RBC Capital Markets, 4 February 2008
Macro environment poor for lifecos in Q4/07
• We expect currency translation to negatively impact the big 3 lifecos' YoY earnings growth by 7% on average with Manulife being the most impacted (8%). The Canadian dollar strengthened against the US Dollar (16%), the Japanese Yen (12%), and the British Pound. Industrial Alliance is not impacted by currency movements.
• Canadian, US and Japanese long-term interest rates were down QoQ and YoY. Lower long-term interest rates negatively impact all lifecos, but Industrial Alliance and Manulife most so. If Canadian interest rates remain at current levels, we believe lifecos may have to increase reserves in upcoming quarters.
• North American equity markets were down during the quarter, which is negative for reserves, but their average level was up YoY and QoQ, which benefits all lifecos' fee based businesses. Great-West's earnings have historically been less sensitive to equity markets but the acquisition of Putnam will increase the sensitivity.
• There were no widespread losses in corporate bonds, which benefits Manulife and Sun Life the most since they have more exposure to lower quality classes of bonds. The widening of credit spreads during the quarter (the CDX North American Investment Grade Index rose from 56 bps to 78 bps during the quarter and is now 109 bps) are positive for yields on new money but, if they are accurate predictors of future credit losses, a negative indication for 2008.
• Holdings of CDO of RMBS are not large and, to the extent that they have not been downgraded and that they match policy liabilities, they are unlikely to cause losses in Q4/07. If we are wrong, Great-West is more at risk in our view.
• We have slightly lowered our Q4/07 EPS estimates to reflect the difficult macro environment. We are still expecting aggregate YoY growth in EPS of 10% as we believe that the size of the lifecos' actuarial reserves is such that reserve releases in some areas may offset macro pressures. The earnings growth profile of the Canadian lifecos in 2001 and 2002 give us comfort that earnings targets can be met, as earnings grew in what was then a difficult macro setting. Multiples should decline, however, as the perceived quality of earnings is likely to be negatively impacted by the current macro environment.
Macro environment poor for lifecos in Q4/07
• We expect currency translation to negatively impact the big 3 lifecos' YoY earnings growth by 7% on average with Manulife being the most impacted (8%). The Canadian dollar strengthened against the US Dollar (16%), the Japanese Yen (12%), and the British Pound. Industrial Alliance is not impacted by currency movements.
• Canadian, US and Japanese long-term interest rates were down QoQ and YoY. Lower long-term interest rates negatively impact all lifecos, but Industrial Alliance and Manulife most so. If Canadian interest rates remain at current levels, we believe lifecos may have to increase reserves in upcoming quarters.
• North American equity markets were down during the quarter, which is negative for reserves, but their average level was up YoY and QoQ, which benefits all lifecos' fee based businesses. Great-West's earnings have historically been less sensitive to equity markets but the acquisition of Putnam will increase the sensitivity.
• There were no widespread losses in corporate bonds, which benefits Manulife and Sun Life the most since they have more exposure to lower quality classes of bonds. The widening of credit spreads during the quarter (the CDX North American Investment Grade Index rose from 56 bps to 78 bps during the quarter and is now 109 bps) are positive for yields on new money but, if they are accurate predictors of future credit losses, a negative indication for 2008.
• Holdings of CDO of RMBS are not large and, to the extent that they have not been downgraded and that they match policy liabilities, they are unlikely to cause losses in Q4/07. If we are wrong, Great-West is more at risk in our view.
• We have slightly lowered our Q4/07 EPS estimates to reflect the difficult macro environment. We are still expecting aggregate YoY growth in EPS of 10% as we believe that the size of the lifecos' actuarial reserves is such that reserve releases in some areas may offset macro pressures. The earnings growth profile of the Canadian lifecos in 2001 and 2002 give us comfort that earnings targets can be met, as earnings grew in what was then a difficult macro setting. Multiples should decline, however, as the perceived quality of earnings is likely to be negatively impacted by the current macro environment.
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Financial Post, Duncan Mavin, 4 February 2008
Canadian life insurance stocks outperformed banks throughout 2007 and will likely do better than the banks in 2008 too, said Desjardins Securities
analyst Michael Goldberg in a note to clients Monday.
The big Lifecos, which begin report annual earnings for 2007 next week, were largely untouched by financial sector turmoil that started in the
United States and spread around the world last year.
But the life insurers have slipped against the banks of late, especially because of softening equity markets, lower government bond yields, and the sky-high loonie that is taking a bite out of earnings from extensive operations in the U.S. and overseas.
However, the lifecos will see a return to form and their stocks will do better than those of the banks this year, said Desjardins Mr. Goldberg.
"They have similar price/earnings valuations as banks despite superior earnings and dividend growth prospects in 2008," he said. "Business
platforms outside Canada are also superior to the banks and demographics remain favourable."
Desjardins¹ top pick is Manulife Financial Corp, with a target price of $48.50.
Canadian life insurance stocks outperformed banks throughout 2007 and will likely do better than the banks in 2008 too, said Desjardins Securities
analyst Michael Goldberg in a note to clients Monday.
The big Lifecos, which begin report annual earnings for 2007 next week, were largely untouched by financial sector turmoil that started in the
United States and spread around the world last year.
But the life insurers have slipped against the banks of late, especially because of softening equity markets, lower government bond yields, and the sky-high loonie that is taking a bite out of earnings from extensive operations in the U.S. and overseas.
However, the lifecos will see a return to form and their stocks will do better than those of the banks this year, said Desjardins Mr. Goldberg.
"They have similar price/earnings valuations as banks despite superior earnings and dividend growth prospects in 2008," he said. "Business
platforms outside Canada are also superior to the banks and demographics remain favourable."
Desjardins¹ top pick is Manulife Financial Corp, with a target price of $48.50.
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Scotia Capital, 28 January 2008
Insurers – an excellent safe haven in times of recession
• Insurers have traditionally outperformed in recessions – an excellent safe haven. Not only has the group been relatively immune to the credit crunch, it has also historically done well in recessions. Over the last two recessions (2001, mid-1990 to early 1991) the lifecos and the P&C insurers have each, on average, outperformed the index in terms of both share price performance and EPS growth, as outlined in Exhibit 1. As the probability of a recession in the ensuing quarters continues to increase, we believe the group, traditionally recession-proof, with very strong balance sheets untarnished by subprime and other credit woes, is a safe haven, not to mention compelling value. Canadian Lifecos - Likely won't beat - 2009 should see 11% EPS growth
• Little chance of beating estimates this quarter as negative year-over-year (YOY) impact of currency (14%) outweighs a more moderate 9% year-over-year increase in average equity markets. Q2/07 (especially) and Q3/07 (to some extent) results for the lifecos beat consensus, largely due to the fact that the YOY increase in equity markets, averaging 17%, significantly offset the negative impact of a 5% YOY appreciation, on average, in the Canadian dollar. This is not expected to be the case for the upcoming Q4/07 results. The tailwind of buoyant equity markets, up just 9% YOY on average in Q4/07, is significantly less than what we have seen for the bulk of 2007, and the negative impact of the 14% YOY increase in the Canadian dollar is significantly higher than the 5% levels it has averaged for the bulk of 2007. Add to the mix the potentially negative impact of low long term interest rates and the end result is a Q4/07 that has little chance of beating estimates, and could in fact modestly miss.
• Even smaller chance of lifting estimates coming out of the quarter. With Scotia Capital’s strategist expecting the average levels of equity markets to increase just 2% in the case of the S&P 500 and 4% in the case of the S&P/TSX, we certainly do not expect equity market gains to help EPS growth to the same extent as they did in 2007, when equity markets were up on average 14%. And the negative impact of an increasing Canadian dollar will be felt much more in 2008, where average YOY appreciation in the Canadian dollar versus the U.S. dollar is expected to be 7%-8% (assuming the Canadian dollar averages US$0.99 in 2008), versus the 4%-5% change we had on average in 2007. EPS growth in the last several quarters has benefited from the fact that the YOY growth in equity markets was significantly higher than the negative impact of currency. This will simply not be the case going forward. And it certainly won’t be the case for Q1/08E and Q2/08E, where extremely sluggish YOY growth in equity markets (expected to be 2%) will be far outweighed by the negative impact of an 11%, on average, YOY appreciation in the Canadian dollar.
• We see 11% average EPS growth for the Canadian lifecos in 2009. Assuming equity markets appreciate 8% YOY on average in 2009, and the Canadian dollar remains at US$0.99 in 2009 on average, the same level we’re assuming for 2008, we see 11% EPS growth for Great-West Lifeco, 9% for Industrial-Alliance, 13% for Manulife, and 12% for Sun Life. While these growth rates are greater than the 2008 estimated EPS growth rates, they are slightly less than 2008E EPS growth rates excluding the impact of currency, reflecting the cumulative impact of a deceleration in equity market growth, the negative impact of lower bond yields, and tougher credit markets, offset to some extent by continued aggressive share buyback activity. Manulife’s growth rate is modestly higher than the group (13% versus the group average of 11%), due primarily to more aggressive share buybacks, and Industrial-Alliance’s growth rate is the lowest, primarily due to the fact that it is the most sensitive to declining interest rates and equity markets, and is by far the most exposed to what we deem to be the slower-growth Canadian market. Exhibit 2 outlines our estimates.
• Long-term bond yields continue to slide – probably the biggest risk for the lifecos. Yields on long-term bonds have fallen over 65 bp in Canada and over 130 bp in the United States in just over six months. Recently, the yields on both Canada and U.S. 10-year government bonds were well below 4%, with 10-year Government of Canada bonds at 3.86% and the U.S. 10-year Treasury yield at 3.58%. Scotia Economics currently forecasts the Government of Canada 10-year bond yield will climb 25 bp by the end of 2008 to 4.10%, and the U.S. 10-year treasury yield will climb 65 bp to 4.25%. If the current low long-term yields hold, though, we could see some EPS “pain” for the lifecos.
• If long-term interest rates remain at these levels, we could see a significant reduction in EPS for our Canadian lifecos. With liabilities longer than assets, a declining long-term interest rate scenario can pose significant reinvestment risk. The earnings impact comes not only in terms of lower investment yield, and hence lower investment income, but more so in terms of reserve increases on long-term insurance business. The long-term interest rate assumption used by actuaries in reserving for this business, referred to as the “ultimate reinvestment rate,” is a function of the 10-year moving average in long-term interest rates. And this keeps going down, which translates into reserve increases and thus lower EPS growth. If current rates remain through year-end 2008, we could see a 25 basis point (bp) YOY reduction in the ultimate reinvestment rate in 2007 (down to 4.45%) and a further 30 bp reduction in 2008 (down to 4.15%). We estimate this could translate into as much as a 3%-4% 2008E EPS hit for Manulife, a 2%-3% hit for Great-West Lifeco, a 1%-2% hit for Sun Life, and a significant 10%+ hit for Industrial-Alliance. Simply said, a long-term interest rate scenario below 4% causes pain, and we believe this is currently the biggest risk for the lifecos. As per the 2006 year-end annual reports, the last time these sensitivities were disclosed, the most sensitive of the lifecos to a 100 bp drop in long term interest rates is Industrial-Alliance (a 35% drop in EPS), with Manulife at a 9% drop in EPS, and Great-West Lifeco and Sun Life at an 8% drop in EPS.
Great-West Lifeco Inc.
1-Sector Outperform – $42 one-year target, based on 3.5x 12/31/08E BV and 14.5x 2008E EPS
• We are looking for EPS of $0.65 for Q4/07, $0.02 above consensus. Our 2008 EPS estimate is $2.68, $0.01 below consensus.
• Another steady quarter – Europe should continue to drive growth.
• Putnam should continue to show margin improvement. We assume margins will go to 24 bp from the current 20 bp (or 16 bp the way Great-West would look at them, where intercompany capital is removed), which should continue to propel earnings growth for Putnam through 2008. We look for net sales to be flat in the quarter. While we expect Putnam to still be small relative to Great-West’s earnings base in 2008 (we estimate it will amount to just 7% of the bottom line), we expect the company will continue to be an active acquirer, with more U.S. mutual fund acquisitions likely now that the Putnam financing is squared away.
• Earnings momentum from recent 401(k) tuck-in acquisitions in the United States should continue to propel bottom line – any more tuck-ins?
• Expect a 6%-8% dividend increase.
Industrial-Alliance Insurance and Financial Services Inc.
2-Sector Perform – $43 one-year target, based on 1.8x 12/31/08E BV and 12.8x 2008E EPS
• We are looking for EPS of $0.78 in Q4/07, $0.01 above consensus. Our 2008 EPS estimate of $3.38 is $0.01 below consensus.
• We do not expect another charge for ABCP, like the $0.09 EPS charge the company took in Q3/07.
• A reduction in new business strain is likely to continue to drive results in Q4/07.
• Individual segfund sales should get a boost from the December 1 launch of new guaranteed minimum withdrawal benefit (GMWB) product.
• Unless another acquisition is made, we see 2009 EPS growth returning to the 9% range.
• Industrial-Alliance is the most sensitive of the Canadian lifecos to declining interest rates and declining equity markets – this makes us somewhat cautious.
• Could get a 5% dividend increase.
Manulife Financial Corporation
2-Sector Perform – $45 one-year target, based on 3.1x 12/31/08E BV and 14.3x 2008E EPS
• We are looking for EPS of $0.71 for Q4/07, in line with consensus. Our 2008 EPS estimate of $3.05 is $0.06 below consensus.
• Continued earnings growth momentum in Canada and Hong Kong/Other Asian Territories should offset continued weakness in U.S. and Japan segments.
• U.S. variable annuity sales and U.S. individual insurance sales expected to continue to gain momentum – Japan sales expected to rebound – any update on the prospect of a Bank of Tokyo Mitsubishi distribution arrangement in Japan for individual insurance?
• Why has it slowed its buyback activity? We don’t believe the company is up to anything special, and we anticipate the buyback activity to pick up again very soon.
• Update on variable annuity hedging – is the company still unhedged? The company is expected to embark on a strategy to hedge the guarantees for its variable annuity/segregated fund businesses, mitigating to some extent the volatility in this sizeable book of business. We expect to get an update on the cost (at least $0.02 per share), which we anticipate to have increased significantly in these volatile markets.
Sun Life Financial Inc.
1-Sector Outperform – $60 one-year target, based on 2.1x 9/30/08E BV and 13.3x 2008E EPS
• We are looking for EPS of $1.05 for Q4/07, $0.01 above consensus. Our 2008 EPS estimate of $4.41 is $0.03 below consensus.
• Could beat on the strength of the funding arrangement put in place two quarters ago. This arrangement is successfully mitigating the strain on U.S. no-lapse guarantee universal life individual sales. But Q4/07 will likely include at least $0.01 to $0.02 in EPS from the recovery of strain from business written in Q4/06 and Q1/07 as well, thus increasing the likelihood this company could beat in the quarter. Also, assuming the pace of U.S. variable annuity sales continues at the exceptional clip of Q2/07 (up 96%) and Q3/07 (up 91%), we could see further EPS benefit.
• U.S should continue to drive earnings growth. We believe the company’s ability to turn around this all-important segment and increase its scale will continue to help increase its multiple relative to the group.
• Excellent risk management helps to mitigate earnings volatility in these uncertain markets, and increase multiple.
• We expect a 6%-8% dividend increase.
;
Insurers – an excellent safe haven in times of recession
• Insurers have traditionally outperformed in recessions – an excellent safe haven. Not only has the group been relatively immune to the credit crunch, it has also historically done well in recessions. Over the last two recessions (2001, mid-1990 to early 1991) the lifecos and the P&C insurers have each, on average, outperformed the index in terms of both share price performance and EPS growth, as outlined in Exhibit 1. As the probability of a recession in the ensuing quarters continues to increase, we believe the group, traditionally recession-proof, with very strong balance sheets untarnished by subprime and other credit woes, is a safe haven, not to mention compelling value. Canadian Lifecos - Likely won't beat - 2009 should see 11% EPS growth
• Little chance of beating estimates this quarter as negative year-over-year (YOY) impact of currency (14%) outweighs a more moderate 9% year-over-year increase in average equity markets. Q2/07 (especially) and Q3/07 (to some extent) results for the lifecos beat consensus, largely due to the fact that the YOY increase in equity markets, averaging 17%, significantly offset the negative impact of a 5% YOY appreciation, on average, in the Canadian dollar. This is not expected to be the case for the upcoming Q4/07 results. The tailwind of buoyant equity markets, up just 9% YOY on average in Q4/07, is significantly less than what we have seen for the bulk of 2007, and the negative impact of the 14% YOY increase in the Canadian dollar is significantly higher than the 5% levels it has averaged for the bulk of 2007. Add to the mix the potentially negative impact of low long term interest rates and the end result is a Q4/07 that has little chance of beating estimates, and could in fact modestly miss.
• Even smaller chance of lifting estimates coming out of the quarter. With Scotia Capital’s strategist expecting the average levels of equity markets to increase just 2% in the case of the S&P 500 and 4% in the case of the S&P/TSX, we certainly do not expect equity market gains to help EPS growth to the same extent as they did in 2007, when equity markets were up on average 14%. And the negative impact of an increasing Canadian dollar will be felt much more in 2008, where average YOY appreciation in the Canadian dollar versus the U.S. dollar is expected to be 7%-8% (assuming the Canadian dollar averages US$0.99 in 2008), versus the 4%-5% change we had on average in 2007. EPS growth in the last several quarters has benefited from the fact that the YOY growth in equity markets was significantly higher than the negative impact of currency. This will simply not be the case going forward. And it certainly won’t be the case for Q1/08E and Q2/08E, where extremely sluggish YOY growth in equity markets (expected to be 2%) will be far outweighed by the negative impact of an 11%, on average, YOY appreciation in the Canadian dollar.
• We see 11% average EPS growth for the Canadian lifecos in 2009. Assuming equity markets appreciate 8% YOY on average in 2009, and the Canadian dollar remains at US$0.99 in 2009 on average, the same level we’re assuming for 2008, we see 11% EPS growth for Great-West Lifeco, 9% for Industrial-Alliance, 13% for Manulife, and 12% for Sun Life. While these growth rates are greater than the 2008 estimated EPS growth rates, they are slightly less than 2008E EPS growth rates excluding the impact of currency, reflecting the cumulative impact of a deceleration in equity market growth, the negative impact of lower bond yields, and tougher credit markets, offset to some extent by continued aggressive share buyback activity. Manulife’s growth rate is modestly higher than the group (13% versus the group average of 11%), due primarily to more aggressive share buybacks, and Industrial-Alliance’s growth rate is the lowest, primarily due to the fact that it is the most sensitive to declining interest rates and equity markets, and is by far the most exposed to what we deem to be the slower-growth Canadian market. Exhibit 2 outlines our estimates.
• Long-term bond yields continue to slide – probably the biggest risk for the lifecos. Yields on long-term bonds have fallen over 65 bp in Canada and over 130 bp in the United States in just over six months. Recently, the yields on both Canada and U.S. 10-year government bonds were well below 4%, with 10-year Government of Canada bonds at 3.86% and the U.S. 10-year Treasury yield at 3.58%. Scotia Economics currently forecasts the Government of Canada 10-year bond yield will climb 25 bp by the end of 2008 to 4.10%, and the U.S. 10-year treasury yield will climb 65 bp to 4.25%. If the current low long-term yields hold, though, we could see some EPS “pain” for the lifecos.
• If long-term interest rates remain at these levels, we could see a significant reduction in EPS for our Canadian lifecos. With liabilities longer than assets, a declining long-term interest rate scenario can pose significant reinvestment risk. The earnings impact comes not only in terms of lower investment yield, and hence lower investment income, but more so in terms of reserve increases on long-term insurance business. The long-term interest rate assumption used by actuaries in reserving for this business, referred to as the “ultimate reinvestment rate,” is a function of the 10-year moving average in long-term interest rates. And this keeps going down, which translates into reserve increases and thus lower EPS growth. If current rates remain through year-end 2008, we could see a 25 basis point (bp) YOY reduction in the ultimate reinvestment rate in 2007 (down to 4.45%) and a further 30 bp reduction in 2008 (down to 4.15%). We estimate this could translate into as much as a 3%-4% 2008E EPS hit for Manulife, a 2%-3% hit for Great-West Lifeco, a 1%-2% hit for Sun Life, and a significant 10%+ hit for Industrial-Alliance. Simply said, a long-term interest rate scenario below 4% causes pain, and we believe this is currently the biggest risk for the lifecos. As per the 2006 year-end annual reports, the last time these sensitivities were disclosed, the most sensitive of the lifecos to a 100 bp drop in long term interest rates is Industrial-Alliance (a 35% drop in EPS), with Manulife at a 9% drop in EPS, and Great-West Lifeco and Sun Life at an 8% drop in EPS.
Great-West Lifeco Inc.
1-Sector Outperform – $42 one-year target, based on 3.5x 12/31/08E BV and 14.5x 2008E EPS
• We are looking for EPS of $0.65 for Q4/07, $0.02 above consensus. Our 2008 EPS estimate is $2.68, $0.01 below consensus.
• Another steady quarter – Europe should continue to drive growth.
• Putnam should continue to show margin improvement. We assume margins will go to 24 bp from the current 20 bp (or 16 bp the way Great-West would look at them, where intercompany capital is removed), which should continue to propel earnings growth for Putnam through 2008. We look for net sales to be flat in the quarter. While we expect Putnam to still be small relative to Great-West’s earnings base in 2008 (we estimate it will amount to just 7% of the bottom line), we expect the company will continue to be an active acquirer, with more U.S. mutual fund acquisitions likely now that the Putnam financing is squared away.
• Earnings momentum from recent 401(k) tuck-in acquisitions in the United States should continue to propel bottom line – any more tuck-ins?
• Expect a 6%-8% dividend increase.
Industrial-Alliance Insurance and Financial Services Inc.
2-Sector Perform – $43 one-year target, based on 1.8x 12/31/08E BV and 12.8x 2008E EPS
• We are looking for EPS of $0.78 in Q4/07, $0.01 above consensus. Our 2008 EPS estimate of $3.38 is $0.01 below consensus.
• We do not expect another charge for ABCP, like the $0.09 EPS charge the company took in Q3/07.
• A reduction in new business strain is likely to continue to drive results in Q4/07.
• Individual segfund sales should get a boost from the December 1 launch of new guaranteed minimum withdrawal benefit (GMWB) product.
• Unless another acquisition is made, we see 2009 EPS growth returning to the 9% range.
• Industrial-Alliance is the most sensitive of the Canadian lifecos to declining interest rates and declining equity markets – this makes us somewhat cautious.
• Could get a 5% dividend increase.
Manulife Financial Corporation
2-Sector Perform – $45 one-year target, based on 3.1x 12/31/08E BV and 14.3x 2008E EPS
• We are looking for EPS of $0.71 for Q4/07, in line with consensus. Our 2008 EPS estimate of $3.05 is $0.06 below consensus.
• Continued earnings growth momentum in Canada and Hong Kong/Other Asian Territories should offset continued weakness in U.S. and Japan segments.
• U.S. variable annuity sales and U.S. individual insurance sales expected to continue to gain momentum – Japan sales expected to rebound – any update on the prospect of a Bank of Tokyo Mitsubishi distribution arrangement in Japan for individual insurance?
• Why has it slowed its buyback activity? We don’t believe the company is up to anything special, and we anticipate the buyback activity to pick up again very soon.
• Update on variable annuity hedging – is the company still unhedged? The company is expected to embark on a strategy to hedge the guarantees for its variable annuity/segregated fund businesses, mitigating to some extent the volatility in this sizeable book of business. We expect to get an update on the cost (at least $0.02 per share), which we anticipate to have increased significantly in these volatile markets.
Sun Life Financial Inc.
1-Sector Outperform – $60 one-year target, based on 2.1x 9/30/08E BV and 13.3x 2008E EPS
• We are looking for EPS of $1.05 for Q4/07, $0.01 above consensus. Our 2008 EPS estimate of $4.41 is $0.03 below consensus.
• Could beat on the strength of the funding arrangement put in place two quarters ago. This arrangement is successfully mitigating the strain on U.S. no-lapse guarantee universal life individual sales. But Q4/07 will likely include at least $0.01 to $0.02 in EPS from the recovery of strain from business written in Q4/06 and Q1/07 as well, thus increasing the likelihood this company could beat in the quarter. Also, assuming the pace of U.S. variable annuity sales continues at the exceptional clip of Q2/07 (up 96%) and Q3/07 (up 91%), we could see further EPS benefit.
• U.S should continue to drive earnings growth. We believe the company’s ability to turn around this all-important segment and increase its scale will continue to help increase its multiple relative to the group.
• Excellent risk management helps to mitigate earnings volatility in these uncertain markets, and increase multiple.
• We expect a 6%-8% dividend increase.
