOC costs), Sun Life has done a very good job of engineering stable earnings growth in its U.S. division, despite the drag of currency. The yield pick-up in the U.S. fixed annuity business was the prominent contributor to the 64% YOY earnings growth in the U.S. division in Q1/06 (ex f/x), over a very poor Q1/05 that had a significant amount of reserve strengthening. Our 11% growth assumption assumes group insurance claims experience will return to more normalized levels. Poor group insurance claims experience was the primary contributor to the 22% QOQ decline in earnings for the division.

• CMG Asia acquisition progressing well and provides the necessary catalyst ($0.05 accretion in 2006, $0.07 accretion in 2007) for the company to exceed 10% EPS growth target in 2006 despite currency headwinds. We look for 11% EPS growth in 2006 and 10% in 2007, which combined with aggressive buyback levels should add 100 bps to ROE over the next two years, just shy of the company's target of 75 bps per year.

• We expect 100 bps improvement in ROE over next two years - 50 bps shy of target - which might suggest the company needs to do something other than buy back stock. With an estimated $1.5 billion in excess capital, we believe the company continues to look for deals. Our impression is prices are too high and the company remains patient. With the CFO set to leave within the next 10 months, and an expected detailed search for a replacement underway, we remain somewhat sceptical as to whether a large and/or complicated deal gets done before the end of the year. Clearly smaller and simple deals, largely accretive, like the CMG Asia acquisition ($560 million spend with $0.05-$0.07 per share accretion) are ideal.

• Asset quality remains strong. Net impaireds at 18 bps remain exceptionally low. With only 3% of bonds below investment grade, we believe Sun Life’s balance sheet is well protected should the credit environment become unfavourable.