Scotia Capital, 17 July 2006
• Valuations, after a modest “correction,” are certainly more reasonable – macro environment modestly favourable – sector’s defensive characteristics provide support in uncertain markets – we continue to recommend market weight, leaning toward overweight should the correction continue. As we approach the Q2/06 earnings season, we are much more comfortable with the Canadian lifeco group’s valuation, which, after a modest and somewhat overdue “correction,” is now in line with historical averages. The correction has brought the valuation for the group relative to U.S. lifecos back closer to historical averages, with the premium (forward P/E) versus the U.S. lifecos declining from 15% to 10%, now closer to its three-year mean of 5%. The premium versus the Canadian banks, at 8% (forward P/E), has not changed in the last three months and remains well above its 2% three-year average. While we certainly believe a premium above historical levels is justified in a rising interest rate environment, and would add that a flattening yield curve environment is much less punitive to the lifecos than the banks, we see little catalyst in the lifeco group that would force the multiple to significantly increase versus the banks going forward. However, in our opinion, the Canadian lifeco sector’s defensive characteristics, specifically a consistent track record of negligible earnings surprises and significant excess capital positions that allow for share buybacks and dividend increases, do warrant a valuation premium, especially in these uncertain markets.
• We are much more comfortable with Canadian lifeco valuations, which, after a modest and somewhat overdue “correction,” are now in line with historical averages. After a modest “correction” in the Canadian lifecos’ forward multiple in the last three months (from a lofty 14.2x to a more reasonable 13.0x), in part attributable to a correction in the S&P/TSX (down 4% in the last three months) as well as some profit-taking on what were indeed stretched Canadian lifeco valuations, and in part attributable to a flattening yield curve putting some pressure on all financials, we now find the Canadian lifecos trading at their long-term average multiple of 13.0x NTM EPS (average from January 2000 to June 2006). Coincidently, the U.S. lifeco group, at 11.8x, is trading in line with its 15-year average level of 11.9x NTM EPS. Relative to the S&P 500, the Canadian lifeco forward multiple has now declined from a lofty 90% level three months ago (the highest level we’ve seen) to 86% of the S&P 500 forward multiple. While we like the trend, we point out that we are still well ahead of the historical mean of 68%, suggesting to us there may be better value in other sectors. Even the U.S lifeco group, which, at 11.8x, is 80% of the S&P 500 forward multiple, while down slightly from three months ago, is just coming off four-year highs. However, with ample excess capital, an improving macro environment, especially with respect to long term interest rates (rising near the 5%-6% level we feel much more comfortable with), a diversified book of business that offers earnings stability, and reasonable growth prospects (we forecast 11%-12% CAGR through 2007), we see little risk to EPS growth going forward. In addition, we believe improved risk management techniques, developed from the fact that over the last four years there have been extremely volatile equity markets, credit markets, and interest rate environments, offer an additional element of earnings stability.
• Valuations contract relative to U.S. lifecos – now closer to historical average. The jump we saw in the group versus the U.S. lifecos in the first three months of 2006, when the premium to the U.S. lifecos (on a forward P/E basis) increased from 9% to 15%, essentially unwound in the past three months, declining from 15% to 10%, still modestly ahead of the 5% long-term average. We believe an increasing premium relative to the U.S. group is justified owing to faster increasing excess capital positions and better growth prospects. (While EPS growth was relatively the same from 2000-2005 for the two groups, Canadian lifecos are expected to grow in the 12% area through 2007, whereas consensus growth for the U.S. group is 10 %.) When you combine these valuation premiums to the U.S. lifecos with increasing levels of excess capital, and a more favourable Canadian currency, we have to believe the Canadian lifecos will look to the highly fragmented U.S. market to make what we consider to be reasonably accretive acquisitions. We expect acquisition activity to increase in 2006 and 2007, as we believe the players will continue to take advantage of low debt financing rates to acquire, and sub-scale players will look to rationalize or specialize.
• Valuation relative to Canadian banks – 8% premium versus 2% three-year mean – suggests banks may be slightly more attractive – unless long-term interest rates continue to rise and the yield curve continues to flatten. Rising long-term interest rates and a flattening yield curve have contributed to the expansion in the premium relative to the banks. We believe a modest premium over historical levels is justified, assuming long-term interest rates rise and the yield curve remains somewhat flat, which is traditionally an environment less punitive to lifecos than to banks. Furthermore, a modest premium to the group is perhaps somewhat warranted given the better growth prospects for the Canadian lifecos (12% through 2007) versus the Canadian banks (10% through 2007). However, we note that the premium the U.S. lifeco group enjoys versus its banks has in fact declined from 10% to 3% over the last six months (but still above its long-term average of 1%), despite rapidly rising long-term interest rates and a flattening yield curve, and despite the fact that consensus growth for the U.S. lifecos, at 10%-11%, is marginally better than the U.S. banks, at 10%.
• Fundamentals remain steady – improving macro environment as long-term interest rates continue to rise. Fundamentals remain steady for the group, with ROEs modestly climbing, excess capital positions growing, and targeted dividend payout ratios rising. Excellent risk-management techniques, in our opinion, help mitigate the risks to any potential unfavourable macro environments. As it stands now, we are comfortable with the risk profiles for the group, and see no apparent headwinds, especially as long-term interest rates continue to rise.
• Increasing long-term interest rates bode well for lifecos – U.S. long-terms well above our “5% threshold” is a positive for GWO, MFC, and SLF – Canada long-terms still well below 5% and not expected to move – negative for IAG. Long-term rates have risen in both the United States and Canada, mitigating our concerns, to some extent, over the negative impact of declining long-term interest rates. With liabilities longer than assets, a declining long-term interest rate scenario can pose significant reinvestment risk to the lifecos, as well as present spread compression issues for the fixed-rate products. We believe a continuation of a more moderate increase in long-term rates, to the 5%-6% range, would be a positive for the lifeco group. Since we are essentially at 5% in the United States (U.S. 10- year treasuries are 5.07%), we remain less concerned about interest rate risk for those companies with predominantly U.S. interest rate risk exposure, namely Great-West Lifeco, Manulife, and Sun Life. However, Industrial-Alliance is still the company most at risk; largely because the company’s business mix (more than half the business is very long tail individual insurance business) makes it the most sensitive to low levels of long-term interest rates, and Canadian long-term rates, currently at 4.45%, still have a way to go before they approach the 5%-6% range. Whether or not they get there remains less certain. Scotia Economics has recently trimmed its Canadian long-term (government) rate forecasts, and now expects the 10-year Canada yield to climb marginally to 4.80% by the end of 2006, and then fall to 4.40% by the end of 2007.
• Credit now is excellent – will the good times continue? Times are good now, but if credit spreads were to widen and the incidence of bond defaults increases, Canadian lifecos’ earnings could suffer. Manulife has the highest exposure of below-investment grade bonds for the group (6% of Manulife’s bond portfolio is below investment grade, as opposed to 3% for Sun Life, 1% for Great-West Lifeco, and 0% for Industrial-Alliance), albeit the entire group is still less exposed than most U.S. lifecos. Exposure to GM and Ford bonds is limited as well, with Sun Life at $0.37 per share, Great-West Lifeco at $0.36 per share, and Manulife at $0.22 per share. Manulife claims that 95% of its exposure to Ford and GM bonds is secured.
• If markets continue to be sluggish, 2007 EPS estimates could come under pressure. Manulife’s and Sun Life’s equity market exposure is largely U.S.-related, and with the S&P 500 up 3% in 2005, and up just 1% year-to-date 2006, the likelihood of average market levels in 2006 meeting or surpassing the expected 7%-8% may be slim, especially if markets remain flat for the rest of 2006. The likelihood of downward adjustments in 2006 for Great-West Lifeco or Industrial-Alliance is less, due to the better performance of the TSX and the FTSE over the last 12-18 months. Industrial-Alliance is 100% exposed to the TSX and Great-West Lifeco is about one-third exposed to each of the TSX, S&P 500, and FTSE. However, if markets continue to be sluggish, as they have been of late, we expect 2007 EPS estimates could come under pressure. Who’s the most sensitive to changes in equity markets? We put Industrial-Alliance first, with every 10% change in equity markets impacting EPS by 9%, followed by Sun Life at 6%, and then Manulife and Great-West Lifeco each at 5%.
• Strengthening Canadian dollar versus the U.S. dollar – Manulife the most at risk. Our EPS estimates assume an average exchange rate of $1.11 (CAD/USD) for 2006, with no currency hedging for Manulife and Sun Life, and a currency hedge for Great-West Lifeco in line with our average rate. Each 5% movement in our estimate is worth about $0.05 per share for Great-West Lifeco (or 2% of 2006E EPS), $0.17 per share for Manulife (or 4% of 2006E EPS), and $0.06 per share for Sun Life (or 2% of 2006E EPS). As Manulife’s U.S. owners (nearly 50% of the shareholder base) would obviously see their stock benefit from an appreciating Canadian dollar, we believe any perceived impact on Manulife’s share price due to an appreciating Canadian dollar may not be so dramatic.
Canadian P&C insurers – market remains rational - auto continues to pace ahead of industry norm, commercial becoming increasingly competitive.
• The profitability of Canadian auto insurance continues to pace well ahead of industry norms due to the sustained effectiveness of automobile reforms and continued low frequency levels. We get the impression from management at ING Canada that this trend will continue throughout 2006. The U.S. non-standard auto market (a significant portion of Kingsway’s business) remains very competitive and perhaps somewhat irrational, as niche players have gained market share. It remains to be seen whether the impact of more expensive reinsurance (in light of the hurricanes) in the July 2006 renewal season will introduce an element of rationality to the market, an obvious positive for Kingsway. However, should this market become more rational, we might expect large traditional players (State Farm, Geico, and Progressive) to no longer “hold back the reins” and possibly re-enter the non-standard market as well, thus increasing competition.
• While the 2005 hurricanes removed US$58 billion from the balance sheets of insurers/reinsurers worldwide (one-half of the impact was on U.S. domestic companies and one-half of the impact was on those outside of the United States, predominantly European and Bermuda domiciled companies), the perceived “hardening” of markets was a reality only for U.S. coastal coverages. Consequently, our Canadian P&C companies will likely see little impact, and we believe rate increases will continue to be flat. While the Canadian commercial market will continue to be increasingly competitive, we believe it will remain rational.
Great-West Lifeco Inc.
1-Sector Outperform – $33 one-year target, based on 2.9x 6/30/07E BV and 13.1x 2007E EPS
• We are looking for $0.52 per share for Q2/06, in line with consensus. Our 2006 EPS estimate of $2.13 is in line with consensus, and our 2007 EPS estimate of $2.43 is $0.03 ahead of consensus.
• Strong growth expected in 2007 when negative impact of hedge roll-off is mitigated.
• European segment (24% of bottom line), up 26% in 2005 (ex foreign exchange), should continue to show double-digit growth – with further support in 2006 from the recently announced acquisition.
Industrial-Alliance Insurance and Financial Services Inc.
3-Sector Underperform – $34 one-year target, based on 1.7x 6/30/07E BV and 11.7x 2007E EPS
• We are in line with consensus for Q2/06 and slightly below consensus for 2006E and 2007E.
• We expect product repricing in March 2006 may cause sales growth to begin to decelerate.
• Individual wealth management earnings growth expected to be strong as the company continues to bring Clarington Fund assets in-house.
Manulife Financial Corporation
1-Sector Outperform – $38.50 one-year target, based on 2.3x 6/30/07E BV and 13.8x 2007E EPS
• We are looking for $0.60 per share for Q2/06, $0.01 per share below consensus. Our 2006 EPS estimate of $2.43 is $0.03 below consensus and our 2007 EPS estimate of $2.76 is $0.04 below consensus.
• We expect the exceptional U.S. variable annuity sales growth will start to slow and return to more “normalized” levels.
• Flush with excess capital – but with this kind of organic growth company, who needs to make an acquisition?
Sun Life Financial Inc.
2-Sector Perform – $52 one-year target, based on 1.9x 6/30/07E BV and 12.8x 2007E EPS
• We are looking for $0.89 per share for Q2/06, $0.01 per share above consensus. Our 2006 EPS estimate of $3.59 is $0.04 above consensus and our 2007 EPS estimate of $3.95 is in line with consensus.
• A “show me” story – we will closely monitor much-needed progress U.S. variable annuity.
• Focus on margin improvement at MFS.
• Spread improvement in U.S. fixed annuity block should continue in Q2/06 as U.S. interest rates continue to rise.
• Little in the way of a catalyst until company announces CFO replacement - not likely until late 2006.
Fairfax Financial Holdings Limited
2-Sector Perform – US$172 one-year target, based on 1.0x 3/30/07E BV
• We expect another steady quarter ($5.00 EPS), not as good as the exceptional Q1/06 ($9.10 EPS), but one with good fundamentals in ongoing insurance operations, and close to break-even in runoff operations.
• Runoff segment remains under the radar screen.
ING Canada Inc.
1-Sector Perform – $61 one-year target, based on 2.3x 6/30/07E BV
• We are looking for $1.08 per share for Q2/06, $0.10 per share below consensus. Our 2006 EPS estimate of $4.53 is $0.09 below consensus and our 2007 EPS estimate of $4.19 is $0.07 below consensus.
• A good chance the company could exceed our estimate and consensus with another excellent quarter of underwriting profitability – we forecast a combined ratio of 89%, not as good as the exceptionally strong 81% in Q2/05, but Q2 and Q3 are typically strong quarters.
Kingsway Financial Services Inc.
2-Sector Perform – $27 one-year target, based on 1.35x 6/30/07E BV
• We are looking for C$0.78 per share for Q2/06; we believe this is in line with consensus.
• We look for a steady quarter in line with consensus, with no significant prior period reserve development and a combined ratio in the 97% range.
• Any catalyst for premium growth in the United States? Likely not in the near term.
• Company does not appear to be aggressively buying back stock as it continues to drift downward - why?
Northbridge Financial Corporation
3-Sector Underperform – $37 one-year target, based on 1.5x 6/30/07E BV
• We are looking for $0.86 per share for Q2/06, $0.03 per share above consensus. Our 2006 EPS estimate of $3.71 is $0.04 below consensus and our 2007E EPS estimate of $3.24 is $0.03 below consensus.
• We expect a steady quarter with nothing unusual.
• Valuation a little rich relative to U.S. commercial lines peers – we see little prospect for multiple growth.
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