Friday, February 13, 2009

Manulife Q4 2008 Earnings

Scotia Capital, 13 February 2009

Increasing EPS Sensitivity to Equity Markets But Capital is Fine

• Slight EPS miss. An EPS loss of $1.24 versus our $0.84 estimate, consensus of $0.94 and company Q4/08 guidance (December 2, 2008) of a loss of $1.00. A $0.40 EPS charge due to the sharp drop in December in swap interest rates used to value segregated fund liabilities accounted for the bulk of the difference, offset by $0.20 EPS in reserve releases. With swap interest rates back up through December 2, 2008 levels this EPS hit should reverse itself in Q1/09.

• Messy quarter - lots of moving parts, but underlying EPS in the $0.57 range. The 23%-24% drop in equity markets hurt EPS by $1.94, with $0.08 EPS in credit hits, offset by $0.21 in reserve releases. Ex these items EPS is in the $0.57 range, similar to the $0.55 EPS underlying we get from our source of earnings analysis exercise in Exhibit 1. Adding to the confusion was a change in basis for segregated fund reserving from CTE80 to CTE65 (which will be, with no change in actual dollar amount of reserve, more like something above the company's target of balance sheet reserves of CTE70 once a more accurate and OSFI approved method is employed, one which uses corporate rates rather than swaps). It is all just noise. We anticipate MFC will hold seg fund reserves at CTE70 going forward, which, assuming Mar 31, 2009 is exactly the same as it was on Dec 31, 2008, would imply no change in seg fund reserves, no EPS hit, and no change in required capital or MCCSR.

• Increasing sensitivity to equity markets - MFC is becoming more and more of a call on the equity markets. The earnings sensitivity for a 10% decline in equity markets has moved from $840M at Q3/08 ($0.56 in EPS) to $1.6B at Q4/08 ($0.99 in EPS). This assumes a CTE70 level is maintained. We noticed the same relative increase for the other lifecos. SLF upped its sensitivity from a $0.40 EPS to a $0.49-$0.62 EPS range, and that assumes the CTE is lowered from its current CTE75 level, so the sensitivity would be more if the CTE was assumed to be frozen like in MFC's case. GWO upped its sensitivity to a 10% equity market decrease from $0.08 in EPS to $0.18 in EPS. We've decrease our estimates for all the lifecos to assume a modest 1%-2% increase in equity markets in 2009, down from a 6%-7% increase. Obviously if/when markets rebound MFC will have the most upside torque.

• Capital remains strong. MCCSR was 233% and RBC of U.S. sub was 400%. A 10% decline in markets hurts MCCSR by 20 points. We estimate the S&P 500 would need to fall to 650 before the company would approach the bottom end of its 180%-200% MCCSR target, and to the mid 500s before it would approach 150%, a level where OSFI might become concerned. Debt-to-total capital is 23%, and if MFC were to be downgraded from Aa1 to Aa2 it would still be at least a notch ahead of most of its peers, and would likely be able to increase its debt-to-total capital ratio to 30%. Moving from 23% to 30% would suggest $3B in debt/preferreds. Each $1B in debt carries about a $0.02 EPS hit, but increases the MCCSR ratio by 11 points, and moves the point at which the company would hit the bottom end of its MCCSR target from 650 to around 600.

• Credit hits just $0.08 in EPS - high asset quality. Just $128 million or $0.08 EPS in credit impairments and downgrades (about half impairments and half downgrades). SLF's EPS hit in this regard was $0.95. Gross unrealized losses on fixed income securities trading below 80% of acquisition cost for more than 6 months was just $998 million or 0.8% of fixed income securities, well less than the corresponding figure for SLF, at 3.0%, and GWO at 1.8%. Lots of detail provided but of note is after-tax exposure to U.K. hybrids, at just $0.21 EPS ($0.08 of which is RBS), and a $5.9B CMBS portfolio (just 3% of invested assets) that is 85% 2005 and prior and all 2006 and later is AAA.

• Once again a very good top line, much better than peer group - franchises remain strong despite the market conditions. Canada individual insurance sales up 2% YOY (peer group down 1%) and up 2% QOQ (peer group down 2%). Canadian individual wealth management sales up 11% YOY (peers down 3%) and 34% QOQ (peers up 1%). U.S. VA down 18% YOY (peers down 37%) and up 11% QOQ (peers down 20%). U.S. individual insurance sales were down 33% YOY over a tough comparable (peers down 16%) but down just 1% QOQ (peers down 2%).
The Globe and Mail, Fabrice Taylor, 13 February 2009

When Dominic D'Alessandro joined Manulife 15 years ago, the company lost its triple-A rating within a month. It took a decade to get it back, and it was during that time that Mr. D'Alessandro cemented his reputation as a world-class chief executive officer, a run capped off by the acquisition of John Hancock.

Now, in essentially his final month with the insurer, Manulife is poised to lose its gold-plated rating again, and Mr. D'Alessandro's once-unassailable reputation is tarnished. Manulife has cost investors a lot of money over the past year. In fact, it's even cost investors money over a five-year period.

It's possible that the damage inflicted on the company's balance sheet will be reversed, or some of it. The company may be more conservative than need be. The stock may well be scraping along the bottom now. Or things could deteriorate. But if the worst is done, Mr. D'Alessandro will sadly be long gone before a redeeming final verdict is in. And because of massive writedowns no one cares that the core business is doing pretty well.

Insurers like Manulife are horridly complex beasts, but Mr. D'Alessandro's troubles have a pretty simple cause: He bet very heavily on positive stock market returns. Manulife sold a lot of products with some type of guaranteed protection, such as segregated funds and variable annuities, on which it would earn a profit if stock markets performed along historical lines.

Unfortunately, the formulas were way too optimistic, in retrospect, and expected profits turned to losses. The charges the company has taken, such as the $3-billion in the latest quarter, mean that Manulife's past earnings were too high, because they were based on stock return assumptions that subsequently came up way short of estimates - and continue to do so.

The upshot is that it has to set aside money to pay the "insurance" on these products, which are massively under water because stock markets have cratered. How deeply submerged? By about $26-billion. Manulife has taken charges of about $5.8-billion to account for that deficit. (If that seems low it's because the liability stretches out a long way into the future, so anything you set aside today will grow with interest such that it will cover off future payments - if the assumptions are right.)

And things could get worse. In fact, they have. Yesterday's results were up to Dec. 31. Since then, the S&P 500 is down about 8 per cent. For every 10-point drop in equity markets, Manulife "loses" $1.6-billion. I put "loses" in quotes because that's a mark-to-market figure that can be reversed if markets do better than expected.

Why is Manulife so exposed to equity markets compared with other insurers? Partly because it heavily flogged the products mentioned above, partly because it didn't hedge its positions. A contrite-sounding Mr. D'Alessandro acknowledged this.

Is the worst over for the business? Probably not. Mr. D'Alessandro joked on yesterday's conference call that incoming CEO Don Guloien would probably want him to handle the next conference call. It was gallows humour.

More serious is a private placement debt portfolio worth more than $26-billion, which has some black-box qualities to it - although the company pledged to shed some light on what's inside. Manulife says it has better credit quality than other insurers. So far yes, but that could change, although executives are insistent that the big portfolio isn't in hot water. And then there's that equity market exposure.

Is the worst over for the shares? Analysts are all over the place, although the stock, by some yardsticks, is looking very cheap historically.

Ultimately the question for investors is whether stocks are at or near their bottom, and to a lesser degree how strongly and quickly will they rebound. If they do so quickly, charges could be reversed and become profits. If not, there's supposedly not much downside since the company insists it's being conservative in its reserves. But if stocks fall, as mentioned, the company's earnings get crushed.

And of course the insurer's financial models will play a big role in determining the outcome. But as Mr. D'Alessandro said about the assumption inherent in accounting for this stuff, "there's no lab where you can assay this and tell if it's 18 carat or 24."

The same goes for his legacy.