Friday, July 28, 2006

Sun Life Q2 2006 Earnings

Scotia Capital, 28 July 2006

• Sun Life reported Q2/06 of $0.88 per share, $0.01 below our estimate and in-line with consensus - but with an additional $0.08 in one-time tax gains, offset to some extent by $0.05 in additional reserves/strain in the U.S. (half of which is sustainable in the near term) we peg this at a $0.05 miss. A mixed quarter. While sales results were strong in areas where we focused (ex f/x U.S. individual insurance sales nearly doubled, U.S. domestic variable annuity sales were up 23%), as well as in other areas (U.S. and Canadian group insurance sales up 20% and 233%, respectively, and Canadian individual sales were up 5%), profitability was not as transparent. A significant increase in new business strain owing to substantial increases in reinsurance rates in the U.S. individual insurance market, coupled with higher-than-average new business volumes, weighed heavily on the company's bottom line in this segment.

• U.S. individual insurance new business/reserve strain - is largely a 2006 issue and less likely a 2007 issue. The company claims that, rather than invoke multiple price changes in Q2/06, at a time when the company had just started selling through the M Group and National Financial Partners (two large and well-established distributors in the U.S.), it chose to take the "reinsurance hit" to earnings in Q2/06. Re-priced products will be launched in August, 2006, and with some of the previous product sales "still in the pipeline", it will take at least one more quarter, if not two, before the "strain issue" will go away. Whether or not Sun Life will lose traction in these channels when it re-prices next month remains to be seen. Also, the yet to be seen level of profitability in the re-priced products is another area of possible concern. In our opinion, the company will do its best to not jeopardize the momentum it currently has with its new distribution partners, and we remain somewhat cautious as to how quickly the profitability of its products will return to pre-2006 levels. That said, we are very impressed with the sales levels in Q2/06 (sales nearly doubled), and expect the company to post double digit sales growth, well above the industry level.

• Lowering EPS estimates to reflect the increased level of new business strain (i.e. lower profitability) in U.S. individual insurance, as well as negative impact of weaker equity markets. We decreased our EPS estimates by $0.05 for the remainder of 2006, and by $0.05 in 2007, to reflect lower-than-expected asset levels at Q2/06 (owing to weaker equity markets) as well as the negative impact of new business strain in the U.S. individual insurance segment in 2006 and into 2007.

• A couple of bright spots - MFS margins continue to improve and U.S. domestic variable annuity sales finally showing some solid double digit growth. MFS margins were up 22% to 27% YOY and up from 26% QOQ, as the company continues to focus on costs. In addition, we believe we are finally starting to see some traction in the U.S. variable annuity market, where a significant increase in the number of wholesalers, as well as an attractive product, contributed to 23% sales growth in the domestic market. However, MFS had negative net sales the second straight quarter (negative $US400,000) and U.S. variable annuity net sales continue to be negative (negative $US218,000), although domestic net sales, while negative, where the best level we've seen in the last five quarters.

• A little too much focus on micro-managing earnings growth by segment - all in we still see the company achieving its 10% EPS growth target through 2007. The company's segments naturally have volatility, but this is offset at the total company level, and we believe an aggregate view of the company provides the clearest picture. In the aggregate we still see the company achieving its 10% EPS growth objective through 2007, assuming equity markets increase in the 7% per annum range. We take some comfort with the company's 14.8% EPS growth (ex f/x) in Q2/06, despite the somewhat weaker equity markets. We take additional comfort in the company's ability to continue to buyback shares ($400 million YTD/06, with a strong likelihood the company could exceed its $500 million target), as well as continue to increase its dividend in the 15% range per annum.

• Canadian segment (50% of bottom line) steady 12% YOY growth - ex tax gains and 73% increase in earnings attributable to the CI funds, we estimate earnings were up 7%. With earnings up 4% YTD/06 (after poor claims experience resulted in a weak Q1/06, with tax gains significantly helping Q2/06) we expect 4% EPS growth in 2007, and 9% EPS growth in 2007. All in, the 6.5% earnings in this segment from 2005-2007 is consistent with the 8% earnings growth (7% ex the contribution form CI funds) in 2005. Group businesses continue to be the bright spot, with exceptional sales growth and increasing profitability. Individual insurance sales, up 5%, continue to pace ahead of the market.

• For the U.S. division we look for strain to continue to pose a drag on earnings growth, but expect a 14% rebound (ex f/x) in 2007, as the strain issue gradually goes away. We expect the August re-pricing to deal with the strain issue to some extent, and look for modestly appreciating equity markets (up 7% per annum) and continuation of the current high level of interest rates to help propel the bottom line, helped to some extent by continued strong individual sales and variable annuity sales.

• CMG Asia acquisition progressing well ($0.05 accretion in 2006, $0.07 accretion in 2007) and helps the company achieve its 10% EPS growth target in 2006 despite
currency/equity market headwinds. We look for 9% 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.

• 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.

• We expect the company to have concluded its search for a new CFO in early fall/2006. We see this as a necessary catalyst to the Sun Life story.
Bloomberg, 27 July 2006

Sun Life Financial Inc., Canada's second-largest insurer, said profit rose 7.3 percent, led by U.S. asset management and life insurance sales in Canada. The stock had its biggest drop in more than two years after earnings missed some analysts' estimates.

Second-quarter net income climbed to a record C$512 million ($451 million) or 88 cents a share, from C$477 million, or 81 cents, a year earlier, the Toronto-based company said today. Revenue rose 4.1 percent to C$6.23 billion.

Profit missed some estimates because of tax gains and higher costs in the U.S. Earnings from the U.S. insurance business fell by almost a third to C$90 million. That included a $4 million loss in individual life because of costs related to new business.

"We're investing in the growth of the business," Chief Executive Officer Donald Stewart said today in a telephone interview. "By the time we get around to Q4, we'll be back on track."

Sun Life shares fell C$1.60, or 3.6 percent, to C$43.36 at the 4 p.m. close of trading on the Toronto Stock Exchange, the biggest one-day drop since May 7, 2004. The stock has fallen 7.2 percent this year, compared with a 1.2 percent gain in the Standard & Poor's/TSX Financials Index.

Robert Wessel, an analyst at National Bank Financial in Toronto, said Sun Life earned 84 cents a share after tax gains and other one-time items, below his estimate of 85 cents. The company was expected to earn 87 cents a share according to the average estimate of 12 analysts polled by Thomson Financial, which declined to elaborate on the estimates.

"We feel when we get the chance to explain some of the details (to investors), that should have a positive impact," on the stock, Stewart said. "I think there's some confusion about the tax rate."

Profit from Canadian insurance climbed 12 percent to C$264 million, led by increased sales of group benefits and individual policies. Earnings at the Boston-based Massachusetts Financial Services Co. mutual fund unit climbed 26 percent to C$53 million because of an increase in assets under management.

Earnings from Asia almost doubled to C$31 million after the company bought CMG Asia Ltd. and CommServe Financial Ltd. for C$560 million to expand its insurance and pension businesses. Sun Life wants to double the proportion of sales it gets from Asia in the next three to five years.

Asian sales, which accounted for about 3 percent of Sun Life's revenue last year, have grown by more than 45 percent a year since 2002.

Profit was reduced by C$28 million, or 5 cents a share, because of the Canadian dollar's appreciation against the U.S. currency. Sun Life said today that future "earnings will benefit from a reduction in the value of the Canadian dollar versus foreign currencies."

"We're not expecting a major shift in foreign exchange," Stewart, 59, said. "We're not expecting huge shifts over the balance of the year."

Return on equity increased to 13.6 percent from 13 percent in the year-earlier quarter.

The company raised its dividend 9.1 percent to 30 cents a share, the fourth increase in two years.

Sun Life is the first of Canada's three main life insurers to report results this quarter. Great-West Lifeco Inc., the third largest by assets, is scheduled to release earnings on Aug. 2, followed by Manulife Financial Corp. on Aug. 3.
RBC Capital Markets, 27 July 2006

First Impression

• Core EPS Light. SLF posted 88¢ EPS versus 84¢ in Q106 and 81¢ in Q205, but the underlying EPS looks like ~80¢, excl. one-time tax items, indicating negligible EPS growth YoY; and ~8% below 87¢ consensus.

• Dividend Hiked More Than Expected. SLF raised its dividend by 2.5¢ or 9%, a penny more than we had expected.

• NILTax Rate Not Sustainable. SLF’s 1% tax rate compared to 21% in Q106, way below our expected sustainable of 23%. Sun realized 8¢ in retroactive accrued tax benefit triggered by the recent change in taxes.

• Key Factors in the “Miss”. Weak equity markets were estimated to cost 5¢ YoY, mostly owing to SLF’s large exposure to U.S. variable annuities and mutual funds. F/X translation dragged on EPS for 5¢ YoY, 1¢ worse than we had modeled. Sales strain cost ~7¢ ‘extra’ this quarter, owing to (i) a change in reinsurance pricing and (ii) higher life sales in the U.S.

• Sales Weak in “Remedial” Divisions. US mutual funds and annuities remained in redemption this quarter, and now we are concerned the volatile equity markets may exacerbate the turnaround challenge. US and Asian life sales moved up handsomely, as did most Group product sales across North America. Domestic life sales were disappointing: independent sales held in, but now Clarica sales declined YoY.

• Morbidity/Mortality Normalized. Last quarter EPS was adversely impacted ~3¢ due to poor morbidity and mortality experience, giving us added concern. It appears to have normalized this quarter, which is good.