24 October 2006

Sun Life Takes MFS Off the Auction Block

The Globe and Mail, Sinclair Stewart, 24 October 2006

It's the word that haunts Don Stewart: "Credibility." Too many investors think he lacks it, which is part of the reason Sun Life Financial trades at a discount to Manulife.

Credibility is what CEOs get when they say they're going to do something, then do it. Mr. Stewart, a hard-working Scot who has been Sun Life's top executive since 1998, has a monster problem in MFS Investment Management, its U.S. mutual fund division. He vowed to fix it, hired bankers to shop it, and came away with dust. The failure, says National Bank Financial's Rob Wessel, "will have a negative impact on" -- here's that word again -- "management credibility."

So the new company line is that Sun Life is going to keep MFS and manage it better. That's fine, but don't count on that as the long-term solution, because so far, Boston-based MFS appears unmanageable, at least by a remote shareholder in Toronto. Mr. Stewart may have decided that the cost of divorce is too high right now, but let's be clear: This is not a healthy marriage, and Sun Life is not done trying to get out of it.

Why can't these two just get along? Because any happy couple has to want the same things, and Sun Life management and MFS brass don't. Sun Life, as the 98-per-cent shareholder of MFS, wants profitability to be as high as possible. MFS's well-fed managers, as owners of the other 2 per cent, may care less about earnings and more about other things. Compensation, for instance. By some accounts, the pay scale is very rich at MFS, even by the usual grotesque standards of the money management business.

This is more than a matter of opinion. In a business where pay is by far the biggest expense, MFS's profit margins, to use the technical term, stink. Yesterday, Sun Life said MFS made about 30 cents in profit, excluding taxes for every dollar of revenue in the third quarter, a dandy improvement from previous quarters. But that's still weak compared with most of the competition. T. Rowe Price made 46 cents (U.S.) per dollar of revenue over the past 12 months, according to data from Standard & Poor's Capital IQ. Nuveen Investments, one of the companies that looked at MFS, makes a similar margin.

But fat paycheques are just one element of the MFS managers' sweetheart deal; they also hold a hammer in any takeover. On a change of control, they are entitled to a 20-per-cent cut of the value (Sun Life has not formally disclosed this arrangement). Plus, there's the usual fear about how the money managers will leave and take assets with them -- though given the mediocre performance of MFS funds, perhaps Sun Life should let them try.

You can see the conflicting priorities here. Sun Life, having failed (for whatever reason) to grab a firmer hand on the operation, needs to outsource its MFS problem to someone else. That means it wants to sell to a strong partner -- a U.S. player with the guts to walk into Boston and start firing people. Sun Life would ride along as a significant shareholder, replicating the formula it has used in Canada with CI Financial.

But if you are an MFS manager, your interests are the opposite. You'd prefer that nothing disrupts your comfortable existence. But if the firm must be sold, you'd rather it went to someone who's weak in asset management -- a player who would need your expertise. Wachovia, a rumoured buyer last week, likely fit the bill from MFS's point of view, but not Sun Life's.

What you've got here is an untenable situation. Mr. Stewart may have been right to walk away from a bad deal, but he has merely deferred the problem. He'll still have to sell a chunk of MFS -- if not to another fund company, then to the public. It will give him better earnings, a better stock price and something else, too. It's called credibility.
Financial Post, Duncan Mavin, 24 October 2006

Sun Life Financial Inc. will have to come up with a new plan for MFS Investment Management after ruling out any potential deal to sell all or part of the Boston-based asset manager yesterday.

Canada's second-largest life insurer had been considering "strategic alternatives" for the under-performing unit, with a host of big name U.S. financial institutions linked to a deal that potentially would have seen MFS rolled into a new entity in which Sun Life was a shareholder.

Observers valued the asset manager at between $4.5-billion and $5.5-billion.

But chief executive Don Stewart admitted the search for a "third-party transaction" is over, despite a "thorough and disciplined assessment [and] ... a high degree of interest in partnering with MFS."

The news was viewed harshly by some investors as Sun Life's stock fell $1.11 to $44.74 on the day.

"We were disappointed to hear that MFS will neither be sold nor be part of a joint venture," said RBC Capital Markets analyst Jamie Keating in a note.

"MFS still lacks scale for investment in technology, marketing, and overhead relative to larger competitors."

National Bank Financial analyst Rob Wessel said "there is no question the impact [of yesterday's announcement] on the company will be very clearly negative." The failure to find a partnership damages management credibility, he added.

Mr. Wessel said the insurer should now look to "plan B" -- taking the company public. Sun Life currently owns about 98% of MFS and could "unlock value" by selling some of its stake, he said.

However, Len Racioppo, president of money manager Jarislowsky Fraser Ltd., said he has a less negative view of management's plan to improve performance without a transaction.

Indeed, Sun Life revealed yesterday that MFS' revenue rose 8.7% in the first six months of the year and third-quarter profit rose 37% to $52-million.

"The value's still there," said Mr. Racioppo.

Nevertheless, the process of looking for ways of improving results at MFS has been ongoing for several months and was made public in September when Sun Life announced it had engaged investment bankers to look at various options.

Most of Sun Life's businesses have been firing on all cylinders of late but MFS has largely stood still. MFS's net income has declined from US$173-million in 2000 to US$148-million in 2005. MFS's assets under management barely budged from US$149-billion in 2000 to US$162-billion last year. The company now manages about US$175-billion of assets.

Sun Life spokesman Michel Leduc said that the company considered partnering with "a variety of organizations," but he would not name names. Speculation in recent weeks has particularly focused on Wachovia Corp. and Mellon Financial Corp but yesterday's announcement would appear to suggest they were not able to offer a suitable transaction.
The Globe and Mail, Andrew Willis, 24 October 2006

Sun Life Financial Inc. decided yesterday to fix its troubled U.S. money management division, rather than sell MFS Investment Management to a rival.

Toronto-based Sun Life put MFS on the block this summer, hoping to exchange its stake for a minority position in a much larger asset manager. The move was meant to boost MFS's profit, jump-start its funds and give Sun Life a larger presence in U.S. money management. A number of U.S. money managers and banks looked at the Boston-based company, which has $175-billion (U.S.) in assets under management. "There was a high degree of interest in partnering with MFS," Sun Life CEO Donald Stewart said. But the right deal, at the right price, was not forthcoming, so Mr. Stewart said in a release: "We will focus on improving performance and profit margins and expanding its global investment and distribution platforms."

A number of industry executives and investment bankers said the amount of influence that Sun Life would have in the merged company, and the roles that MFS executives would play going forward, also stood in the way of a deal. Analyst Robert Wessel of National Bank Financial Inc. said in a note: "Not achieving this objective will have a negative impact on management credibility."

Analysts have pointed out that MFS can improve margins that lag rivals by outsourcing administrative functions and shifting its head office from downtown Boston to cheaper real estate. Mr. Wessel estimates these moves could cut costs by $67-million a year. A Sun Life spokesman declined to comment on specific plans for MFS.

At the same time it took down the For Sale sign at MFS, Sun Life announced that the company's results were improving, with profit up 11 per cent to $52-million in the third quarter from the previous three months. International fund assets are expanding and MFS executives have said a priority is improving performance in U.S. funds. Sun Life will officially announce third-quarter results on Thursday. Founded in 1924, MFS ranks as the No. 45 U.S. money manager by assets.

Companies interested in MFS included money managers Nuveen Investments Inc. and Federated Investors Inc., and two banks, Wachovia Corp. and Mellon Financial Corp., investment bankers who worked with potential buyers said. Analyst Jason Bilodeau at UBS Securities said: "While we believe there were a number of interested parties, the combination of price and management's desire to remain invested in the asset management business in the U.S. prevented a deal from coming together."

Mr. Wessel said in a note: "We continue to believe there is a value to be unlocked with respect to this operating subsidiary, which will be realized eventually." He suggested Sun Life show what MFS is worth by selling a portion of the subsidiary in an initial public offering.
BMO Capital Markets, 23 October 2006

Sun Life announced this morning 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. It is clearly disappointing that the strategic review concluded in this manner. However, no deal is better than a bad deal. Moreover, the company did announce that MFS Q3/06 earnings would be US$52 million versus our estimate of US$47 million, which translates into an additional $0.01 per share. Pre-tax margins improved to 30% from the low 20%-range last year. We suspect that net inflows remain modestly negative. We believe that the improved margins reflect better cost controls and there should be some more room to improve margins into the 35% range over the next 12-24 months. Nevertheless, we believe that MFS remains at risk of becoming marginalized in the U.S. mutual fund business in the absence of a strategic partner as net flows remain negative in the mutual fund segment. While disappointed, investors should note that SLF shares traded at $40 at the end of 2000 and currently trade at $45.85 despite compound annual growth rate in earnings and dividends of 11% and 46%, respectively.
RBC Capital Markets, 23 October 2006

Back to Basics – With the MFS Strategic Review Over, Our Focus Shifts Back to the Upcoming Quarter

Investors’ will now shift their focus back to Sun Life’s management execution, in our view, aimed at upgrading weak sales. In our view, sales growth lags the industry norms across the following platforms: (i) domestic individual insurance and wealth, (ii) U.S. annuities; (iii) U.S. mutual funds. Further, last quarter’s spike in sales of U.S individual life insurance was not based on market pricing, so as pricing is increased to market levels, we believe even the U.S. life sales may revert lower again.

We have a Below-Consensus Earnings Outlook for the Upcoming Q3/06

We are expecting EPS of $0.85 for Q3, 3¢ below consensus, up 4% YoY, and down 1% QoQ. On a constant currency basis, we are expecting 7% (7¢) YoY earnings growth. We are particularly cautious after what we interpreted as weak EPS quality in Q2/06. We are also wary of acceleration in mutual fund and/or annuity net redemptions after potential disruption from the MFS strategic review. Our Q3 estimates are based on the following divisional constant currency YoY growth rates: (i) Canada 10%; (ii) US -25%; (iii) MFS 20%; (iv) Asia 300% and; (v) Corporate -15%.

Underlying EPS Quality a Little Suspect in Q2/06

Sun reported Q2/06 EPS at $0.88 although underlying EPS we estimated as arguably as low as $0.80. Sun recorded a one-time tax benefit of 8¢ - this should not repeat in the current quarter. There were three mitigating features in the Q2 results, each of which may improve again this quarter. First, the U.S. life division recorded unusually high sales strain last quarter, which cost an estimated -7¢ in EPS. We expect the sales strain will repeat, but in a -6¢ magnitude in Q3/06. Second, weak equity markets cost an estimated -5¢ in Q2/06, and this we believe may still be a -4¢ factor in Q3/06. Last, foreign exchange translation cost - 5¢ in YoY EPS performance – for Q3/06 we estimate the F/X cost at -4¢. Collectively, we estimate 3-5¢ benefit from these three factors, roughly building to our $0.85 Q3/06 estimate.

Factoring Market-Like Domestic Life Sales Growth

We estimate that domestic life insurance sales for Q3 will be $38 million, up 6% YoY from $36 million in Q3/05, for an industry-neutral growth rate. SLF’s sales growth through newly-reopened independent channels has been strong from a small base, while growth from the Clarica sales force has looked stagnant, declining 5% YoY last quarter. Part of Sun’s domestic sales challenge may be that they do not offer a participating insurance policy, unlike the other 3 lifecos, and industry sales for this category grew 21% YoY in Q2/06, triple the industry average including term and universal life (Sun’s key products). Also, we continue to expect aggressive pricing pressure in Sun’s core universal life product, this quarter as Manulife dropped prices mid-quarter on its popular UL product and service offering.

We Believe Sun’s U.S. Life Insurance Sales Are Not Sustainable

We estimate that U.S. insurance sales will come in at US$70 million, indicated up 94% YoY from $36 million in Q3/05. However, management confirmed last quarter that the recent leap in U.S. insurance sales is owing to a decision to sustain below-market life insurance rates that Sun has left in place longer than would be normal to support significant new marketing agreements signed up in Q1/06. The higher market rates reflect recent increases in reinsurance costs that most competitors have passed onto insureds with price increases. With competitors priced higher, Sun Life is getting a higher-than-normal proportion of business until they too follow with higher rates of their own. SLF confirmed that their below-market pricing would positively impact a portion of Q3 sales, but it would seem not thereafter. Accordingly, we are wary that SLF will not be able to sustain sales at their current levels once pricing is raised in-line with the other insurance companies.

Also, we caution investors to be careful to also break out the lower quality, institutionally-driven single premium COLI/BOLI sales. Roughly 25% of Sun’s U.S. life insurance sales in the past four quarters have been of this nature, which we consider lower-quality and lower margin. We have included an estimate that US$15 million of our estimated US$70 million in U.S. insurance sales will be COLI/BOLI sales, implying an estimate of US$55 million in core life sales.


Our $49 price target is set at 14x our 12-month-forward EPS estimate of $3.50 (Q3/06-Q2/07). Our Sun Life target P/E is set a multiple below our 15x sector target P/E. We believe the discount is warranted based on Sun’s growth challenges in domestic insurance and U.S. annuities. We also believe Sun’s financial performance is more reliant on favourable interest rates and equity markets, than for the peer group.

Price Target Impediments

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 rebuild.
Bloomberg, Sean B. Pasternak, 23 October 2006

Sun Life Financial Inc., Canada's second-largest insurer, decided not to sell its MFS Investment Management unit after the company failed to find a suitable partner for the U.S. money manager, investors said.

Sun Life said last month it hired investment bankers to consider a sale or asset swap for Boston-based MFS, which manages the oldest U.S. mutual fund. Wachovia Corp. and Mellon Financial Corp. were bidding for the unit, in a sale that would have raised about $3 billion, the people said.

"They probably didn't like the bids they were getting," said Len Racioppo, president of Montreal-based money manager Jarislowsky Fraser Ltd., which has about 8.4 million Sun Life shares among its $54 billion in assets. "In asset management, it's very important how you structure the deal, what partner you get."

Toronto-based Sun Life said in a statement today it will keep MFS, after the money manager increased profit following four years of withdrawals from its mutual funds. Revenue rose 8.7 percent in the first six months of the year and third- quarter profit rose 37 percent to $52 million. Assets increased to a record $175 billion.

"We never believed that an outright sale of MFS was in the cards," Desjardins Securities analyst Michael Goldberg said in a note to investors, adding that Sun Life wanted to keep a minority stake in a rival firm in exchange for MFS. "The termination of the process reflects the inability of Sun and its bankers to put together the ideal transaction."

Goldberg said that the "ideal" transaction would have been similar to Sun Life's one-third stake in CI Financial Income Fund, Canada's second-biggest mutual fund company. In 2002, Sun Life exchanged its Spectrum Investment Management and Clarica Diversico businesses for 30 percent of CI of Toronto.

Shares of Sun Life fell C$1.11, or 2.4 percent, to C$44.74 at the 4 p.m. close of trading on the Toronto Stock Exchange, the biggest decline in three months.

Sun Life may now look at an initial public offering for MFS, said Robert Wessel, an analyst at National Bank Financial.

"We continue to believe that there is value to be unlocked with respect to this operating subsidiary, which will be realized eventually," Wessel wrote today in a note to investors.

Michel Leduc, a Sun Life spokesman, declined to comment on whether Sun Life would consider an IPO.

Leduc declined to say which companies were interested in MFS or whether any bids were submitted. Chief Executive Officer Donald Stewart said in the statement there was a "high degree of interest in partnering with MFS."

MFS's assets are split almost evenly between mutual funds and institutional accounts. The firm had $6.8 billion in net inflows since the start of 2005, as institutional sales offset redemptions from stock and bond funds, according to MFS spokesman John Reilly.

Individual investors began withdrawing 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.

MFS agreed in 2004 to pay $351 million in penalties for allowing some investors to make improper trades in its funds. The settlement was made with the U.S. Securities and Exchange Commission, New York Attorney General Eliot Spitzer and New Hampshire securities officials.

"The very fact that they were putting it up for sale signaled to me that, at least in the U.S., they were pulling back from the mutual fund/asset-management business," said Ian Nakamoto, director of investments at MacDougall, MacDougall & MacTier Inc. in Toronto, which manages the equivalent of about $3.2 billion, including Sun Life shares.

U.S. banks were considering a purchase of MFS to expand their money management businesses, analysts said. Mellon Financial, the Pittsburgh-based owner of Dreyfus mutual funds, purchased Edinburgh-based Walter Scott & Partners Ltd. this month. Charlotte, North Carolina-based Wachovia, the No. 4 U.S. bank, bought Metropolitan West Capital Management LLC of Newport Beach, California, in June.

MFS was being shopped at the same time Marsh & McLennan Cos., the world's largest insurance broker, was soliciting offers for Putnam Investments, its mutual-fund unit. Marsh & McLennan spokeswoman Robin Liebowitz had no immediate comment on the status of Putnam, which oversees $180 billion.