Thursday, July 31, 2008

Great-West Lifeco Q2 2008 Earnings

  
Scotia Capital, 31 July 2008

Event

• Q2/08 EPS (ex $0.73 one-time gain) was $0.63, versus our $0.57 and consensus of $0.61.

What It Means

• A reasonably clean quarter, we would peg "underlying" EPS in the $0.61 to $0.62 range. Excellent expense control, despite acquisitions, with a very scalable platform especially in Europe and U.S. Financial Services. Europe still going strong, 401(k) and P/NP net flows continue to gain momentum, and Putnam net sales improve to just negative $0.2 billion.

• No credit issues - subprime securitized first mortgage loan exposure modestly declines 7% to $1.4 billion (1.4% of invested assets) and while three times the relative exposure of MFC and SLF, it is 1/3 the relative exposure of U.S. counterparts - company reconfirms its comfort level with credit.

• Negatives. Monoline wrapped asset exposure increases 11% due to Standard Life acquisition, but provisions for default increase by 1/2 the amount. Europe top-line sluggish do to poor equity markets.

• Net. Excellent GARP story, attractive valuation, 4% dividend yield and immaterial credit exposure - reiterate 1-Sector Outperform.

Positives

• A beat - always good to see in these difficult markets. Q2/08 EPS was $0.63, versus our $0.57 and consensus of $0.61. A reasonably clean quarter, we would peg "underlying" EPS in the $0.61 to $0.62 range, when adjust for "unusuals" or what could be construed as "onetimers." These consisted of a $0.01 EPS gain in the MV of the company's preferreds versus the underlying assets plus a $0.04 EPS gain from a currency hedge used to transfer U.S. dollar assets to back the Canadian portfolio, offset by an estimated $0.04 EPS increase in actuarial default provisions mainly associated with European financial guarantors. Our Source of Earnings analysis confirms the $0.63 reported EPS to be relatively clean.

• No credit issues - subprime securitized first mortgage loan exposure modestly declines 7% to $1.4 billion (1.4% of invested assets) and while three times the relative exposure of MFC and SLF, it is 1/3 the relative exposure of U.S. counterparts - company reconfirms its comfort level with credit. Detailed disclosure was once again provided, showing no adjustable rate mortgage loan exposure (all fixed and all first mortgages), 60% pre-2005 origination, 92% AAA, 99.6% senior bonds, with a cumulative loss to date of just 1.1%. We take comfort from the fact that since the sub-prime exposure was first identified in Q1/07 the company has continually provided more than sufficient detail on its exposure, has had excellent default experience, has, in our opinion, more than sufficiently scenario tested it, and has continuously demonstrated that its subprime mortgage portfolio is very different than the ones we've been reading in the press.

• Excellent expense control - despite acquisitions - a very scalable platform especially in Europe and U.S. Financial Services. We remain impressed. As outlined in Exhibit 2, general expenses in the company's Europe operations were up just 11% YOY, whereas gross profits were up 28%, and general fund assets were up 30% (largely due to the Standard Life acquisition of $12.6 billion in payout annuity assets). We see the same in U.S. Financial Services (largely 401(k), 457 and FASCore P/NP business) where, despite markets falling 8% YOY, gross profit is up 6% YOY, and expenses are up just 3% despite a 17% YOY increase in FASCore and P/NP participants. Finally, in Canada, the company continues to benefit from scale, with expenses up just 3%, far below the 10% increase in gross profits.

• Europe still going strong. 31% YOY growth (ex FX) clearly shows the company is benefiting not only from increased scale, as well as yield enhancements on its payout annuity business (we estimate $0.03 in EPS in the quarter, most of which is sustainable), and continued excellent growth in group insurance. When we adjust for an estimated $0.02 EPS hit due to a bump in actuarial default provisions for a tougher credit environment in the U.K. the growth would be 44%.

• 401(k) and P/NP net cashflow continues to gain momentum. At $508 million, up from $353 million in Q1/08 and negative $135 million in Q4/07, the company continues to gain traction in this high growth and highly profitable segment.

• Putnam net flows improve. At just negative $0.2 billion, net sales were better than expected, and much better than the negative $3.7 billion in Q1/08 and the negative $3.1 billion in Q2/07. Margins at 16.4%, primarily due to weak markets, remain below the company's 25%-30% target.

Negatives

• Monoline wrapped asset exposure increases from $3.5 billion to $3.9 billion due to Standard Life acquisition. We take comfort however from the fact when monoline exposure increased by $400 million the company also booked a $166 million increase in default provisions in actuarial reserves, which, to the extent not needed would flow into income. As well, despite the increase, the less than BBB monoline exposure fell $76 million to $140 million. Finally, one-half of the $1.8 billion BBB monoline wrapped asset exposure is government related.

• Weak top-line in Europe. While Canada was reasonable (individual insurance sales up 11%, wealth management sales down 6%), Europe continues to be weak with revenue premium down 17% (ex FX), after declining 15% in Q1/08, largely due to the continuing effect of financial market volatility.
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