RBC Capital Markets, Andre-Philippe Hardy, 8 May 2009
Sun Life: Q1/09 EPS below expectations but good upside potential/downside risk protection
Q1/09 core EPS fell short of our estimate primarily driven by increases in actuarial reserves related to interest rates as the impacts of equity markets and credit were in line with our expectations. Regulatory capital levels were as expected; remaining high. Sun Life remains well capitalized and its stock offers investors an attractive combination of upside reward with more limited downside risk than the stocks of some of its peers.
Q1/09 core EPS of ($0.33) compared to our ($0.09) estimate, consensus estimates of ($0.01) and EPS of $0.93 in Q1/08.
• GAAP EPS of ($0.38) include $0.05 in restructuring costs aimed at lowering expenses.
• The after-tax impact of equity markets was $0.58 per share, close to our estimate of $0.51 per share.
• The after-tax impact of credit/impairments ($0.44 per share) was close to our estimate of $0.49 per share. Actual impairments were low in the context of challenged credit and equity markets and the size of the company's investment portfolio. Increases in reserves related to downgrades accounted for $0.30 of the $0.44.
• SLF increased actuarial reserves related to interest rates as well as an internal reinsurance transaction, which cost the company $0.17. If long term interest rates stay low, we believe that all lifecos will be pressured to increase reserves over time, although timing is difficult to predict.
Excluding the impacts of credit and equities and other unusual items, EPS would have been approximately $0.86, close to the company's recent “earnings power” (which we continue to believe that Sun Life will not earn in the near term, not accounting for lifts from equity markets in good quarters).
• We have increased our 2009 estimated EPS by $0.08 to $2.40. The increase in our estimated EPS reflects (1) the Q1/09 shortfall versus our estimates, (2) a more conservative view of experience gains related to asset fair value, credit impairments and group claims, which are more than offset by (3) the positive impact on earnings of the increase in equity markets seen so far in Q2/09.
o We believe there could be further credit hits in Q2/09 as downgrades continue and defaults are likely to rise and we expect group claims experience to be negatively impacted by rising unemployment.
o The rebound in equity markets (global markets are up 12-16% since the end of March) should more than offset, though.
o A 10% move in equity markets would have an impact on net income of $250-325 million ($0.45-$0.58 per share), according to management’s disclosed sensitivities.
• Our 2010 EPS estimate reflects a ROE of 10.6%, which is below what we would expect the company to earn in a normal year, reflecting our lack of clarity on near term earnings.
Capital ratios were line with our expectations, remaining high. We believe that Sun Life remains better capitalized than its peers, particularly when considering sensitivity to equity markets.
• The MCCSR ratio was 223% - versus our expectations for 220%-230%. The RBC ratio of 357% was slightly higher than the company’s target of 300-350% and well above the regulatory minimum of 200%.
• We believe that the company has additional capital at the holding company level that has not been down-streamed to the regulated entities, including the recent $500 million debt issue.
• We expect the recent downward pressure on the MCCSR ratio to abate in Q2/09 given the upward move in equity markets.
• The MCCSR sensitivity to equity markets is low relative to peers but it has increased on the downside - with 10% declines in equity markets now estimated to affect the MCCSR by 8%. A 10% upward move in equity markets would increase the MCCSR by 5%. Equity markets alone are not likely to cause the firm to raise capital as we believe a MCCSR ratio of 180% is appropriate, but even a 200% ratio seems unlikely to be reached only because of declines in equity markets.
• Flexibility has declined, however given the issues of capital securities in the last year, and reported losses which have offset the gain from the sale of CI. Debt and preferred shares now represent 27.0% of capital – up from 23.4% in Q1/08 but still at the lower end of the group.
• While the company’s number one objective is balance sheet strength, we believe that Sun Life is interested in taking advantage of current market disruptions to bulk up its U.S. presence. We also believe that Sun Life would ideally like to buy good assets from distressed sellers than buy entire companies. In that context, this is not something we would expect U.S. lifecos to agree to until their backs are up against the wall.
Credit-related hits were driven by downgrades more than by impairments. The investment portfolio was a drag on earnings, as discussed above, as Sun Life was not immune to global weakness in credit markets. If isolating writedowns and downgrades, the size of the credit-related earnings impact was low in the context of challenged credit and equity markets and the size of the company's investment portfolio
• The after tax impact of impairments ($34 million for credit and $42 million for equities) is in the context of a $104 billion investment portfolio. The impairments are net of the expected quarterly benefit of $40 million that results from the $160 million in additional credit reserves set aside in Q4/08 for 2009.
• Sun Life provided added disclosures around commercial mortgages, which provide us with comfort as we believe that U.S. commercial real estate will be a very challenged asset class. The company estimates an average loan to value of only 55% based on 2008 revaluations. Commercial mortgages amount for 15% of Sun Life’s investment portfolio. For holdings of commercial mortgage backed securities (which account for just under 2% of the investment portfolio) 80% were originated prior to 2006.
• We continue to believe that Sun Life and other Canadian lifecos’ earnings will be negatively impacted by the credit environment; but that they have the capital so do so and equity-related hits should abate.
• Unrealized losses on bonds rose $1 billion to $10 billion - a slower rate of increase than in the prior quarter. Credit spreads have tightened since Q1/09 ended, which should be helpful. Fixed income securities that have traded below 80% of cost for more than six months totaled $2.9 billion ($0.3 billion in AFS, $2.6 billion in available for sale), compared to $1.8 billion in Q4/08.
We were surprised by the vigor of the company’s sales, which were for some products were not as bad as we thought and for some other products were outright solid. We suspect that, outside of Canada, the company is probably perceived as financially strong which at the margin would help sales.
• In Canada segregated funds sales were up 17%, group benefits 97% and group retirement 32%. Only individual insurance sales were down, falling 17%, which compares to a range of -3% to -7% for peers.
• In the U.S. core individual sales rose 15%, as did employee benefit sales, fixed annuities jumped from $90 million in Q1/08 to $407 million, and domestic VA sales rose 8%. VA sales appear particularly strong in the context of industry sales. Fixed annuity sales are expected to decline, as we believe that the company sold an unusually large amount of fixed annuities in the quarter in order to replace maturing liabilities and keep related assets that it finds attractive.
• Value of new business (which is measured on a trailing 12 months basis) was down 26%, however, in contrast with the sales trends as margins implicitly declined. We believe that the decline in margins was driven by low interest rates, volatile equity markets and the increased cost of hedging. MFS set up to benefit from eventual rebound in mutual fund sales. MFS’ YoY assets under management and revenues were severely impacted by equity market declines and, as is typical of assets management companies, operating leverage worked against them, causing significant operating margin compression (although margins held up surprisingly well on a sequential basis given market declines). However, investment performance relative to peers, combined with sales that we would have expected to be weaker in these weak equity markets, leads us to believe that MFS will be well positioned when equity markets turn to benefit from rising AUM, rising sales and rising margins.
• Q1/09 average AUM declined 33% YoY, driven primarily by declines in equity markets. The revenue decline that resulted from the AUM declines, combined with negative operating leverage (the operating margin declined from 35% in Q1/08 to 21%), drove a drop in net income from US$59 million to US$23 million.
• Gross sales of mutual funds declined from $4.9 billion to $4.1 billion but redemptions declined faster so net sales improved by $1.3 billion to ($0.6 billion).
• Gross sales of institutional products dropped from $4.9 billion in Q1/09 to $3.9 billion, but net sales improved by $1.7 billion to $0.8 billion as outflows shrank.
• Three-year mutual fund performance as measured by Lipper is strong with 93% of U.S. retail fund assets ranked in the top half of their Lipper Category Average.
Embedded value rose as currency and the sale of CI offset credit and equity-related hits.
• Embedded value per share was disclosed at $31.16 – up from $30.14 in the prior year, as the negative impact of experience variances and changes in assumptions was offset by the positive impact of currency, the gain on sale of CI and expected growth of in force business and new sales.
• In theory, if actuarial assumptions were 100% accurate and the company never generated another dollar of sales, the present value of future cash flows from business sold in the past is $31.16, which implies that the current share price is cheap (or embedded value is about to fall…) as it implicitly assumes that the company will not ever create value from new sales. Canadian lifeco stocks have not historically traded on embedded value however.
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Sun Life: Q1/09 EPS below expectations but good upside potential/downside risk protection
Q1/09 core EPS fell short of our estimate primarily driven by increases in actuarial reserves related to interest rates as the impacts of equity markets and credit were in line with our expectations. Regulatory capital levels were as expected; remaining high. Sun Life remains well capitalized and its stock offers investors an attractive combination of upside reward with more limited downside risk than the stocks of some of its peers.
Q1/09 core EPS of ($0.33) compared to our ($0.09) estimate, consensus estimates of ($0.01) and EPS of $0.93 in Q1/08.
• GAAP EPS of ($0.38) include $0.05 in restructuring costs aimed at lowering expenses.
• The after-tax impact of equity markets was $0.58 per share, close to our estimate of $0.51 per share.
• The after-tax impact of credit/impairments ($0.44 per share) was close to our estimate of $0.49 per share. Actual impairments were low in the context of challenged credit and equity markets and the size of the company's investment portfolio. Increases in reserves related to downgrades accounted for $0.30 of the $0.44.
• SLF increased actuarial reserves related to interest rates as well as an internal reinsurance transaction, which cost the company $0.17. If long term interest rates stay low, we believe that all lifecos will be pressured to increase reserves over time, although timing is difficult to predict.
Excluding the impacts of credit and equities and other unusual items, EPS would have been approximately $0.86, close to the company's recent “earnings power” (which we continue to believe that Sun Life will not earn in the near term, not accounting for lifts from equity markets in good quarters).
• We have increased our 2009 estimated EPS by $0.08 to $2.40. The increase in our estimated EPS reflects (1) the Q1/09 shortfall versus our estimates, (2) a more conservative view of experience gains related to asset fair value, credit impairments and group claims, which are more than offset by (3) the positive impact on earnings of the increase in equity markets seen so far in Q2/09.
o We believe there could be further credit hits in Q2/09 as downgrades continue and defaults are likely to rise and we expect group claims experience to be negatively impacted by rising unemployment.
o The rebound in equity markets (global markets are up 12-16% since the end of March) should more than offset, though.
o A 10% move in equity markets would have an impact on net income of $250-325 million ($0.45-$0.58 per share), according to management’s disclosed sensitivities.
• Our 2010 EPS estimate reflects a ROE of 10.6%, which is below what we would expect the company to earn in a normal year, reflecting our lack of clarity on near term earnings.
Capital ratios were line with our expectations, remaining high. We believe that Sun Life remains better capitalized than its peers, particularly when considering sensitivity to equity markets.
• The MCCSR ratio was 223% - versus our expectations for 220%-230%. The RBC ratio of 357% was slightly higher than the company’s target of 300-350% and well above the regulatory minimum of 200%.
• We believe that the company has additional capital at the holding company level that has not been down-streamed to the regulated entities, including the recent $500 million debt issue.
• We expect the recent downward pressure on the MCCSR ratio to abate in Q2/09 given the upward move in equity markets.
• The MCCSR sensitivity to equity markets is low relative to peers but it has increased on the downside - with 10% declines in equity markets now estimated to affect the MCCSR by 8%. A 10% upward move in equity markets would increase the MCCSR by 5%. Equity markets alone are not likely to cause the firm to raise capital as we believe a MCCSR ratio of 180% is appropriate, but even a 200% ratio seems unlikely to be reached only because of declines in equity markets.
• Flexibility has declined, however given the issues of capital securities in the last year, and reported losses which have offset the gain from the sale of CI. Debt and preferred shares now represent 27.0% of capital – up from 23.4% in Q1/08 but still at the lower end of the group.
• While the company’s number one objective is balance sheet strength, we believe that Sun Life is interested in taking advantage of current market disruptions to bulk up its U.S. presence. We also believe that Sun Life would ideally like to buy good assets from distressed sellers than buy entire companies. In that context, this is not something we would expect U.S. lifecos to agree to until their backs are up against the wall.
Credit-related hits were driven by downgrades more than by impairments. The investment portfolio was a drag on earnings, as discussed above, as Sun Life was not immune to global weakness in credit markets. If isolating writedowns and downgrades, the size of the credit-related earnings impact was low in the context of challenged credit and equity markets and the size of the company's investment portfolio
• The after tax impact of impairments ($34 million for credit and $42 million for equities) is in the context of a $104 billion investment portfolio. The impairments are net of the expected quarterly benefit of $40 million that results from the $160 million in additional credit reserves set aside in Q4/08 for 2009.
• Sun Life provided added disclosures around commercial mortgages, which provide us with comfort as we believe that U.S. commercial real estate will be a very challenged asset class. The company estimates an average loan to value of only 55% based on 2008 revaluations. Commercial mortgages amount for 15% of Sun Life’s investment portfolio. For holdings of commercial mortgage backed securities (which account for just under 2% of the investment portfolio) 80% were originated prior to 2006.
• We continue to believe that Sun Life and other Canadian lifecos’ earnings will be negatively impacted by the credit environment; but that they have the capital so do so and equity-related hits should abate.
• Unrealized losses on bonds rose $1 billion to $10 billion - a slower rate of increase than in the prior quarter. Credit spreads have tightened since Q1/09 ended, which should be helpful. Fixed income securities that have traded below 80% of cost for more than six months totaled $2.9 billion ($0.3 billion in AFS, $2.6 billion in available for sale), compared to $1.8 billion in Q4/08.
We were surprised by the vigor of the company’s sales, which were for some products were not as bad as we thought and for some other products were outright solid. We suspect that, outside of Canada, the company is probably perceived as financially strong which at the margin would help sales.
• In Canada segregated funds sales were up 17%, group benefits 97% and group retirement 32%. Only individual insurance sales were down, falling 17%, which compares to a range of -3% to -7% for peers.
• In the U.S. core individual sales rose 15%, as did employee benefit sales, fixed annuities jumped from $90 million in Q1/08 to $407 million, and domestic VA sales rose 8%. VA sales appear particularly strong in the context of industry sales. Fixed annuity sales are expected to decline, as we believe that the company sold an unusually large amount of fixed annuities in the quarter in order to replace maturing liabilities and keep related assets that it finds attractive.
• Value of new business (which is measured on a trailing 12 months basis) was down 26%, however, in contrast with the sales trends as margins implicitly declined. We believe that the decline in margins was driven by low interest rates, volatile equity markets and the increased cost of hedging. MFS set up to benefit from eventual rebound in mutual fund sales. MFS’ YoY assets under management and revenues were severely impacted by equity market declines and, as is typical of assets management companies, operating leverage worked against them, causing significant operating margin compression (although margins held up surprisingly well on a sequential basis given market declines). However, investment performance relative to peers, combined with sales that we would have expected to be weaker in these weak equity markets, leads us to believe that MFS will be well positioned when equity markets turn to benefit from rising AUM, rising sales and rising margins.
• Q1/09 average AUM declined 33% YoY, driven primarily by declines in equity markets. The revenue decline that resulted from the AUM declines, combined with negative operating leverage (the operating margin declined from 35% in Q1/08 to 21%), drove a drop in net income from US$59 million to US$23 million.
• Gross sales of mutual funds declined from $4.9 billion to $4.1 billion but redemptions declined faster so net sales improved by $1.3 billion to ($0.6 billion).
• Gross sales of institutional products dropped from $4.9 billion in Q1/09 to $3.9 billion, but net sales improved by $1.7 billion to $0.8 billion as outflows shrank.
• Three-year mutual fund performance as measured by Lipper is strong with 93% of U.S. retail fund assets ranked in the top half of their Lipper Category Average.
Embedded value rose as currency and the sale of CI offset credit and equity-related hits.
• Embedded value per share was disclosed at $31.16 – up from $30.14 in the prior year, as the negative impact of experience variances and changes in assumptions was offset by the positive impact of currency, the gain on sale of CI and expected growth of in force business and new sales.
• In theory, if actuarial assumptions were 100% accurate and the company never generated another dollar of sales, the present value of future cash flows from business sold in the past is $31.16, which implies that the current share price is cheap (or embedded value is about to fall…) as it implicitly assumes that the company will not ever create value from new sales. Canadian lifeco stocks have not historically traded on embedded value however.
