BMO Capital Markets, 7 September 2006
Measured Returns: A Historical Perspective
Since June 2003, the shares of the four Canadian life insurers have generated a total return ranging from 57% to 94% (see Table 1). These returns include share price appreciation plus dividends. The last three years represent a profitable and interesting period for lifeco shareholders given the consolidation of the Canadian marketplace and growing influence of international operations.
Share price returns are comprised of two components: Investment Returns (or Fundamental Factors) and changes in valuation. Investment returns represent the sum of dividend yield and earnings and/or book value growth over that period. These returns are driven by the insurers’ own actions, reflecting dividend payout ratio policies and the ability to drive earnings growth. The valuation component measures the change in valuation (P/E and/or P/B) since June 2003 and is a reflection of general market conditions and an insurer’s general level of profitability (ROE and EPS growth outlook). In this report, we analyze the components of the total shareholder returns over the last three years for the Canadian lifecos under two different approaches and then provide an outlook for these two components, and shareholder returns, over the next few years.
In the first approach, we analyze the growth in EPS from 2003 to 2006. The absolute growth in EPS ranges from 38% at GWO to 52% at IAG. Adding the impact of dividends generates the Fundamental Return (Table 2). Overall, Investment Returns, or Fundamental Returns, ranged from 49% at GWO and SLF to 56% at Manulife and 60% at IAG. Of the total return to shareholders over the last three years, the Fundamental Returns accounted for 60–86% of these returns. The balance of shareholder returns was accounted for by an increase in P/E multiples (see Table 3). GWO had the most modest improvement in valuation, while MFC experienced the greatest valuation improvement using the P/E analysis.
The rise in MFC’s valuation on a P/E basis reflects the success of the JHF acquisition in enhancing the value of the company’s franchise and providing a strong foundation for future growth. GWO’s modest valuation improvement reflects a changing landscape. Prior to 2003, we believe GWO garnered a premium multiple given two robust channels of growth: domestic consolidation in Canada and organic growth in the U.S. Given that domestic consolidation is largely complete and roughly 40% of the U.S. operations (i.e. health care) has generated sub-optimal growth rates, expectations for future growth are limited, which we discuss in greater detail below.
In the second approach, we use growth in BVPS from June 2003 to June 2006. We would expect similar results in the second approach as in the first approach. Since June 2003, the absolute growth in book value per share has ranged from 13% at SLF to 60% at MFC (Table 4). Including the impact of dividends, Fundamental Returns have ranged from 21% at SLF to 68% at Manulife. As a percentage of total shareholder returns calculated in Table 1 above, Fundamental Returns using BVPS growth account for 32–68% of total returns. The other component in total return is the change in valuation, specifically P/B in this case. In this approach, 68% of SLF’s return over the last three years is a result of a higher P/B versus 46% at IAG, 32% at GWO and 27% at MFC (Table 5).
Between the two approaches, improving valuation accounted for an average of 25% of the total returns in the P/E analysis and 43% of the total return in the P/B analysis. Why the difference in contribution from valuation improvement between the two approaches? The difference boils down to the 41% improvement in Sun Life’s P/B valuation over that time period. The improvement in price to book reflects a significant increase in ROE to 13.5% in 2006E from 10.5% in 2003. This rising ROE has been driven by a 40% increase in EPS over the time period, plus share repurchases of $1.4 billion from June 2003 to June 2006 representing 10% of the company’s shareholders equity on June 30, 2003. On a P/E basis, SLF’s valuation improved 13% over the indicated time period, which is consistent with the peer group average on this valuation metric. Manulife’s growth in book value is attributable to the large share issuance needed to acquire John Hancock.
Fundamental Return Projections:
Handicapping the Future
What does this analysis indicate about the future? We believe that valuation gains will be increasingly difficult to achieve in the years ahead, given the likelihood of a less robust credit and operating environment and potentially rising interest rates. As a result, returns are more likely to come from fundamental components: dividends plus earnings, or book value, growth.
In projecting fundamental returns for the purposes of this report we have ignored our more detailed financial models and relied on the “bigger picture” variables, specifically applying long-term ROE and payout ratio assumptions to 2006 year-end book values. Our ROE assumptions over the next three years are similar to current run-rate ROE results, which we believe are reasonably indicative of long-term ROEs. Payout ratio assumptions are based on the middle of an insurer’s targeted range, with the exception of Great-West LifeCo, which we assumed stayed stable at 40% of earnings. We used these assumptions to estimate growth in EPS and BVPS out to 2009.
EPS Growth Outlook
In our projections analyzing EPS growth over the next three years, Manulife enjoys the highest Fundamental Return at 55%, followed by Great-West at 52%, IAG at 50% and Sun Life at 41% (see Table 6). Manulife enjoys the highest Fundamental Return in the EPS scenario due to its ability to retain 70% of its earnings and generate a long-term ROE of 16%. Sun Life trails the group because the model assumes that its long-term ROE is 13.5% and it retains a slightly smaller portion of earnings.
In reviewing the results calculated in Table 6, our instincts suggest that these forecasts are too optimistic. For example, GWO’s projected compound annual return in EPS of 15% from 2006 to 2009, while plausible, appears aggressive. Roughly 47% of GWO’s earnings come from Canada, which is a mature insurance market. While we believe that GWO’s Canadian operations are world class by any measure, the maturity of the domestic market implies a sustainable growth rate in the 10% range. In addition, 11% of GWO’s earnings are derived from U.S. health care, which has struggled and based on the current situation long-term growth expectations should probably be 5% (over the last four years GWO’s U.S. health care operations generated compound annual growth rates in aftertax earnings, in U.S. dollars, of 3%). Furthermore, reinsurance— an unpredictable, low-multiple business in our view—represents another 4% of 2006E earnings. Our models generally assume 0% growth in reinsurance.
Summing these three businesses indicates that 62% of GWO’s business could generate long-term earnings growth of 8.5%, and the balance of the businesses— Europe and U.S. Financial Services— need to grow at a combined 26% to achieve a consolidated 15% EPS CAGR over the next three years. While this growth rate is plausible, it is not without challenges. Over the last four years, U.S. Financial services has generated compound annual growth rate in net earnings, in U.S. dollars, of 20%. In Europe, which includes insurance and annuities, net earnings grew at a compound annual rate of 25% since the operations were acquired in July 2003. On a combined basis, Europe and U.S. Financial Services have not reached the targeted combined growth rate of 26% (for more details on Great-West, please refer to our report dated June 2, 2006 and entitled “Strategic Alternatives for U.S. Healthcare”).
Similarly, projected EPS compound annual returns for Sun Life and IAG of 12% and 14%, respectively, over the next three years appear optimistic. For SLF to generate a CAGR of 12% over the next three years, earnings growth from U.S. annuities will need to accelerate significantly. Approximately 55% of SLF’s earnings are generated in Canada and we would expect these operations to generate earnings growth of 8–10%. Accordingly, to generate 12% growth, the other operations—MFS, U.S. insurance, and Asia— will need to grow earnings at a combined rate of 15–18%. While we expect SLF to continue to build its variable annuity book of business and gradually improve spreads in fixed annuities, it is diffi cult for us to foresee such growth from these businesses, particularly as credit conditions weaken and/or equity market returns prove more elusive.
For Industrial Alliance, achieving a 14% compound annual return in EPS calculated in this analysis is more achievable relative to EPS growth forecasts for GWO and SLF discussed above. However, individual insurance and individual wealth management, which combined account for 75% of IAG’s total 2006E earnings, growth rates in individual wealth management will need to remain elevated in the high teens and earnings growth from individual insurance will need to accelerate from its current rates. We believe that individual insurance growth rates can increase to 11–13% from 9–11% if issues surrounding new business strain are resolved and long-term interest rates remain at or above current levels.
Our Manulife estimate of 16% EPS compound annual return appears to be the most achievable, although still 100–150 basis points too high (we assume 15% EPS growth). This faith is based on strong growth from the U.S. insurance and wealth management businesses in the mid-teens, which account for 50% of earnings, high teens growth from Asia and other (combined 25% of earnings), and offset by 8–10% growth in Canada (25% of earnings). While new business growth will inevitably moderate at MFC’s U.S. operations, we believe that the success of the JHF acquisition and new product launches provides MFC with signifi cant earnings momentum over the next couple of years.
In this analysis, we have not directly included the benefi ts that could be derived from share buybacks. However, we believe that share repurchase activity will be an important tool at SLF and MFC in meeting long-term EPS growth targets. While we have not made any explicit calculation of share buyback, we believe that they are indirectly included in our forecasts discussed above.
Book Value Growth Outlook
Analyzing projected growth in BVPS, using the same assumptions as in Table 6, should, hopefully, yield similar results. In our BVPS analysis, the Fundamental Returns are roughly equivalent to those calculated in the EPS growth analysis; however, the ranking has shifted somewhat. While Sun Life continues to trail the peer group with a Fundamental Return of 41% over the next three years, our analysis indicates that Great-West offers the most favourable Fundamental Returns over the next three years at 56% versus Manulife and IAG at 48% each (see Table 7). We believe this result highlights the fact that GWO has a higher ROE and, as a result, BVPS compounds at a higher rate than the rest of the industry, despite its higher payout ratio of 40%.
Similar to our EPS growth forecasts, we suspect that these projected BVPS growth rates may be too optimistic for two other reasons in addition to those factors referred to above. First, share repurchase activity is likely to diminish book value growth rates, particularly at Manulife and Sun Life. Second, exchange rate movements can add volatility to BVPS. For instance, we estimate that the strength in the Canadian dollar has reduced Manulife’s book value per share by $0.75–1.00. On the other hand, a weakening Canadian dollar could cause book value per share growth to accelerate. Another issue to mention is the new investment accounting rules that come into effect on January 1, 2007 (for a more detailed analysis of this issue, please see our report dated December 14, 2005 entitled “Investment Accounting Changes in 2007”). Unrealized gains and losses on assets held as available for sale will be included in other comprehensive income (“OCI”), which is a component of shareholders equity. While we anticipate analyzing BVPS and ROE exclusive of OCI, inclusion of OCI could have a material impact on shareholders’ equity.
We believe that this high level analysis is useful in analyzing long term trends in EPS growth, BVPS growth and returns, but it does have some shortcomings that should be acknowledged. First, this analysis is sensitive to the major assumptions on ROE and payout ratios. For example, in the event that SLF could generate a 15% ROE, as opposed to 13.5%, it would eliminate the Fundamental Return gap with the rest of the industry. Second, our analysis assumes that valuations will remain constant. However, given that markets are in constant fl ux, valuations are unlikely to remain unchanged. Third, this analysis is a static analysis and it does not incorporate dynamic events such as acquisitions and/or spin-offs, as well as no explicit recognition of share repurchases. Given Manulife’s ability (and desire) to acquire in the U.S. and Asia, Great-West’s need for scale in the U.S., and strategic options for MFS at Sun Life, we believe that allowances should be made to this static analysis.
Conclusions
We believe that there are two broad conclusions that can be drawn from this exercise. First, the outlook for Fundamental Returns over the next three years is comparable to the Fundamental Returns experienced in the last three years. This reflects the sustainability of earnings growth from the Canadian lifecos based on expanding international operations and a steady supply of excess capital from the consolidated domestic market. While Fundamental Returns should be comparable, total returns are expected to be lower, as the Canadian lifecos are unlikely to enjoy the same valuation improvement over the next three years as in the previous three years. Second, this analysis confi rms that a signifi cant portion of shareholder returns is directly attributable to internal capital allocations decisions— payout ratios, acquisitions, internal projects and share buybacks— rather than the vagaries of the equity markets. More specifically, ROE is at the centre of long-term shareholder returns.
We currently recommend the Canadian lifecos and we have overweight recommendations on Sun Life, Manulife and IAG. We believe results in this report support our overweight recommendations on Manulife and IAG, but the reader may ask why continue to recommend Sun Life? As referred to in the previous section, this analysis is largely a static analysis and we believe that SLF is likely to undergo some dynamic changes over the next year or two, including a possible spin-off or sale of MFS and improved performance from the U.S. operations. However, this report does highlight SLF’s key weakness vis-à-vis its peer group in Canadian financial services: a low ROE. Sun Life has embarked on a significant share repurchase plan over the last several years and is growing its payout ratio. While these efforts are positive developments, driving ROE higher will depend on improving the profi tability of its existing operations, particularly U.S. annuities, the avoidance of acquisitions in commodity-type segments, such as fixed annuities, and disciplined pricing on any future acquisitions. We believe the company is making progress on this front and the addition of three new senior managers, including a new CFO, should inject new energy and new ideas into Sun Life.
;
Measured Returns: A Historical Perspective
Since June 2003, the shares of the four Canadian life insurers have generated a total return ranging from 57% to 94% (see Table 1). These returns include share price appreciation plus dividends. The last three years represent a profitable and interesting period for lifeco shareholders given the consolidation of the Canadian marketplace and growing influence of international operations.
Share price returns are comprised of two components: Investment Returns (or Fundamental Factors) and changes in valuation. Investment returns represent the sum of dividend yield and earnings and/or book value growth over that period. These returns are driven by the insurers’ own actions, reflecting dividend payout ratio policies and the ability to drive earnings growth. The valuation component measures the change in valuation (P/E and/or P/B) since June 2003 and is a reflection of general market conditions and an insurer’s general level of profitability (ROE and EPS growth outlook). In this report, we analyze the components of the total shareholder returns over the last three years for the Canadian lifecos under two different approaches and then provide an outlook for these two components, and shareholder returns, over the next few years.
In the first approach, we analyze the growth in EPS from 2003 to 2006. The absolute growth in EPS ranges from 38% at GWO to 52% at IAG. Adding the impact of dividends generates the Fundamental Return (Table 2). Overall, Investment Returns, or Fundamental Returns, ranged from 49% at GWO and SLF to 56% at Manulife and 60% at IAG. Of the total return to shareholders over the last three years, the Fundamental Returns accounted for 60–86% of these returns. The balance of shareholder returns was accounted for by an increase in P/E multiples (see Table 3). GWO had the most modest improvement in valuation, while MFC experienced the greatest valuation improvement using the P/E analysis.
The rise in MFC’s valuation on a P/E basis reflects the success of the JHF acquisition in enhancing the value of the company’s franchise and providing a strong foundation for future growth. GWO’s modest valuation improvement reflects a changing landscape. Prior to 2003, we believe GWO garnered a premium multiple given two robust channels of growth: domestic consolidation in Canada and organic growth in the U.S. Given that domestic consolidation is largely complete and roughly 40% of the U.S. operations (i.e. health care) has generated sub-optimal growth rates, expectations for future growth are limited, which we discuss in greater detail below.
In the second approach, we use growth in BVPS from June 2003 to June 2006. We would expect similar results in the second approach as in the first approach. Since June 2003, the absolute growth in book value per share has ranged from 13% at SLF to 60% at MFC (Table 4). Including the impact of dividends, Fundamental Returns have ranged from 21% at SLF to 68% at Manulife. As a percentage of total shareholder returns calculated in Table 1 above, Fundamental Returns using BVPS growth account for 32–68% of total returns. The other component in total return is the change in valuation, specifically P/B in this case. In this approach, 68% of SLF’s return over the last three years is a result of a higher P/B versus 46% at IAG, 32% at GWO and 27% at MFC (Table 5).
Between the two approaches, improving valuation accounted for an average of 25% of the total returns in the P/E analysis and 43% of the total return in the P/B analysis. Why the difference in contribution from valuation improvement between the two approaches? The difference boils down to the 41% improvement in Sun Life’s P/B valuation over that time period. The improvement in price to book reflects a significant increase in ROE to 13.5% in 2006E from 10.5% in 2003. This rising ROE has been driven by a 40% increase in EPS over the time period, plus share repurchases of $1.4 billion from June 2003 to June 2006 representing 10% of the company’s shareholders equity on June 30, 2003. On a P/E basis, SLF’s valuation improved 13% over the indicated time period, which is consistent with the peer group average on this valuation metric. Manulife’s growth in book value is attributable to the large share issuance needed to acquire John Hancock.
Fundamental Return Projections:
Handicapping the Future
What does this analysis indicate about the future? We believe that valuation gains will be increasingly difficult to achieve in the years ahead, given the likelihood of a less robust credit and operating environment and potentially rising interest rates. As a result, returns are more likely to come from fundamental components: dividends plus earnings, or book value, growth.
In projecting fundamental returns for the purposes of this report we have ignored our more detailed financial models and relied on the “bigger picture” variables, specifically applying long-term ROE and payout ratio assumptions to 2006 year-end book values. Our ROE assumptions over the next three years are similar to current run-rate ROE results, which we believe are reasonably indicative of long-term ROEs. Payout ratio assumptions are based on the middle of an insurer’s targeted range, with the exception of Great-West LifeCo, which we assumed stayed stable at 40% of earnings. We used these assumptions to estimate growth in EPS and BVPS out to 2009.
EPS Growth Outlook
In our projections analyzing EPS growth over the next three years, Manulife enjoys the highest Fundamental Return at 55%, followed by Great-West at 52%, IAG at 50% and Sun Life at 41% (see Table 6). Manulife enjoys the highest Fundamental Return in the EPS scenario due to its ability to retain 70% of its earnings and generate a long-term ROE of 16%. Sun Life trails the group because the model assumes that its long-term ROE is 13.5% and it retains a slightly smaller portion of earnings.
In reviewing the results calculated in Table 6, our instincts suggest that these forecasts are too optimistic. For example, GWO’s projected compound annual return in EPS of 15% from 2006 to 2009, while plausible, appears aggressive. Roughly 47% of GWO’s earnings come from Canada, which is a mature insurance market. While we believe that GWO’s Canadian operations are world class by any measure, the maturity of the domestic market implies a sustainable growth rate in the 10% range. In addition, 11% of GWO’s earnings are derived from U.S. health care, which has struggled and based on the current situation long-term growth expectations should probably be 5% (over the last four years GWO’s U.S. health care operations generated compound annual growth rates in aftertax earnings, in U.S. dollars, of 3%). Furthermore, reinsurance— an unpredictable, low-multiple business in our view—represents another 4% of 2006E earnings. Our models generally assume 0% growth in reinsurance.
Summing these three businesses indicates that 62% of GWO’s business could generate long-term earnings growth of 8.5%, and the balance of the businesses— Europe and U.S. Financial Services— need to grow at a combined 26% to achieve a consolidated 15% EPS CAGR over the next three years. While this growth rate is plausible, it is not without challenges. Over the last four years, U.S. Financial services has generated compound annual growth rate in net earnings, in U.S. dollars, of 20%. In Europe, which includes insurance and annuities, net earnings grew at a compound annual rate of 25% since the operations were acquired in July 2003. On a combined basis, Europe and U.S. Financial Services have not reached the targeted combined growth rate of 26% (for more details on Great-West, please refer to our report dated June 2, 2006 and entitled “Strategic Alternatives for U.S. Healthcare”).
Similarly, projected EPS compound annual returns for Sun Life and IAG of 12% and 14%, respectively, over the next three years appear optimistic. For SLF to generate a CAGR of 12% over the next three years, earnings growth from U.S. annuities will need to accelerate significantly. Approximately 55% of SLF’s earnings are generated in Canada and we would expect these operations to generate earnings growth of 8–10%. Accordingly, to generate 12% growth, the other operations—MFS, U.S. insurance, and Asia— will need to grow earnings at a combined rate of 15–18%. While we expect SLF to continue to build its variable annuity book of business and gradually improve spreads in fixed annuities, it is diffi cult for us to foresee such growth from these businesses, particularly as credit conditions weaken and/or equity market returns prove more elusive.
For Industrial Alliance, achieving a 14% compound annual return in EPS calculated in this analysis is more achievable relative to EPS growth forecasts for GWO and SLF discussed above. However, individual insurance and individual wealth management, which combined account for 75% of IAG’s total 2006E earnings, growth rates in individual wealth management will need to remain elevated in the high teens and earnings growth from individual insurance will need to accelerate from its current rates. We believe that individual insurance growth rates can increase to 11–13% from 9–11% if issues surrounding new business strain are resolved and long-term interest rates remain at or above current levels.
Our Manulife estimate of 16% EPS compound annual return appears to be the most achievable, although still 100–150 basis points too high (we assume 15% EPS growth). This faith is based on strong growth from the U.S. insurance and wealth management businesses in the mid-teens, which account for 50% of earnings, high teens growth from Asia and other (combined 25% of earnings), and offset by 8–10% growth in Canada (25% of earnings). While new business growth will inevitably moderate at MFC’s U.S. operations, we believe that the success of the JHF acquisition and new product launches provides MFC with signifi cant earnings momentum over the next couple of years.
In this analysis, we have not directly included the benefi ts that could be derived from share buybacks. However, we believe that share repurchase activity will be an important tool at SLF and MFC in meeting long-term EPS growth targets. While we have not made any explicit calculation of share buyback, we believe that they are indirectly included in our forecasts discussed above.
Book Value Growth Outlook
Analyzing projected growth in BVPS, using the same assumptions as in Table 6, should, hopefully, yield similar results. In our BVPS analysis, the Fundamental Returns are roughly equivalent to those calculated in the EPS growth analysis; however, the ranking has shifted somewhat. While Sun Life continues to trail the peer group with a Fundamental Return of 41% over the next three years, our analysis indicates that Great-West offers the most favourable Fundamental Returns over the next three years at 56% versus Manulife and IAG at 48% each (see Table 7). We believe this result highlights the fact that GWO has a higher ROE and, as a result, BVPS compounds at a higher rate than the rest of the industry, despite its higher payout ratio of 40%.
Similar to our EPS growth forecasts, we suspect that these projected BVPS growth rates may be too optimistic for two other reasons in addition to those factors referred to above. First, share repurchase activity is likely to diminish book value growth rates, particularly at Manulife and Sun Life. Second, exchange rate movements can add volatility to BVPS. For instance, we estimate that the strength in the Canadian dollar has reduced Manulife’s book value per share by $0.75–1.00. On the other hand, a weakening Canadian dollar could cause book value per share growth to accelerate. Another issue to mention is the new investment accounting rules that come into effect on January 1, 2007 (for a more detailed analysis of this issue, please see our report dated December 14, 2005 entitled “Investment Accounting Changes in 2007”). Unrealized gains and losses on assets held as available for sale will be included in other comprehensive income (“OCI”), which is a component of shareholders equity. While we anticipate analyzing BVPS and ROE exclusive of OCI, inclusion of OCI could have a material impact on shareholders’ equity.
We believe that this high level analysis is useful in analyzing long term trends in EPS growth, BVPS growth and returns, but it does have some shortcomings that should be acknowledged. First, this analysis is sensitive to the major assumptions on ROE and payout ratios. For example, in the event that SLF could generate a 15% ROE, as opposed to 13.5%, it would eliminate the Fundamental Return gap with the rest of the industry. Second, our analysis assumes that valuations will remain constant. However, given that markets are in constant fl ux, valuations are unlikely to remain unchanged. Third, this analysis is a static analysis and it does not incorporate dynamic events such as acquisitions and/or spin-offs, as well as no explicit recognition of share repurchases. Given Manulife’s ability (and desire) to acquire in the U.S. and Asia, Great-West’s need for scale in the U.S., and strategic options for MFS at Sun Life, we believe that allowances should be made to this static analysis.
Conclusions
We believe that there are two broad conclusions that can be drawn from this exercise. First, the outlook for Fundamental Returns over the next three years is comparable to the Fundamental Returns experienced in the last three years. This reflects the sustainability of earnings growth from the Canadian lifecos based on expanding international operations and a steady supply of excess capital from the consolidated domestic market. While Fundamental Returns should be comparable, total returns are expected to be lower, as the Canadian lifecos are unlikely to enjoy the same valuation improvement over the next three years as in the previous three years. Second, this analysis confi rms that a signifi cant portion of shareholder returns is directly attributable to internal capital allocations decisions— payout ratios, acquisitions, internal projects and share buybacks— rather than the vagaries of the equity markets. More specifically, ROE is at the centre of long-term shareholder returns.
We currently recommend the Canadian lifecos and we have overweight recommendations on Sun Life, Manulife and IAG. We believe results in this report support our overweight recommendations on Manulife and IAG, but the reader may ask why continue to recommend Sun Life? As referred to in the previous section, this analysis is largely a static analysis and we believe that SLF is likely to undergo some dynamic changes over the next year or two, including a possible spin-off or sale of MFS and improved performance from the U.S. operations. However, this report does highlight SLF’s key weakness vis-à-vis its peer group in Canadian financial services: a low ROE. Sun Life has embarked on a significant share repurchase plan over the last several years and is growing its payout ratio. While these efforts are positive developments, driving ROE higher will depend on improving the profi tability of its existing operations, particularly U.S. annuities, the avoidance of acquisitions in commodity-type segments, such as fixed annuities, and disciplined pricing on any future acquisitions. We believe the company is making progress on this front and the addition of three new senior managers, including a new CFO, should inject new energy and new ideas into Sun Life.
