Thursday, November 02, 2006

Great-West Life Q3 2006 Earnings

Scotia Capital, 2 November 2006

• Excluding the negative impact of the roll-off of attractive currency hedges, EPS growth was 15%. The roll-off of attractive hedges on the currency translation of the company's U.S. Reinsurance and European operations brought down the company's operating EPS growth from 15% (ex f/x) to 5%. EPS growth YTD Q3/06 was 4%, but 12% excluding the impact of the hedges. We expect EPS growth to be in the 6%-7% range for the remainder of 2006 (but closer to 15% ex f/x), after which we expect 15% growth in 2007, where we expect no impact from hedges on YOY growth, and look for approximately $0.04 in EPS accretion, including $0.03 from the Equitable Life payout annuity acquisition (announced May 11, 2006) and $0.01 accretion from the Met Life 401(k) acquisition (announced June 26, 2006 and closed October 2, 2006).

• Good top-line growth, particularly in Canada and Europe and, robust earnings growth (ex f/x) particularly in Europe (up 43% ex f/x) all contributed to a strong quarter. The announcement of another small acquisition in the U.S. healthcare space, adding 75,000 members (an additional 4%) further underscores the company's commitment to this business segment. We look for more tuck-in acquisitions going forward, particularly in the U.S. and Europe.

• Reiterate 1-Sector Outperform rating with target increased by $2 to $35. With a welldiversified book of business with an attractive 3% dividend yield, excellent 13%-14% EPS growth (CAGR) through 2008, and an attractive multiple (NTM forward P/E multiple of 13.4x is 4% above the sector average, still well below its 8% average premium), we believe Great-West Lifeco is still compelling value. In addition, we believe there is further upside from many more tuck-in type acquisitions, namely in the U.S. and Europe.

• U.S. healthcare operations (10% of bottom line) post encouraging results. After posting results below expectations in Q1/06 and Q2/06, we were pleased with the 5% YOY earnings increase (excluding f/x) in the quarter and the 1% QOQ increase in membership, primarily due to growth in the high margin specialty market, in keeping with the company's TPA rollout strategy. QOQ earnings in this segment were up 57%, as significantly poor aggregate stop loss experience negatively impacted Q2/06 earnings. Going forward this segment should benefit from the 75,000 additional members (a 4% increase in membership) that will be added from the October 31, 2006 announced purchase of Indiana Health Network (IHN), an Indiana-based hospital and physician network. This small acquisition adds more providers and better discounts to Great-West's network, and, carries along with it the prospect of selling more products, including largely profitable stop-loss, to the 75,000 members. We look for 9% earnings growth in this segment through 2008, helped in part by the IHN acquisition. We look for similar, if not larger, acquisitions in the healthcare segment going forward.

• The U.S. Financial Services segment (15% of the bottom line in Q3/06) - down 15% over a Q3/05 that had significant tax gains - ex one-timers we put growth in the 8%-9% range in the quarter and 15% YTD. The company continues to increase sales (up 14% in the quarter and 24% YTD), as well as FASCore and P/NP participants (up 14%). In these niche businesses, with sizeable barriers to entry (in one of the businesses, the 457 market, Great-West Lifeco is #2 behind Nationwide), we expect earnings growth to continue in the 13%-14% range through to 2008, assuming equity markets increase in the 7% range, as the company continues to build assets and scale. We look for the Met Life acquired 401(k) business (announced June 26, 2006 and closed October 2, 2006) to increase assets by $1.6 billion, and add an additional $7 billion in assets "onboard" for administration and recordkeeping functions. Given the additional earnings potential of the Met Life acquisition, as well as the added distribution (expected to double GWO's current capabilities), we believe our 13%-14% EPS growth estimate through to 2008 for this segment is on the conservative side.

• Canadian operations (46% of bottom line in Q3/06) steady, with 9% EPS growth in quarter. Q3/06 was a steady quarter for both top-line and bottom-line growth for the Canadian operations. Earnings were up 9% YOY, and more importantly, in our opinion, gross profit (i.e. earnings before the impact of operating expenses and taxes) was up 9% YOY, building on a 14% YOY increase in the first half of 2006 and a 10% increase in 2005. Strong growth in assets and sales, good persistency and good expense control (operating expenses were up 6% YOY) all contributed to the 9% earnings growth. The company continues to make large gains in the Universal life brokerage market (individual insurance sales up 20% in Q3/06, with UL sales up a healthy 57%), as well as in the individual wealth management segment, where sales were up 18%, and in the group retirement services business, where sales were up 33%. New business strain associated with the rapid growth in UL sales amounted to a $6 million drag on YOY earnings growth (we estimate), and even despite the strain earnings were up 9%. With top market share in individual life insurance sales, group life and health premiums and deposits, and individual segregated fund assets, #2 market share in group wealth management assets, and a rapidly growing mutual fund arm (Quadrus assets are now over $4.1 billion with a 19% increase in sales in the quarter), we believe the company can grow earnings in the 10% range (a conservative estimate in our opinion) CAGR through 2008.

• European Insurance and Annuity (21% of bottom line in Q3/06) continues to excel, up 43% ex f/x. With revenue premium up 58% (ex f/x), helped by the 2005 acquisition of Phoenix and London's payout annuity business, as well as strong sales growth in the Isle of Man and Germany and Ireland, and a careful eye on operating expenses (up just 16% ex f/x despite the strong top-line growth), this division continues to produce excellent results. Payout annuity sales continue to surge following the implementation of new retirement legislation in April of 2006. With an additional $9.3 billion in assets coming in the second half of 2006 (from the recent Equitable Life payout annuity acquisition, announced May 12, 2006) and contributing to earnings in the second half of 2006 and more so in 2007, we expect the company is well positioned in this increasingly important segment. The combination of relatively good markets, a capital and tax advantage over local players, expanding distribution and solid positioning in markets with relatively high barriers to entry should all contribute to exceptional double digit growth in this segment going forward. We believe our 32% earnings growth estimate (ex f/x) for 2006 and our 38% estimate for 2007 could be on the conservative side, given the 33% YOY growth YTD Q3/06. We expect $0.03 accretion from the Equitable Life acquisition in 2007.

• GWO is definitely not standing still - we look for more tuck-in acquisitions in near future, likely in U.S. Great-West Lifeco is definitely not standing still. We counted at least five potential deals CEO Raymond McFeetors said the company is looking into at its recent Investor Day, most of which are in the U.S. We are not surprised. The company has never relied 100% on organic growth, is an excellent acquirer and integrator, and looks to augment its third party administration (TPA) rollout growth strategy in U.S. healthcare with acquisitions as well as build on its recent success in acquiring U.S. 401(k) business and U.K. payout annuity business. Finally, with CEO McFeetors, who was instrumental in the acquisition and integration of London Life (1997) and Canada Life (2003), now spending nearly 50% of his time in the company's U.S. headquarters (Denver), we would have to expect a deal in the U.S. sooner rather than later.