Thursday, August 03, 2006

Great-West Life Q2 2006 Earnings

TD Newcrest, 3 August 2006


Neutral. Overall, it was a decent quarter. Strong earnings and sales results out of Canada and Europe were offset by poor claims experience in the U.S. Health division. Currency continues to be a factor, with the fall-off from hedged results in 2005 resulting in a $35 million ($0.04 per share) negative impact. As we look towards 2007, GWO’s EPS growth rate should be better. However, given our skepticism surrounding the ongoing U.S. Health division turnaround and lack of enthusiasm towards GWO’s acquisition strategy, we are maintaining our HOLD rating and $31 price target. Since the previously mentioned currency impact is trending towards the high end of management’s guidance ($130-$140 million in 2005), we are reducing our 2006E EPS to $2.08 from $2.10. Our 2007E EPS remains unchanged at $2.40.

Canada Delivers Another Strong Quarter

GWO’s most important division did not disappoint, posting 16% earnings growth and generating double-digit sales growth across most product lines. Its wealth businesses produced particularly good sales results in both individual and group segments. We were impressed with net seg fund deposit growth of 37% yr/yr, particularly given the choppy equity markets during Q2. We believe this is a great example of the value of GWO’s captive sales force. Individual life sales were also very good, with 50% yr/yr growth, driven by Universal Life (UL). This is the fourth straight quarter of exceptional (i.e. 30%+ growth, from a low base) UL sales, which we find interesting given management’s previous positioning (i.e. before acquiring Canada Life) away from UL. As a result of these strong sales, new business strain was up, with UL contributing $8.4 million to the increase. We note that industry sources describe GWO’s UL pricing strategy as aggressive.

U.S. Results Hampered by Poor Claims in Health Division

GWO’s U.S. division generated lackluster Q2 earnings, growing by only 3% in constant currency, constrained by the U.S. Health division, which saw its earnings drop 33% yr/yr on the back of poor claims experience. It appears management’s attempts to provide more competitive pricing backfired, leading to a 94% benefit ratio (i.e. claims divided by premiums), compared to a 76% average over the previous four quarters. Management plans to increase pricing in certain segments to offset rising medical cost trends. We do not expect a short-term turnaround given the rise in industry competitive trends (i.e. pricing) that could put further pressure on margins and the time it takes to implement pricing adjustments. That said, other elements, such as faster claims processing times, magnified the claims impact this quarter, thus we view this quarter as unusually weak.

Acquisitions Targeted in U.S. and Europe – But How Meaningful can they be?

Following its recent acquisitions of a block of payout annuity business in the U.K. and a 401(k) business from Met Life in the U.S., GWO remains keen on making future acquisitions that generate incremental earnings. While these acquisitions appear to be relatively low-risk from an integration perspective and are accretive, our enthusiasm is constrained. In particular, we are less excited about European payout annuities, which are essentially low-margin spread businesses that don’t appear to offer a platform towards other growth channels or offer major strategic benefits. With a 32% debt-to-cap ratio, we believe GWO is less likely to make a major acquisition in the near-term.

We derive our $31 target price using a 13x multiple on our 2007E EPS. In comparison, we value Manulife and Sun Life 15x and 13x 2007E EPS, respectively. Lack of disclosure on the European division, concerns regarding the future growth potential of the U.S. Health business and a relatively less compelling acquisition strategy, in our view, justifies a discounted multiple to MFC.

Key Risks to Target Price

1) Appreciation of the Canadian dollar against the US; (2) regulatory changes in the insurance market; (3) aggressive moves in markets where the risks are under-appreciated; (4) sudden interest rate spikes; (5) significant equity market downturn; (6) regulatory investigations into industry sales practices.

Investment Conclusion

GWO had a decent quarter, despite currency headwinds. Top-line growth appears to be taking precedence over cost cutting, which could translate into more sustainable earnings growth in the long run. However, we are unsure about management’s growth through acquisitions strategy, given these appear to be low margin businesses with uninspiring growth prospects. We rate the stock a Hold.