Friday, January 19, 2007

Scotia Capital Upgrades Life Insurance Cos to Overweight

Scotia Capital, 19 January 2007

Increasing EPS estimates due to F/X and moving to Overweight

• Canadian Insurers - moving to overweight. The macro environment continues to look good for our insurers. Currency rates are much more favourable than 6 months ago and continue to move in a direction that adds to our EPS estimates. Long term interest rates appear to have stabilized, and with Scotia Economics forecasting both U.S. 10-year treasuries and Government of Canada 10-year yields to remain relatively at current levels through to the middle of 2008, we see little in the way of head winds due to declining long term yields. U.S. equity markets, where the Canadian lifecos have the majority of their equity market risk, appear to be cooperating, which after increasing 14% last year appear to be on track (as per our strategist) to increase 7% this year (with average levels up closer to 10%, well above 7% estimate implied by our models and most company reserve assumptions). Credit conditions continue to track at very favourable levels. Given this backdrop, along with an expected S&P/TSX increase in the mid-single digit range for 2007, we are subsequently increasing our recommendation for the Canadian insurers from marketweight to overweight.

• Increasing EPS due to revised f/x estimates. Over the last six weeks Scotia Economics has increased its 2007 average estimate for the USD, the Yen, and the British pound (all versus the Canadian dollar) by 5%, 1% and 8% respectively, and increased its 2008 average estimate for the USD, the Yen and the British pound (all versus the Canadian dollar) by 3%, 2% and 5% respectively. With considerable earnings exposure outside of Canada (70% for MFC, 55% for GWO and 50% for SLF), we have adjusted our EPS estimates for these stocks accordingly. Exhibit 1 summarizes our EPS estimate changes. In Manulife's case, the EPS estimate changes were enough to warrant an increase in the share price target (from $41 to $42). For Great-West Lifeco and Sun Life our targets remain $37 and $55 respectively. Our average exchange rate for the USD is C$1.164 in 2007 and C$1.116 in 2008 (or US$0.86 and US$0.89), with the pound at C$2.28 in 2007 and C$2.16 in 2008, and the Yen at C$0.0104 in 2007 and C$0.0110 in 2008.

• With favourable currency tailwinds we expect solid mid-to-high teen EPS growth for GWO, MFC and SLF in 2007. The increase in the Canadian dollar over the last five years has masked the underlying EPS growth for these three large international Canadian lifecos. EPS CAGRs from 2002 for GWO, MFC and SLF were an impressive 15%, 15% and 12%, respectively, but, excluding the impact of currency, they were 18% in the case of GWO, 19% in the case of MFC and 16% in the case of SLF, as outlined in exhibit 2. Excluding the impact of currency we expect 2006-2008 EPS CAGR of 14% for MFC and GWO and 12.5% for SLF.

• A 50% increase in the U.S. Fixed Products segment contributed to MFC's exceptional 18% growth (24% ex f/x) - we don't expect this trend to continue. Exceptional one-time gains (as described by management) in 2006 in the U.S. Fixed Products segment, a business which accounts for 1/3 of the company's U.S divisions and, in our opinion, was somewhat reluctantly taken in the John Hancock deal due to its inherent low ROE, was the primary 2006 growth catalyst. Assuming earnings for this segment increased in line with its historical average (10%), we estimate earnings for the company's U.S. division would have increased 10% (ex f/x) in first nine months of 2006 (rather than actual 22% ex f/x), and overall EPS growth would have been in the 11%-12% range (14%-15% ex f/x). Assuming little in the way of exceptional one-time gains in the Fixed Products segment in 2007 and 2008, we expect the U.S. segment to grow earnings in the 10% range (ex f/x), still better than US Lifecos (which average 8% EPS growth through 2008) and much better than the 4% CAGR earnings growth rate MFC's U.S. division experienced in the three years prior to the John Hancock acquisition.

• Banks or Lifecos? - Assuming long term rates don't fall lifecos look attractive, with favourable currency trends providing the additional upside. Canadian lifecos currently trade at a 2% premium (forward P/E multiple) to the Canadian banks, in line with their 2% average, and below the 4%-10% levels we've seen over the past three years. The expected growth in EPS is heavily in the Canadian lifecos favour (15% in 2007, versus 10% for the banks, and 11% in 2008, versus 9% for the banks). Furthermore, we see a strong correlation in relative multiple (lifecos/banks) versus the U.S. 10-year treasury (see Exhibit 3). Assuming long-term yields do not fall we do not expect the relative multiple to decline below its current 2% premium. Should long term yields continue to climb, we would expect the lifeco premium to the banks to expand beyond current levels.

• Versus U.S. Lifecos the Canadian Lifecos look attractive, with multiple spread trading in-line with historical average and better EPS growth. The forward P/E multiple for the Canadian lifecos have come down relative to their U.S. counterparts, from a 15% premium a year ago to a 5% premium now, in-line with long term average of 5%. With much better EPS growth, 13% annually through 2008 versus the U.S. lifecos at 8%-9%, we believe the Canadian lifecos look attractive relative to the U.S. lifecos.