28 August 2011

Manulife's Financial Outlook Still Too Uncertain

Citigroup Global Securities, 28 August 2011

Risk of Earnings Shortfalls Rising as Weak Macro-Economic Climate Exacerbating Pricing Mistakes at John Hancock

• Maintain Sell but target lowered — We reiterate our Sell (3H) rating on MFC’s shares but have lowered our target price to C$12/US$12 and downwardly revised our 2011E-13E to C$0.65, C$1.60 and C$1.75. As one of the largest writers in the U.S. of VAs offering living benefits, secondary guarantee universal life (SGUL), individual long-term care (LTC) and VAs in Japan, MFC possesses well above average sensitivity to both equity markets and long-term interest rates. Our target and estimate changes incorporate the decline each has seen and our expectation current levels will persist for the foreseeable future. Quarter-to-quarter results will likely remain volatile and largely outside of management’s control including a $0.50/share loss we now project for 3Q11.

• Balance sheet quality issues persist — The recent drop in U.S. interest rates and equity markets coupled with pricing mistakes made at John Hancock on VAs, LTC and SGUL will depress MFC’s earnings and ROE for years, if not decades to come. Exacerbating this was weaker, relative to peers, risk management practices. While we have been encouraged by the steady increase MFC’s use of hedging activities, the announcement of a $700M or $0.39/share charge in 3Q11 for adverse mortality at John Hancock raises a new area of concern. It relates primarily to deteriorating experience on Hancock’s old permanent life insurance block. MFC is the only insurer we are aware of to have this issue and leads us to question overall reserve adequacy and other deficiencies that have yet to come to light.

• 2Q11 better than forecast but core trends mixed — On a nominal basis, operating earnings of C$490M compared favorably to a loss of C$(2.4)B a year earlier. While the U.S. Insurance and Wealth Management, and Reinsurance segments performed better than our forecast, Canada was weaker than projected and Asia was in-line. ROE of 8.2% compared to 17.4% in 1Q11. Targeted insurance and wealth management sales were up 28% to C$575M and C$275M to C$8.4B, respectively; while non-targeted sales fell 68% and 30%, respectively. Targeted premiums & deposits grew 3.7% to C$16.9B, where targeted products represent 90% of in-force vs. 85% in 2Q10.

• Pace of improvement will be slow — We are encouraged by the steps management has taken to help to stabilize MFC’s financial position, but it will still take many years to fully resolve the problems at John Hancock. The risk of earnings shortfalls vs. market expectations remains tangible. Despite the high growth potential of a very strong Asian franchise and the stable and high ROE of its Canadian business, from a risk vs. reward perspective this is more than offset by the uncertainty posed by John Hancock.