27 October 2006

Sun Life Q3 2006 Earnings

BMO Capital Markets, 27 October 2006

Investment Thesis & Outlook – An Interesting Week

It has been an interesting week for SLF shareholders. On Monday, the company announced that it had concluded its strategic review of MFS and decided not to merge with any partners. The potential of finding a partner for MFS was a significant catalyst and the lack of a transaction deflated the shares. However, yesterday the company reported some of the strongest quarterly earnings results in years. Fully diluted EPS of $0.93 in Q3/06 compared with $0.82 in Q3/05, our estimate of $0.85 and the First Call Mean of $0.88. The higher earnings were driven by improved results in the U.S. and a higher contribution from the U.K. slightly offset by weaker than expected earnings in the other Canadian operations. Annualized ROE increased above 14% —the strongest result since the IPO.

In-force profits rose for the second quarter at 20%+ and excluding acquisitions, still rose at 16% in the quarter—a very strong result. Sales of protection products across all geographic segments and premiums & deposits also showed continued momentum from a good Q2/06. A benign credit environment, rising spreads, and good equity markets drove U.S. annuity earnings. The company achieved these excellent results while maintaining the highest level of reserves on seg fund secondary guarantees of CTE 80. Pre-tax margins at MFS rose to 30% and are projected to rise to 32% in 2007.

The Best Medicine for an Ailing Share Price: Improving ROE

Since upgrading the shares in June 2005, we have consistently indicated that a rising ROE was the key to improving shareholder returns. The “ROE-gap” has started to narrow between Sun Life and the other major Canadian financial services companies, which have ROEs in the high teens to low twenties. The company’s ROE languished relative to its peer group in Canadian financial services due to the acquisitions of Clarica and Keyport in 2001. Annualized ROE was 14.4% in Q3/06, up from 10.3% in 2003. Higher ROE should translate into higher valuations for the shares.

The ROE has improved for a variety of factors that have been underway for sometime but are becoming more evident now. These factors include the beneficial impact of the company’s share buyback program (34 million shares have been re-purchased since the end of 2003), improved efficiencies in the U.K., rising margins at MFS (MFS is a very high margin business), and improved productivity in Canada. ROE in Canada has increased from 12.0% in 2003 to an average of 14% in 2006. Also very importantly has been the improvement in profitability in the U.S. annuities operation which has benefited from improved spreads, benign credit, and good equity markets. ROE in the U.S. has improved from 7% to 12%. As importantly, SLF has been able to improve ROE despite some heavy investment required for Canada in distribution and technology as well as distribution initiatives in the U.S.

Although disappointed, the company did not find a partner for MFS, good quality quarterly earnings combined with solid new business growth create a favourable backdrop for earnings and ROE improvements in 2007. We revised our 2007 ROE estimate to 14.3% from 13.8%. Although we believe the company has some important operational challenges, key financial metrics are trending in the right direction.

The challenges mainly focus on the company’s U.S. wealth management operations: variable annuities and MFS. Gross sales of domestic variable annuities remain low but are rising. MFS remains in net outflows particularly in the mutual fund segment. While MFS is in the process of launching a number of new initiatives, which should help improve net flows, these initiatives only surfaced after a strategic review and after four years of net redemptions in U.S. mutual funds.

We expect to scrutinize the developments in the Clarica agency sales force. SLF initiated a productivity program in this distribution channel (i.e., weed-out unproductive advisors) but we believe that this process is largely complete and we expect to see growth in the ICA channel over the next few years.

Sun Life remains rated Outperform. Sun Life bought back 1.9 million shares in the quarter. We expect the company to remain active in its share repurchase program. Given good results in the quarter, we raised 2006E and 2007E EPS to $3.58 and $4.00 from $3.45 and $3.80, respectively. The higher earnings reflect higher expectations from U.S. annuities, the U.K., and a lower tax rate. A summary financial model is included at the end of this comment. We also increased the target price to $53 from $51, representing 1.8x 2007E BVPS and 13x 2007E EPS. SLF is the cheapest large cap financial services stock on a P/E and P/B basis in Canada.


Earnings in Canada increased 5% to $240 million from $228 million in Q3/05, and were lower than our expectations of $258 million, due to weaker results in individual life and group retirement services, which were somewhat offset by strong results in group benefits. Increased investment in distribution and IT systems also negatively affected earnings in the quarter. Premiums and deposits were $3.7 billion, up from $3.5 billion in Q3/05.

Results from group wealth rose 3% to $32 million from $31 million in Q3/05 due to increased income on higher AUM, which was offset by less favourable investment experience in the quarter (i.e., investment gains in Q2/06 were not as robust as in Q2/05). DC plan assets are 8% higher than the same quarter last year and are up 4% from the previous quarter due to stronger sales. Sun Life is the largest DC provider in Canada, with a 38% market share of DC sales in 2005 and leads the market with asset retention levels of four times its closest competitor for the 12 months ended June 30, 2006.

Earnings from individual insurance and investments declined 4% to $123 million in Q3/06 from $128 million in Q3/05 largely due to less favourable investment experience in Individual Wealth (similar to the experience in group wealth) and new business strain. Sales in individual life and health insurance were $38 million in Q3/06, up 6% from $36 million in Q3/05, but down from $42 million last quarter. The wholesale channel is gaining traction, while sales results were flat in the Clarica channel compared to the same quarter last year.

The earnings contribution from group benefits rose 23% to $85 million from $69 million in Q3/05, largely attributable to the favourable reserve impact of better cash-flow matching totalling $18 million and strong investment results, which were somewhat offset by unfavourable morbidity experience of $15 million. Gross sales are down 1% year over year, while business in-force increased by 11% from Q3/05. Retention rates remain solid: in excess of 97%.

Overall, growth in Canada is somewhat below expectations due to some heavier investments in infrastructure and distribution that should help drive earnings in future years. We continue to expect SLF Canada to generate earnings growth of 10% over time and generate an ROE of 15%. Over the last couple of years, the size of the company’s Clarica distribution channel has declined as it focused on agent productivity. We believe that this process is at an end and we will increasingly focus on growth in the Clarica channel. While we are encouraged by the company’s success in the third party channel, Clarica advisors remain key to its long-term competitive advantage.


Earnings in the U.S. rose 11% to US$121 million compared with US$109 million in Q3/05, but increased only 2% in Canadian dollar terms due to the appreciation of the Canadian dollar. The stronger results were due to better equity markets, improved spreads in fixed annuities, benign credit and the favourable impact of the lower cost funding solution for UL product reserves in Individual Life. These were partially offset by higher new business strain and the reserve impact of increased reinsurance rates on new business in Individual Life.

Spreads within fixed annuities have increased to 202 basis points from 172 basis points in Q3/05. The rise in spreads reflect higher earned rates and the fact that rates on some multi-year guarantee business written by Keyport can now be reset. While clearly positive for parts of the fixed annuity block, reset periods on these multi-year agreements do not unfold in an orderly fashion. The favourable credit environment is also helping spreads. We expect spreads within fixed annuities to be roughly 180-190 basis points over the next few quarters.

Over the last year, Sun Life has issued roughly $2.7 billion of MTNs (including $900 million in Q3/06), or what we prefer to call institutional spread based products. We are not believers in these products because it is hard to develop and sustain a competitive advantage in this segment. Clients tend to be large institutions that are very price sensitive. We would prefer the company to build its business around the core retail annuity, individual life, and group benefits businesses as opposed to institutional, or wholesale, spread-based product. The company maintains that spreads meet targeted hurdle and return rates but we believe that the capital used for these products could be best used to support the other businesses or buyback shares.

The trend in sales of variable annuities appears to show very early signs of improvement. Net redemptions in domestic VAs continued to moderate to US$236 million from US$291 million in Q3/05 and US$277 million in Q2/06. While redemptions will likely remain steady given a relatively mature block of variable annuity assets, the key to net sales will be to reinvigorate gross sales. Gross sales were fairly flat in the quarter at US$547 million from US$545 million in Q3/05, although gross sales of domestic variable annuities rose 16%. Reserves on secondary guarantees remained at a level of CTE80 in the quarter, the same level as last quarter. The rise of the equity markets enabled SLF to maintain the highest reserves on secondary guarantees and release roughly $12-14 million in pre-tax earnings from reserves in the quarter.

Individual life reported earnings of US$22 million up 5% from US$21 million in Q3/05 largely attributable to the favourable impact of the lower cost funding solution for UL product reserves and a higher proportion of earnings from lower tax jurisdictions, partially offset by higher new business strain and reserve strengthening due to increased reinsurance rates. The company does sell substantial individual life sales in the offshore market. Sales results were very strong, increasing to US$150 from US$36 million in Q3/05 and US$97 million in Q2/06, primarily due to several large case wins in the COLI/BOLI channel, combined with a new core UL product launched in the quarter, which was re-designed and re-priced to help reduce sales strain. Excluding COLI/BOLI product sales, individual life sales rose to US$80 million in the quarter from US$29 million in Q3/05 and US$67 million in Q2/06. The new distribution arrangements announced by SLF appear to be gaining traction.

Earnings in the group life and health business rose 10% to US$11 million from Q3/05 due to improved claims experience, which was slightly offset by increased infrastructure investment. Business in-force in U.S. group life and health rose to US$1.1 billion in the quarter from US$928 million in Q3/05. Sales declined 12% to US$57 million from US$65 million in Q3/05 despite increased sales through the Medical Group Insurance Services partnership. New business growth should continue to provide a solid backdrop for earnings over the next couple of years.


MFS reported US$52 million in earnings during the quarter, improving from US$38 million in Q3/05 and US$47 million from last quarter. Revenues for the quarter were US$352 million versus US$342 million in Q3/05, reflecting higher average net assets in the quarter to US$170 billion from US$155 billion in Q3/05. The mix of assets continues to favour institutional products versus retail mutual funds (discussed below).

MFS recorded total net redemptions of US$0.1 billion in the quarter, as net outflows from retail mutual funds outpaced the inflows from institutional business. In the quarter net redemptions from retail mutual funds declined to US$1.2 billion, down from net outflows of US$1.6 billion in Q2/06, but up from net redemptions of US$0.7 billion a year ago. Institutional net inflows totalled US$1.1 billion, which is lower than the US$2.1 billion in net sales in Q3/05 and US$1.2 billion the prior quarter. The key to improving net sales is to drive gross sales as redemption rates will likely remain near current levels. The company is currently working on improving performance, focusing on marketing and sales as well as developing new products to capture market share in areas where it has not had a presence in the past (e.g. fixed income, international and global equity).

We continue to believe that MFS is an excellent franchise but the stubborn net redemptions in retail mutual funds are discouraging. While pre-tax margins continue to improve to 30% in the quarter from 27% last quarter and 22% a year ago, this is still lower than the industry average in the high 30s. MFS set a target margin of 32% by the end of 2007, which we believe is achievable, and is based on “normal” market growth of 5-6% in 2007.

Recently, Sun Life announced that it has concluded its strategic review process of MFS with no transaction at this time. While we believe there was significant interest in acquiring MFS, the challenge was finding the right partner. While it is disappointing that the strategic review concluded in this manner, we maintain that no deal is better than a bad deal. Nonetheless, the company’s mutual fund operations have experienced consistent net redemptions for at least the last four years. While the build-out of the company’s institutional platform has met with some considerable success, we continue to believe that MFS is at risk of becoming marginalized in the U.S. mutual fund business. During the conference call, MFS announced a number of new initiatives to improve its net inflows including using outside managers for different types of mandates. These outside advisors will manage MFS-branded funds and use the MFS distribution capabilities. These developments are certainly encouraging but we continue to believe that the future of MFS, and SLF’s investment, is more secure in a partnership.


Earnings from Asia increased to $13 million in the quarter from $10 million Q3/05 primarily due to the CMG Asia acquisition and business growth, which was somewhat offset by reserve strengthening in Indonesia. The CMG acquisition contributed to strong sales results in Hong Kong, which were up 111% in local currency from a year ago. In China, sales grew 149% from Q3/05 as the company opened three new sales offices in the quarter.

Sun Life’s Indian operations, while small, are expected to show good growth as it expands the direct sales force in the region. At the end Q3/06, the number of agents increased to 21,500, surpassing its target of 20,000 agents. While India offers significant long-term growth prospects, over the next 5–10 years, it is not expected to be a material contributor to earnings.

Corporate & Other

Earnings from the U.K. operations were $57 million during the quarter compared with $48 million in Q3/05 and our expectations of $45 million. The improved earnings were primarily due to the reimbursement of certain mortgage endowment costs, net of other provisions. The U.K. operations are in run-off and we believe that sustainable earnings from this operation are approximately $50-53 million per quarter, up from our previous estimate of $45 million per quarter. The reinsurance operations reported net earnings of $25 million in Q3/06 compared to a loss of $6 million in Q3/05, due to better mortality and the absence of reserve strengthening that occurred in Q3/05. The other operations reported a gain $12 million in the quarter versus a loss of $29 million in Q3/05, as results in the prior year were negatively affected by an after-tax loss of $51 million related to the sale of the company’s Chilean investment.

Credit Quality

Credit remains strong at Sun Life as net impaired assets declined to $111 million from $145 million in the previous quarter, and from $182 million in Q3/05. Net impaired assets as a percentage of invested assets were 0.11% in the quarter, down from 0.15% in Q2/06 and 0.19% in Q3/05. In addition, there was an increase in credit provisions of $4 million in the quarter, compared to a reversal of $3 million in the same quarter last year. We believe the company’s credit profile remains very strong.

A strong credit profile is supported by a strong capital ratio, with an MCCSR of 225% in Q3/06. The company repurchased 1.9 million shares in Q3/06 for $85 million, for a total share buyback of $484 million year-to-date. We continue to believe that the share buyback is the most appropriate use of capital and that Sun Life should continue to be active in its share repurchase program. We are projecting a share buyback of 12 million in 2007.

Conclusion & Recommendation

Sun Life remains rated Outperform. Overall, results were good in the quarter. In-force profits rose 21% in Q3/06 (15% excluding $16 million from CI’s conversion) and value of new business rose 4.5% (6.5% excluding MFS). Premiums and deposits rose 5% in Canada and 51% in the US driven by individual insurance and group. Pre-tax margins at MFS improved to 30% from 22% a year ago and net outflows improved to US$100 million, but the mutual fund operations continue to experience significant net outflows of US$1.2 billion. ROE improved to 14.4% from 13.1% a year ago and Sun Life bought back 1.9 million shares in the quarter. We continue to believe that the major capital allocation decision over the next 12 months will focus on the timing and size of share repurchases.

Given results in the quarter, we increased our 2006E and 2007E EPS to $3.58 and $4.00, respectively from $3.45 and $3.80, reflecting improved earnings from the U.S. (mainly due to better spreads in fixed annuities) and an upwards revision to the quarterly sustainable earnings estimate from the U.K. to $50-53 million from $45 million, combined with a reduced share count. Our $53 target price represents 13x 2007E EPS and 1.8x 2007E BVPS.
Scotia Capital, 27 October 2006

• A good steady clean quarter - above consensus. Sun Life reported Q3/06 with $0.93 (fd) EPS, $0.03 per share above our estimate, and $0.05 above consensus. With about $0.03 per share in one-time reserve releases, we peg the underlying number at $0.90 per share, in-line with our estimate and $0.02 per share above consensus. After modest misses in Q1/06 and Q2/06 (incorporating a series of one-timers), we believe the relatively clean and respectable Q3/06 results, albeit assisted to some extent by buoyant equity markets, should help the stock "catch-up" in terms of valuation relative to its peers, namely Manulife and Great-West Lifeco.

• Increasing EPS estimates by $0.05 in 2007 and $0.03 in 2006 to reflect the "beat" in the quarter. Our EPS estimate increase reflects better-than-expected margin improvement at MFS, better-than-expected new business volumes in U.S. individual insurance, and larger than-expected asset values at the end of Q3/06 due to buoyant equity markets. MFS margins continue to improve at a faster clip than we anticipated, up from 22% (pre-tax) to 30% YOY and up from 27% in Q2/06. The distribution arrangements established earlier this year with the M Group and National Financial Partners (two large and well-established distributors in the U.S.) are certainly bearing fruit in terms of top-line growth in U.S. individual insurance, where sales were up over 300%, after nearly doubling in Q2/06. Finally, buoyant equity markets, especially in the U.S., up 5% QOQ in Q3/06 and a further 4% since the end of Q3/06, contributed to the increase in estimates. We forecast a 7% increase in yearly average levels of the S&P500 and the S&P/TSX in 2007, with Sun Life being more sensitive to changes in the S&P500. We estimate each 10% change in the growth rate for equity markets impacts our EPS estimate by approximately $0.20 per share.

• Multiple versus the group looking attractive - while valuation is certainly a "catalyst," a number of new members in the senior management team give Sun Life a "fresh new look." Sun Life is trading at a 7% discount to the average forward (NTM) P/E multiple of the Canadian lifeco group, well below its 4% average discount. Versus Manulife, Sun Life is currently trading at over twice its historical discount (currently Sun Life is a 15% discount on a forward P/E basis, versus its 7% average). We counted only three times the spread has exceeded 15%. Once, for two months shortly after Sun Life launched its IPO in 2000, another time, for two months in 2002 when 10-year treasuries in the U.S. fell below 4%, and another time, for nearly two months in the summer of 2006, as Sun Life shares fell to their 2006 lows in August. As well, two months ago Sun Life announced the addition of a new CFO (Rick McKenney, former CFO for U.S. insurer Genworth), as well as Stephan Rajotte (President, Sun Life Asia) and Dean Connor (Executive VP). We believe the compelling valuation, combined with a new fresh look to the senior management team, could be the necessary catalyst to move the stock, provided we continue to see quarters similar to the one we just saw in Q3/06.

• After strategic review of MFS, Sun Life decides to continue with current structure - citing opportunities in institutional market - looks to further improve margins to 32% (from current 30%) by end of 2007 . The company outlined the conclusions of its strategic review of MFS on the call. Management explained it came to the conclusion that MFS was very well positioned to grow and seek out opportunities, particularly in the global institutional marketplace, and that the economics of institutional and domestic retail were not significantly different (lower commissions, stickier assets). Institutional business makes up roughly one-half of MFS's assets, is a much larger potential market, and the company has taken advantage of its global institutional platform, where assets under management have increased 38% in the last 12 months. For the U.S. retail line, where the company is experiencing heavy redemptions in its growth category, MFS is opening up proprietary distribution to third-party products, and adopting funds that have track records and rebranding them MFS. Finally the company will continue to focus on cost containment, back office efficiencies, real estate, and outsourcing.

• Q4/06 MFS net flows will be negatively impacted by the media speculation in September/October 2006 - we've reflected this in our estimates. We forecast the rapid earnings growth rate in MFS in Q3/06 and YTD Q3/06, 36% and 32% respectively, to moderate to a 20% rate in Q4/06, to reflect an increase in net redemptions from US$100 million in Q3/06 to over US$1.3 billion in Q4/06. We believe our estimates are conservative.

• All in MFS appears to be on the right track - with earnings up 36% in the quarter and 32% YTD. MFS, which is only about 10% of Sun Life's bottom-line, has in-fact grown earnings (ex f/x) from 2004 through Q3/06 at a CAGR of 19%, faster than the Canadian division (10%) and at a greater clip than the entire company's EPS growth (14%).

• Canadian division (45% of bottom line) continues to be weak - with earnings up 5% YOY and 4% YTD. The Canadian market continues to be very competitive, and, despite being on the verge of an oligopoly, the market is not behaving as such. Excluding reserve releases (about $0.03 per share, due to cash flow methodology refinements in the group benefits segment), earnings were down 1% YOY in the quarter, as claims experience was slightly worse than normal (by about $0.02-$0.03 per share). Earnings were up just 8% in 2005 (7% excluding the contribution from CI funds), and we believe that earnings growth will be in the mid-single digit range through 2008. We expect 6% growth in 2007 and 2008. Group businesses continue to be the bright spot, with exceptional sales growth and increasing profitability. Individual insurance sales, up 6%, continue to pace ahead of the market, but pricing remains very competitive.

• U.S. division (25% of bottom line) - up 11% (ex f/x) YOY and up 10% YTD - we look for 12%-13% earnings growth in 2007, as the strain issue subsides. As the early August 2006 re-pricing has dealt with the Q2/06 individual insurance strain issue, we expect modestly appreciating equity markets (expected to be up 7% per annum) and continuation of the current high level of interest rates to help propel the bottom line, helped to some extent by continued strong individual sales (tripled in Q3/06 YOY, and doubled in Q2/06 YOY) and good variable annuity sales (domestic gross sales up 16%).

• Buybacks and CMG Asia acquisition help the company achieve its 10% EPS growth - we are introducing 2008E EPS estimate of $4.35. We look for 11% EPS growth in 2006 and 2007 and 10% growth 2008, which combined with aggressive buyback levels should add 100 bp to ROE over the next two years, just shy of the company's target of 75 bp per year.

• Asset quality remains strong. Net impaireds at 11 bp remains exceptionally low. With only 3% of bonds below investment grade, we believe Sun Life’s balance sheet is well protected should the credit environment become unfavourable.
RBC Capital Markets, 27 October 2006

Strong Result Amid Rising Volatility – Raising Estimates 6% and Target by 8%

Sun Life beat consensus by 7% this quarter, impressive after the rather weak result last quarter. In our view, certain of the divisions reported above trend (e.g. U.S. Annuities and Domestic Group Benefits), however, on the whole the result was solidly above expectations. Strong equity markets and improved fixed income spreads were significant factors. Management also cited efficiency gains, such as 300 fewer employees in the domestic operation, among others. We do believe there was a small benefit from a variable annuity guarantee reserve release, perhaps in the 1¢ range, but not enough for which to make an adjustment. Overall, we gave serious consideration to a rating upgrade from Sector Perform to Outperform, but based on: (i) our lack of EPS estimation confidence combined with (ii) higher total return outlooks for others in the sector, we stayed with our current rating.

Raising Estimates. We are raising our 2006 estimate 6% from $3.44 to $3.65, and our 2007 estimate rises 6% to $3.91 from $3.70. We are also lifting our price target from $49 to $53. This is set at 12.5x our new 2008 estimate of $4.25. It is also roughly in line with our previous method of targeting 14x our 4-quarter forward earnings estimate, now raised to $3.84. Thirdly, the $53 target is 1.79x our projected book value of $29.57 as at Q4/07, again roughly in line with today’s valuation of 1.75x.

MFS Ordeal is Over. Management confirmed the MFS strategic review was never in contemplation of an outright sale, rather just to choose between a joint venture option and a go-it-alone strategy. It seems that MFS will now remain with Sun Life and we do not expect there are any ‘Plan B’s’ in motion, such as an IPO or other, at least not until management has a chance to stabilize flows.

Expecting Higher EPS Volatility. While we can identify no major “items of note” this quarter, we do see continued volatility in Sun’s earnings, in particular on a divisional basis. Factors include wide shifts in the tax rate and sales strain, both largely dependent on product mix. Increasing sensitivity to equity markets and bond yields is also at play as the U.S. wealth division profit margins improve.

Corporate Division and Annuities Were Big Positive Variance Against Our Model. Sun registered positive variances versus our model across four of six divisions: (i) U.S. Annuities (5¢ on positive spread and equity-related reserve gains, both are unlikely to repeat to the full extent in future quarters); (ii) Corporate (7¢ on a more normal earnings level from reinsurance and the closed U.K. block of business); (iii) MFS (1¢ on improved margins); (iv) U.S. life (2¢ from a variety of items, likely sustainable in aggregate). U.S. individual life net income improved $10 million more than expected to $25 million, but the underlying remains clouded by heavy sales strain as reflected in unusually high sales, likely unsustainable, and an offsetting AXXX reinsurance funding gain. Earnings from Canada and Asia came in a collective $28MM below our estimated level (5¢) on a combination of sales strain and reserves taken. Fortuitously, the company-wide tax rate at 22% looks closer to the new sustainable range, and while down from ~28% a year ago, was still well above the most recent quarterly tax rates.

Canada – Earnings of $240M - 44% of Total – Up 5% YoY – We See Moderate Growth in 2007

SLF Canada missed our estimated contribution by about 5% this quarter. SLF reported Q3/06 earnings of $240M, 5% below our estimate of $251M, but up 5% YoY. By our calculation, half the realized growth rate can be attributed to a low tax rate. The divisional tax rate of 26.7% in Q3/06 was down from 29.7% in Q3/05 and accounted for ~$7M of the $12M YoY increase in earnings. Normalizing the tax rate would imply a 2% YoY growth rate. The trailing 6-quarter average earnings growth rate for this division is 6.8%.

Sun’s Canadian business is underpinned by the Individual Insurance operation, which has contributed 60% of divisional profit year-to-date (27% of overall company net income). Individual insurance profit dipped 4% YoY, and was also down 20% from the H1/06 run rate of $153 million. The sequential decline likely reflects a significant pull-back in the CI Funds contribution, expected down on lower gains this quarter (CI Funds does not report until next quarter, so Sun ‘buried’ an undisclosed ‘estimate’ of the CI profit this quarter, pending the public release next week).

Following in the footsteps of competitors IAG and GWO last quarter, SLF also felt the sting of increased sales strain this quarter. This, we estimate in the $10 million range on its level COI universal life product sales, hinting to us just how very competitive the Canadian market has become. Domestic insurance sales of $38M were up 6% YoY from $36M in Q3/05 and in line with our estimate of $38M. Clarica, the direct distribution channel sales of $30 million remained flat YoY and in line with our estimate of $31 million. The independent channel sales at $8 million, while up 33% YoY, have yet to make a break-out, tracking the same level as the prior two quarters. Looking forward, we expect this division has modest upside.

The domestic Group Benefits division was a star this quarter, growing earnings 23% YoY to $85 million to match its Q4/05 record level. Strong investment income was the driving factor, although the 97% retention rate and an 11% lift in business in-force were also solid underpinnings. This division now contributes 15% of profit. Group health sales of $70M were in-line with Q3/05 sales of $69M and down from $155M in Q2/06. Group health earnings and sales tend to be lumpy from quarter to quarter. Our Q4 earnings estimate for the division is $75 million, assuming added morbidity and less robust investment income.

The domestic Group Pension division (GRS) earned $32 million, up $1 million YoY to contribute 6% of earnings, level with the year ago result. We are factoring a $35 million contribution next quarter.

SLF U.S. Division - Earnings of $121M – 22% of Total and Up 11% YoY – Near a High Water Mark

Sun’s U.S. earnings benefited from the strong equity market performance and unusually high annuity spreads. We also think the division spawned a $7 million variable annuity reserve release, roughly 1¢ / share. Management confirmed this is probably the last quarter in which there will be any measurable earnings release from annuity guarantee reserves.

Management disclosed that the annuities division earnings pick-up division from these two factors was ~$15 million or 3¢ EPS. We expect these macro-factors will continue to be the principal earnings drivers for the U.S. division in the next few quarters. We estimate that every 10 bps change in US division annuity spreads is worth $2 million in after-tax earnings and that every 10 points on the S&P 500 is worth ~$8 million in annuity fee earnings.

We also anticipate annuity and fund redemptions will persist for a while yet. The Q3/06 total was another US$1.2 billion in fund redemptions, well into the high end of the range of the past couple of years. Worse, MFS may be poised to lose more momentum in mutual fund sales and institutional mandates starting this quarter as fall-out from their very public strategic review.

U.S. Insurance Bolstered by Lower Quality COLI/BOLI Sales. U.S insurance sales of US$150 million, were up 3-fold, roughly double our estimate of $70 million. SLF reported US$70 million of wholesale COLI/BOLI sales, $55 million higher than our estimate of $15 million. COLI/BOLI is a wholesale form of business insurance, typically lower margin than individual. The very high individual sales at $80 million beat our $55 million estimate, likely owing to continued off-priced product with key distributors. Insurance sales spiked up on Sun’s now-out-of-date pricing model, so we expect should revert lower to a more sustainable range starting next quarter. The higher-gain cost of new business sales strain was largely offset by an AXXX funding benefit, so the underlying insurance contribution was probably near a normal run-rate.

Watching for Annuity Earnings To Level Off Here. Contributing about 16% of overall Sun Life profit, we believe the annuity division earnings are near a high-water mark, at least until flows turns positive. We are anticipating a slight decline in annuity earnings next quarter to US$80 million from the $89 million just realized as (i) spread normalizes and (ii) no more reserve guarantee releases. The annuities sales force has yet to gain traction despite some eight-five wholesalers in the market. One would think this has got to improve in 2007, but we have no real visibility yet – net redemptions remained near all-time highs.

We are factoring a flat contribution from the U.S. individual and group life & health businesses in Q4/06 at about 7% of total earnings.

MFS – Earnings of $58M – 11% of Total – Up 26% YoY – Now Also Reaching Potential

MFS registered a 300 bps improvement in operating margin (i.e. from 27% to 30%) on fixed cost leverage, in part driven by the market-driven AUM gains. Management signaled that the 30% operating margin is nearing potential, which they indicated and targeted at 32% for next year.

Revenues do not appear to be growing, flat in USD and down 7% in CAD, though this just reflects the mix shift to institutional from retail.

Mutual fund redemptions remained surprisingly high at US$1.2 billion, while the US$1.1 billion in new institutional mandates nearly offset the retail outflows. The MFS game plan to go after international institutional mandates is working very well, but now management should apply that magic to their mutual fund business.

SLF Asia - Earnings of $13 million – 2% of Total – Set To Rebound Slightly

SLF Asia earnings were down roughly 50% from the prior two quarters on a reserve strengthening taken in the Indonesian operation. We would expect this to normalize next quarter, helping earnings rebound $8 million to $21 million. Revenue grew 58% YoY driven by the recent Hong Kong-based acquisition of CMG and fast-paced expansion in both India and China. Sales were up 53% in CAD. Under normal circumstances, SLF Asia should be contributing about 5% of total earnings, but growing at twice the pace of the parent company.

Corporate Division - Earnings of $94M - 17% of Total – Up 67% YoY – Probably at Full Potential

SLF U.K. earnings on a closed block of business were $57 million, up 50% YoY owing to the reimbursement of certain mortgage endowment costs. We are assuming this is a fair indication of a run-rate for our forecast period. Reinsurance profit improved to $25 million from a very low level a year ago, but similar to last quarter and the divisional run rate, in our view. Better mortality and absence of reserve strengthening in the prior year were the YoY drivers.


Our new $53 price target, up $4, is set at 12.5x our new 2008 EPS estimate of $4.25. Our Sun Life target P/E is set a half multiple below our 13x sector target P/E to reflect Sun’s growth challenges in domestic insurance and U.S. wealth (annuities and mutual funds). We also believe Sun’s financial performance is more sensitive to interest rates and equity markets, in most part through the U.S. annuity portfolio, than for the peer group. Last, we are layering in consideration for a lack of transparency on earnings. In our view, the extreme volatility in segment earnings is creating a serious challenge to earnings predictability. Impediments to achievement of our target price include: (i) another round of extra-low interest rates; (ii) an equity market correction; (iii) poor execution on the U.S. Annuities sales turnaround and/or domestic independent retail insurance platform re-build.
The Globe and Mail, Andrew Willis, 27 October 2006

Some of Sun Life Financial Inc.'s clients have a rather high opinion of their worth. This month, the company began offering $100-million of life insurance to individuals, the largest single policy ever flogged in this country, as part of a push to be a market leader with the country's richest families.

Offering massive amounts of insurance to entrepreneurs and business owners is part of Sun Life's drive to win over wealthy clients and differentiate its products in a sector where one insurer looks a lot like the next. Policies this large can be a tax-efficient way to move money from one generation to the next. In the past, an agent who wanted to buy this much coverage would typically have been forced to buy a series of $20-million policies.

"If you look at the enormous wealth creation that's taken place in Canada, with Calgary entrepreneurs for example, you can see there's a need for this type of service," said Sun Life chief executive officer Donald Stewart, who has already signed off on policies this big at the company's U.S. and Bermuda operations. He added: "Sun Life has been a leader in the high-net-worth category in the U.S. and we're bringing that expertise to this market."

Sun Life's coffers won't be drained if it writes a $100-million cheque to a bereaved spouse, as the risks are shared with three reinsurance firms.

Increasing insurance sales and improved money management boosted Sun Life earnings, released yesterday, to a record $541-million in the third quarter, a profit of 94 cents a share that topped the 88-cent consensus forecast.

Mr. Stewart forecast both profit and Sun Life's return on equity will improve in 2007, partly because the company's investment in Asia should begin to pay off.

Profit from Canadian operations, the largest segment, was up 5.3 per cent from the previous year to $240-million, while the U.S. division earned $136-million, up 2.3 per cent. Asian earnings jumped by 30 per cent, but amounted to just $13-million, as Sun Life continues to build networks in India and China.

Sun Life boosted its return on equity to 14.4 per cent, up from 11.5 per cent a year ago, and the company is targeting 15-per-cent-plus ROE for next year. UBS Securities analyst Jason Bilodeau said U.S. and Canadian insurance sales were strong, amid intense price competition in the American market. He said, "Sun Life continues to make progress against objectives."

Sun Life's profit margins trail those of domestic rivals, which have larger U.S. operations. Manulife Financial Corp. posted ROE of 16.3 per cent in its most recent results, while Great-West Lifeco Inc. came in at 20.2 per cent.

This week, Sun Life ended talks with potential buyers of its U.S. mutual fund arm, MFS Investment Management. Rather than sell the company for a minority stake in a larger player, Sun Life opted to try improving fund performance.

Analysts have said Sun Life could do an initial public offering of a portion of MFS, to demonstrate the value of a company with $175-billion (U.S.) in assets that's currently buried within Sun Life. Mr. Stewart said an IPO is not in the cards. "Our clear priority at MFS is to focus on improving operations. Anything else we undertake, such as an IPO, would only be a distraction."

Profit at Boston-based MFS rose 26 per cent to $58-million, driven by a rise in international fund sales. Sun Life disclosed the division results earlier this week.

Mid-sized U.S. insurers such as UnumProvident Corp. have been mentioned as takeover targets, with Sun Life seen as a potential buyer. Mr. Stewart said Sun Life has the capital for large acquisitions, and further consolidation is expected in the insurance market. But the CEO cautioned: "We're always looking at a number of potential deals, but we have a strong discipline that we bring to any transaction."
Financial Post, Duncan Mavin, 27 October 2006

While speculation about the future of MFS Investment Management mounted in recent weeks, the Boston-based company was growing assets under management and recording a jump in earnings that contributed to a record quarter for parent Sun Life Financial Inc.

"The results this quarter are a little ahead of plan, but the plan to improve margins at MFS has been around for the entire year," said Don Stewart, Sun Life's chief executive.

"The strategy at MFS is to stay focused, because inevitably speculation can be distracting," Mr. Stewart said.

MFS has struggled in recent quarters because of high expenses relative to its peers as well as net redemptions. Analysts have also said the value of MFS -- estimated at between $4.5-billion and $5.5-billion -- was not adequately reflected in Sun Life's share price.

In September, Sun Life revealed it was reviewing "alternative strategies" for the unit. However, when the strategic review concluded on Monday with the announcement that Sun Life will hang on to MFS after all, some investors were disappointed and Sun Life's stock drooped.

But MFS' third-quarter results -- including a profit margin up to 30% from 22% last year -- could mark a turnaround for the unit.

MFS delivered net income of US$52-million for the third quarter of 2006, up 37% from US$38-million last year. Assets under management grew to a record US$175-billion. The company is expected to reduce costs further in future quarters through a variety of measures, including outsourcing some areas.

"Despite some disappointment at not being able to sell part of MFS, it really posted quite strong results," said Tom Kersting an analyst at Edward Jones Investments.

Mr. Kersting said Sun Life's wealth-management businesses including MFS in the United States and its interest in CI Financial in Canada are "something a little unique that not all life insurance companies offer."

Mr. Stewart said it was never Sun Life's intention to sell all of MFS, whose future has been the subject of "an unusual amount" of speculation.

"I saw the phrase 'on the block,' used for MFS and that was simply not the case," Mr. Stewart said.

For Sun Life as a whole, "it was solid growth across all divisions," said Edward Jones' Mr. Kersting.

Sun Life produced record earnings of $541-million, or 94 cents a share, up 26% from $430-million, or 74 cents, a year earlier.

Net income growth came from across Sun Life's geographic markets, Mr. Stewart said. There was particularly strong growth in the group benefits division in Canada and at operations in China and India. Results were also helped by stronger equity markets.
Bloomberg, Sean B. Pasternak, 26 October 2006

Sun Life Financial Inc., Canada's second-largest insurer, said third-quarter profit increased 26 percent to a record, led by its U.S. money manager MFS Investment Management.

Net income climbed to C$541 million ($482 million), or 94 cents a share, from C$430 million, or 74 cents, a year earlier, the Toronto-based company said today in a statement. The shares rose as profit beat analysts' estimates.

Higher institutional fund sales and a rally in stocks boosted earnings at Boston-based MFS by 26 percent to C$58 million. Sun Life said Oct. 23 it plans to keep MFS after hiring investment bankers last month to find a partner for the unit, which manages the oldest U.S. mutual fund.

"Our strategic review did not include the possibility of an outright sale," Sun Life Chief Executive Officer Donald Stewart told investors today. He said there are no plans to change the MFS ownership structure.

A rise in equity markets increased MFS's assets under management 11 percent to $175 billion. That offset $100 million in redemptions during the quarter, compared to $1.4 billion in net sales in the year-earlier period. Redemptions slowed from $400 million in the second quarter. MFS's revenue fell 4.1 percent to C$395 million as the Canadian dollar gained against the U.S. currency.

Shares of Sun Life rose 79 cents, or 1.7 percent, to C$46.26 at 4:10 p.m. in trading on the Toronto Stock Exchange. They've fallen 1 percent this year, compared with an 8.2 percent increase for the 38-member S&P/TSX Financials Index.

MFS has started to rebound after four years of withdrawals from its mutual funds. Individual investors began pulling money because of poor growth-fund performance during the 2000-2002 bear market and continued after the company's involvement in a mutual-fund trading scandal and undisclosed sales payments to brokers.

Stewart said this week there was a "high degree of interest" in MFS. Analysts including Robert Wessel at National Bank Financial said the insurer may instead sell a stake in MFS through an initial public offering.

"If they manage to spin that off that would be quite positive," said David Cockfield, who holds Sun Life shares among the $1.1 billion he helps manage at Leon Frazer & Associates Inc. in Toronto. "The mutual fund business is not a great place to be."

Sun Life said profit from Canada rose 5.3 percent to C$240 million on gains in the group benefits business. Earnings from the U.S. insurance arm increased 2.3 percent to C$136 million, while profit from Asia rose 30 percent to C$13 million. Overall revenue rose 20 percent to C$6.6 billion.

Earnings in the year-ago quarter were reduced by C$51 million because of the sale of its investment in Chilean pension fund Administradora de Fondos de Pensiones Cuprum SA. Excluding one-time items, Sun Life said profit was 94 cents a share.

Wessel was expecting 87 cents a share. The company was expected to earn 88 cents a share, according to the average estimate of six analysts surveyed by Bloomberg.