Citigroup Global Markets, 5 August 2010
2Q10 a miss – Operating EPS of (C$1.36) compared unfavorably to 2Q09 EPS of C$1.09, and was well below our estimate of $0.00 and FC of (C$0.62). While disappointing, we did not find much during our initial review of the results with respect to business line performance that came as a surprise in terms of sales or underwriting trends. But, Canadian GAAP incorporates a more mark-to-market present valuation of liabilities which dictates the present value of the impact of equity market or long-term interest rate movements flow through earnings much more rapidly than U.S. GAAP. While this results in the book value of Canadian life insurers being closer to their underlying “economic” value, it can also cause considerably greater swings in quarter-to-quarter earnings. For MFC in 2Q10 the cost of the decline in global equity markets was (C$1.7B) plus continued low interest rates cost added a charge of (C$1.5B). Absent these, along with a couple of other minor items, and normalized adjusted operating earnings were $658M or about $0.37/share; down modestly from their adjusted level of $0.42 in 1Q10.
Capital remains an issue – Although Manulife’s statutory MCCSR (Minimum Continuing Capital and Surplus Requirements) ratio of 221% at 2Q10 was still strong, it did decline from 250% in 1Q10. In light of management’s acknowledgment on the earnings call that charges from its annual actuarial assumption review in 3Q10 may exceed C$1 billion, we expect that MCCSR will fall further. The pending 3Q10 charges came on top of the (C$2.4B) net loss for 2Q10 and because of this, we continue to anticipate a common equity raise in the C$1.5B – C$2.0B range by YE10. The pricing mistakes made on variable annuities, secondary guarantee universal life (SGUL) and individual long-term care (LTC) at Manulife’s U.S. John Hancock operations will materially depress overall corporate ROE for decades to come. The cost of fully reserving for what we estimate are roughly US$35 billion of largely un-hedged variable annuities written in 2005-07 with generous living benefits, along with the $18.2B of reserves backing LTC and an estimated $15 billion of reserves behind SGUL will be very painful. But, we believe Manulife’s CEO Don Guloien is moving towards finally stepping up to do so in order to allow his company to begin to move forward from the legacy issues he was left by his predecessor. All three of these lines are also candidates to be put into run-off and we would note rival Sun Life, as part of its 2Q10 results, announced it had formally exited SGUL. At 2Q10, MFC had $32.3B in capital and in the last 12 months has raised $3.5B of new capital split between $2.5B of common equity and $1.0B of Tier 1 notes. The company maintained its $0.13 quarterly dividend and we do not believe it is at risk.
Expect another difficult quarter in 3Q10/4Q10 – Management could not provide an estimate of what the charge in 3Q10 would be as part of its annual actuarial assumption review. Instead they guided for a “material charge” which we believe help to spook the market and precipitate the approx. 15% sell-off in the shares. We believe it will be at least as big as the 3Q09 C$783M after-tax charge experienced from changes to actuarial morbidity and policyholder lapse assumptions. If this wasn’t enough, the pending adoption by Canadian life insurers of phase 1 of International Financial Reporting Standards (IFRS) is likely to bring with it several billion dollars worth of additional charges. Most notable of this will be a material impairment of the company’s C$7.2B goodwill asset that equaled 25.9% of equity at 2Q10. However, unlike Sun Life that was able to offer some insight as to what the accounting impact of the transition costs to IFRS would be, Manulife CFO Michael Bell was considerably less precise when asked on the earnings call.
Regulatory update - As announced by Office of the Superintendent of Financial Institutions (OSFI) on July 28/10, existing capital requirements related to new (but not in-force) segregated fund/VA business written starting in 2011 will change.
VA hedging remains a primary valuation risk issue – It was clear again from today’s call that Manulife’s CEO Mr. Guloien plans to continue what is largely his company’s very large un-hedged investment in equity markets. While he stated that by YE12 he intends to hedge or reinsure at least 70% of the company’s VA guarantees vs. 51% as at 2Q10, it was clear no formal program for averagingin has been adopted. Rather it will continue to be done on an “ad-hoc” basis with management essentially hoping equity markets cooperate and rise. Mr. Guloien anticipates this will reduce the company’s equity market sensitivity by 15% relative to June 30/10 but we would point out the hedge program will continue to largely avoid addressing the deeply in the money 2005-07 vintages whose estimated US$35 billion of guarantees appear to us to be over 35% in the money. And, per the step-up features on these contracts, their guaranteed amount will continue to rise at a minimum rate of 5% net of fees annually.
Sales results mixed:
Insurance –On a constant currency basis sales were up 9% to $648M. Asian insurance sales were driven by 41% upside in Japan to US$117M, a 36% rise in Hong Kong to US$45M, and 41% growth in China & Taiwan to US$27M. In Canada, individual insurance and affinity sales grew 12% to $73M but consistent with peers, group benefits declined 20% to $70M. US life sales fell 9% to US$154M following the steep price increases in term and guaranteed universal life products. LTC sales jumped 72% to US$62M, reflecting good gains in group sales.
Wealth management - Sales excl. VA rose 12% Y-O-Y to $7.1B, led by 19% upside in Hong Kong to US$175M, Other Asia increase of 35% to US$520M, and new products launched in Japan. In Canada, mutual fund deposits jumped 175% to $297M and MFC bank sales rose 6% to $1.1B. But, consistent with peers, this was offset by a 37% drop in fixed products to $247M and 51% decline in group retirement sales to $175M. Similarly, in the US, mutual fund sales rose 51% to US$2.4B, and retirement plan services rose 24% to a record $1.1B, driven by the acquisition of larger cases, improved markets and expanded distribution relationships.
Investment strategy
Our Buy/Medium Risk (1M) rating on the shares of Manulife reflects our view that despite near term challenges including the risk of another common equity raise it continues to be one the premier global life insurance franchises. That said, the combination of weak risk management poor product pricing discipline over the past few years along with rising investment losses has measurably weakened its financial condition. However, we believe CEO Don Guloien is committed to putting MFC’s problems at its troubled U.S. John Hancock operations behind it once and for all.
We also have growing confidence MFC is beginning to regain its former sales momentum led by its high growth Asian businesses. An important factor behind our upgrade is recent management changes and our belief these reflect that CEO Don Guloien is finally getting a full handle on the significant product pricing and risk management mistakes made in the U.S. In our view the issue for MFC is not regulatory capital, but rather the economic cost of the VA and UL pricing mistakes made in the U.S. We expect these will limit the company’s long-term earnings growth rate and ROE to somewhere in the 12%-13% range for each. That said we believe its Asian operations offer superior growth potential and expect them to play a steadily rising role in future earnings growth and possible M&A.
Valuation
When deriving valuations for life insurers, we primarily utilize a peer comparison of P/B regressed against ROE. In support of this we also use a relative P/E assessment, sum-of-the-parts analysis and PV of excess returns. To arrive at our C$22/US$21 target price for Manulife’s shares we performed a P/B vs. ROE regression for a peer group of North American life insurers. We adjusted this to allow for the historical 10%-15% premium Canadian life insurers have traded above their U.S. peers which we attribute to differences in accounting. Longer-term we look for ROE to stabilize in the 12%-14% range and EPS growth to be 10%-12%.
Price-to-book value – Our target price was established using a 1.4x P/BV multiple of projected year-end 2010 book value of C$15.97. While above the level inferred by our industry price/book versus ROE regression model based on a 2010 projected ROE of 7.6%, it factors in what we forecast will be a significant 60-70 bps annual improvement over the next two years. This compares to an average for the large-cap peer group of 1.03x and range of 0.64x–2.1x, with ROEs of 9.2%-27.9%.
Relative P/E – Our target price utilizes a multiple of 18.3x our 2010E of C$1.20 and 11.0x our 2011E of C$2.00. This compares to the 2010 peer average of 9.0x and range of 7.6x-10.8x and 2011 average and range of 7.9x and 6.6x-8.7x.
PV of Excess returns – Infers share value of C$22.76.
Risks
We rate Manulife Financial as Medium Risk for several reasons. The first is liability risk related to variable annuities, no-lapse and individual long-term care. These products were significantly under-priced industry wide by insurers and MFC was a leading writer of each of them. Along with the Japanese VA line they may all require further reserve strengthening. A second risk factor is interest rates. We estimate over half of earnings come from individual life insurance products and are meaningfully impacted by the level of long-term interest rates. Management est. a 100bps upward shift in rates would benefit capital by C$1.6B while a similar drop would reduce it by C$2.2B. A third risk factor relates to the general account long term investment portfolio that equaled C$188.3B at 1Q10. While we consider it conservative with only 4% held in bonds rated below investment grade, its sheer size means it is not immune to the general credit environment. A fourth factor is earnings sensitivity to equity market movements. These impact fees generated off segregated and mutual fund AUM which totaled C$194.1B and C$36.8B, respectively, at 1Q10. Management est. an immediate 10% equity market drop would reduce capital by C$1.2B. A final risk factor is currency as over half of earnings originate outside of Canada, primarily the U.S., and are influenced by changes to the Cdn/$ exchange rate. Our forecasts assume an exchange rate of 0.96x. If any of these factors has a greater/lesser impact than predicted, the shares could have difficulty achieving our target price or could exceed it.
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2Q10 a miss – Operating EPS of (C$1.36) compared unfavorably to 2Q09 EPS of C$1.09, and was well below our estimate of $0.00 and FC of (C$0.62). While disappointing, we did not find much during our initial review of the results with respect to business line performance that came as a surprise in terms of sales or underwriting trends. But, Canadian GAAP incorporates a more mark-to-market present valuation of liabilities which dictates the present value of the impact of equity market or long-term interest rate movements flow through earnings much more rapidly than U.S. GAAP. While this results in the book value of Canadian life insurers being closer to their underlying “economic” value, it can also cause considerably greater swings in quarter-to-quarter earnings. For MFC in 2Q10 the cost of the decline in global equity markets was (C$1.7B) plus continued low interest rates cost added a charge of (C$1.5B). Absent these, along with a couple of other minor items, and normalized adjusted operating earnings were $658M or about $0.37/share; down modestly from their adjusted level of $0.42 in 1Q10.
Capital remains an issue – Although Manulife’s statutory MCCSR (Minimum Continuing Capital and Surplus Requirements) ratio of 221% at 2Q10 was still strong, it did decline from 250% in 1Q10. In light of management’s acknowledgment on the earnings call that charges from its annual actuarial assumption review in 3Q10 may exceed C$1 billion, we expect that MCCSR will fall further. The pending 3Q10 charges came on top of the (C$2.4B) net loss for 2Q10 and because of this, we continue to anticipate a common equity raise in the C$1.5B – C$2.0B range by YE10. The pricing mistakes made on variable annuities, secondary guarantee universal life (SGUL) and individual long-term care (LTC) at Manulife’s U.S. John Hancock operations will materially depress overall corporate ROE for decades to come. The cost of fully reserving for what we estimate are roughly US$35 billion of largely un-hedged variable annuities written in 2005-07 with generous living benefits, along with the $18.2B of reserves backing LTC and an estimated $15 billion of reserves behind SGUL will be very painful. But, we believe Manulife’s CEO Don Guloien is moving towards finally stepping up to do so in order to allow his company to begin to move forward from the legacy issues he was left by his predecessor. All three of these lines are also candidates to be put into run-off and we would note rival Sun Life, as part of its 2Q10 results, announced it had formally exited SGUL. At 2Q10, MFC had $32.3B in capital and in the last 12 months has raised $3.5B of new capital split between $2.5B of common equity and $1.0B of Tier 1 notes. The company maintained its $0.13 quarterly dividend and we do not believe it is at risk.
Expect another difficult quarter in 3Q10/4Q10 – Management could not provide an estimate of what the charge in 3Q10 would be as part of its annual actuarial assumption review. Instead they guided for a “material charge” which we believe help to spook the market and precipitate the approx. 15% sell-off in the shares. We believe it will be at least as big as the 3Q09 C$783M after-tax charge experienced from changes to actuarial morbidity and policyholder lapse assumptions. If this wasn’t enough, the pending adoption by Canadian life insurers of phase 1 of International Financial Reporting Standards (IFRS) is likely to bring with it several billion dollars worth of additional charges. Most notable of this will be a material impairment of the company’s C$7.2B goodwill asset that equaled 25.9% of equity at 2Q10. However, unlike Sun Life that was able to offer some insight as to what the accounting impact of the transition costs to IFRS would be, Manulife CFO Michael Bell was considerably less precise when asked on the earnings call.
Regulatory update - As announced by Office of the Superintendent of Financial Institutions (OSFI) on July 28/10, existing capital requirements related to new (but not in-force) segregated fund/VA business written starting in 2011 will change.
VA hedging remains a primary valuation risk issue – It was clear again from today’s call that Manulife’s CEO Mr. Guloien plans to continue what is largely his company’s very large un-hedged investment in equity markets. While he stated that by YE12 he intends to hedge or reinsure at least 70% of the company’s VA guarantees vs. 51% as at 2Q10, it was clear no formal program for averagingin has been adopted. Rather it will continue to be done on an “ad-hoc” basis with management essentially hoping equity markets cooperate and rise. Mr. Guloien anticipates this will reduce the company’s equity market sensitivity by 15% relative to June 30/10 but we would point out the hedge program will continue to largely avoid addressing the deeply in the money 2005-07 vintages whose estimated US$35 billion of guarantees appear to us to be over 35% in the money. And, per the step-up features on these contracts, their guaranteed amount will continue to rise at a minimum rate of 5% net of fees annually.
Sales results mixed:
Insurance –On a constant currency basis sales were up 9% to $648M. Asian insurance sales were driven by 41% upside in Japan to US$117M, a 36% rise in Hong Kong to US$45M, and 41% growth in China & Taiwan to US$27M. In Canada, individual insurance and affinity sales grew 12% to $73M but consistent with peers, group benefits declined 20% to $70M. US life sales fell 9% to US$154M following the steep price increases in term and guaranteed universal life products. LTC sales jumped 72% to US$62M, reflecting good gains in group sales.
Wealth management - Sales excl. VA rose 12% Y-O-Y to $7.1B, led by 19% upside in Hong Kong to US$175M, Other Asia increase of 35% to US$520M, and new products launched in Japan. In Canada, mutual fund deposits jumped 175% to $297M and MFC bank sales rose 6% to $1.1B. But, consistent with peers, this was offset by a 37% drop in fixed products to $247M and 51% decline in group retirement sales to $175M. Similarly, in the US, mutual fund sales rose 51% to US$2.4B, and retirement plan services rose 24% to a record $1.1B, driven by the acquisition of larger cases, improved markets and expanded distribution relationships.
Investment strategy
Our Buy/Medium Risk (1M) rating on the shares of Manulife reflects our view that despite near term challenges including the risk of another common equity raise it continues to be one the premier global life insurance franchises. That said, the combination of weak risk management poor product pricing discipline over the past few years along with rising investment losses has measurably weakened its financial condition. However, we believe CEO Don Guloien is committed to putting MFC’s problems at its troubled U.S. John Hancock operations behind it once and for all.
We also have growing confidence MFC is beginning to regain its former sales momentum led by its high growth Asian businesses. An important factor behind our upgrade is recent management changes and our belief these reflect that CEO Don Guloien is finally getting a full handle on the significant product pricing and risk management mistakes made in the U.S. In our view the issue for MFC is not regulatory capital, but rather the economic cost of the VA and UL pricing mistakes made in the U.S. We expect these will limit the company’s long-term earnings growth rate and ROE to somewhere in the 12%-13% range for each. That said we believe its Asian operations offer superior growth potential and expect them to play a steadily rising role in future earnings growth and possible M&A.
Valuation
When deriving valuations for life insurers, we primarily utilize a peer comparison of P/B regressed against ROE. In support of this we also use a relative P/E assessment, sum-of-the-parts analysis and PV of excess returns. To arrive at our C$22/US$21 target price for Manulife’s shares we performed a P/B vs. ROE regression for a peer group of North American life insurers. We adjusted this to allow for the historical 10%-15% premium Canadian life insurers have traded above their U.S. peers which we attribute to differences in accounting. Longer-term we look for ROE to stabilize in the 12%-14% range and EPS growth to be 10%-12%.
Price-to-book value – Our target price was established using a 1.4x P/BV multiple of projected year-end 2010 book value of C$15.97. While above the level inferred by our industry price/book versus ROE regression model based on a 2010 projected ROE of 7.6%, it factors in what we forecast will be a significant 60-70 bps annual improvement over the next two years. This compares to an average for the large-cap peer group of 1.03x and range of 0.64x–2.1x, with ROEs of 9.2%-27.9%.
Relative P/E – Our target price utilizes a multiple of 18.3x our 2010E of C$1.20 and 11.0x our 2011E of C$2.00. This compares to the 2010 peer average of 9.0x and range of 7.6x-10.8x and 2011 average and range of 7.9x and 6.6x-8.7x.
PV of Excess returns – Infers share value of C$22.76.
Risks
We rate Manulife Financial as Medium Risk for several reasons. The first is liability risk related to variable annuities, no-lapse and individual long-term care. These products were significantly under-priced industry wide by insurers and MFC was a leading writer of each of them. Along with the Japanese VA line they may all require further reserve strengthening. A second risk factor is interest rates. We estimate over half of earnings come from individual life insurance products and are meaningfully impacted by the level of long-term interest rates. Management est. a 100bps upward shift in rates would benefit capital by C$1.6B while a similar drop would reduce it by C$2.2B. A third risk factor relates to the general account long term investment portfolio that equaled C$188.3B at 1Q10. While we consider it conservative with only 4% held in bonds rated below investment grade, its sheer size means it is not immune to the general credit environment. A fourth factor is earnings sensitivity to equity market movements. These impact fees generated off segregated and mutual fund AUM which totaled C$194.1B and C$36.8B, respectively, at 1Q10. Management est. an immediate 10% equity market drop would reduce capital by C$1.2B. A final risk factor is currency as over half of earnings originate outside of Canada, primarily the U.S., and are influenced by changes to the Cdn/$ exchange rate. Our forecasts assume an exchange rate of 0.96x. If any of these factors has a greater/lesser impact than predicted, the shares could have difficulty achieving our target price or could exceed it.
