Monday, January 30, 2006

RBC Capital Q4 2005 Cdn Insurance Earnings Preview

  
Highlights

• Expecting Double-Digit EPS Growth. We expect a positive tone on the Q4 results, buoyed by strong momentum in wealth management products. MFC and IAG should lead Q4 with approximately 23% and 18% EPS growth, respectively. We are above consensus for GWO and MFC, and marginally below consensus for SLF.

• Wealth Momentum Rising. MFC and IAG are growing domestic wealth sales well above industry averages – growth rates for SLF and GWO have lagged just slightly. In the U.S. and Asia, MFC continues to show sales growth at the top end of industry ranges. Central to our positive investment thesis is that surging wealth sales will have a positive near-term impact on margins and EPS revisions.

• Q4 Life Sales Seasonally Strong. Life sales typically bulge 15% to 20% QoQ in the year-end sales season. In domestic life, GWO sales may be strongest given: (i) the increasing popularity of the whole life product where GWO excels; and (ii) continued success by Canada Life in the independent channels. In the U.S., both MFC and SLF carried excellent momentum into Q4 – we look for big results there.

• U$ Translation Headwind Abating? After a benign Q3/05 and now just -4% erosion YoY in Q4/05, the impact of the declining U$ was just half the average run rate of the past couple of years. This is most favourable for MFC and SLF, but less so in the near term at GWO, which is still adjusting from hedged to unhedged.

• Sales Mix, Excess Capital and Higher Dividend. As the product mix shifts to less capital-intensive wealth products, capital generation by the lifecos should accelerate, in our view, boosting dividend growth. We factor 14% to 18% growth rates in 2006/2007. This quarter, we are looking for a 13% increase at MFC, and 6% at SLF.

• Time to Reload on Lifecos with Rates Rising. Lifecos are trading at 103% of the banks on forward P/E, well below their typical relative valuation of 114%, depressed by low interest rates. However, interest rates have started to move off their lows, relieving spread compression broadly. Also, insurers have adjusted crediting rates down to much lower levels, reflecting the new interest rate reality, resulting in improved spreads on new and renewal business. The stage is now set for improvement in earnings performance and valuation.

• Manulife remains Top Pick. We believe MFC is positioned to continue gaining ground in the U.S. high-net-worth life and annuity markets, capitalizing on the early distribution success through the newly acquired John Hancock channels.

Favourable Year-End Outlook

We expect a positive tone on the Q4 results, buoyed by strong momentum in wealth products. Manulife and IAG should lead Q4 with approximately 23% and 18% EPS growth, respectively. We are above consensus for both MFC and GWO, and while we are below consensus for Sun Life, it is only marginally.

MFC and IAG are growing domestic wealth sales well above industry averages – growth rates for Sun and GWO have lagged just slightly. In the U.S. and Asia, MFC continues to show sales growth at the top end of industry ranges. Central to our positive investment thesis is the view that surging wealth sales will have a positive near-term impact on margins and EPS revisions.

Life sales typically bulge 15% to 20% QoQ in the year-end sales season. In domestic life, GWO sales may be strongest given: (i) the increasing popularity of the whole life product where GWO excels; and (ii) continued success by Canada Life in the independent channels. In the U.S., both MFC and Sun carried excellent momentum into Q4, so we look for big results there.

After a benign Q3/05 and now just -4% erosion YoY in Q4/05, the impact of the declining USD was just half the average run rate of the past couple of years. This development is most favourable for MFC and SLF – less so in the near term at GWO, which is still adjusting from hedged to unhedged. On average, the Canadian dollar appreciated by $0.05 relative to the U.S. dollar in Q4/05. We estimate that quarterly EPS will be negatively impacted by $0.02 to 0.03 for Manulife, and by $0.01 to $0.02 for Sun Life compared to last year. Great-West Lifeco’s earnings are protected by currency hedges on the euro (87% hedged at CAD/EUR1.61) and the U.S. dollar (100% hedged at CAD/USD1.34), but due to the reduced CAD/USD hedge rate from $1.58 last year, the year-on-year impact on GWO’s quarterly EPS is projected at $0.01 to $0.02. There is no currency impact on Industrial Alliance.

As the sales mix shifts to less capital-intensive wealth products, capital generation at the lifecos should accelerate, in our view, boosting dividend growth. We have factored growth rates of 14% to 18% in 2006/2007. This quarter, we are looking for a 13% increase at MFC and 6% at SLF.

Lifecos are trading at 103% of the banks on forward P/E, well below their typical relative valuation of 114%, depressed by low interest rates. However, interest rates have started to move off their lows, relieving spread compression broadly. Also, insurers have adjusted crediting rates down to much lower levels, reflecting the new interest rate reality, resulting in improved spreads on new and renewal business. The stage is now set for improvement in earnings performance and valuation.

Canadian Life Insurers – A Positive Investment Thesis

Product mix shift to wealth management should drive more capital-efficient earnings growth. Robust wealth management sales are the most encouraging lead indicator of near-term earnings growth, for two reasons. First, the wealth management products have the earliest profit emergence of all lifeco businesses, with fee income recognized immediately on customer deposits. By contrast, life insurance sales typically do not generate profit in the early years post-sale, as profit is held back, should experience differ from actuarial projections. Second, the wealth divisions now account for increasing proportions of overall lifeco business, now at roughly one-third of the whole.

Life insurance sales were increasingly disappointing in 2005 on tepid interest rates and buyer fatigue after the sustained rebound in strength in 2003-2004. A slightly higher interest rate would be ideal for another rebound in protection sales. Regardless, the powerful top four Canadian publicly traded lifecos have had better sales growth than the broad sector average through this lull across North America. With sales heavily skewed to wealth products in the current cycle, we expect that overall net income growth will track above long-term average growth rates and market expectations.

Another positive by-product of the wealth-rich sales mix is more efficient regulatory capital usage. Wealth products attract much lower regulatory capital requirements than life insurance policies, so we also anticipate above-average dividend payout growth in this cycle.

Manulife, Sun Life have flexibility to raise dividends. With payout ratios on trailing earnings in the low 30% range, plenty of excess capital and an oft-stated commitment to return capital to shareholders, both Manulife and Sun Life have both the flexibility and willingness to increase dividends. Great-West has traditionally been a strong yield play, but it now has less room to manoeuvre than in the past, with low excess capital and challenged earnings growth over the next year. It is, however, a clear beneficiary in the longer term of any favourable adjustments to dividendtaxation policies. IAG has already earmarked its excess capital for the CFI acquisition, and also consequently falls into the category of long-term beneficiary of any proposed changes to dividend taxation.

Lifeco valuation more attractive than banks. Canadian lifeco valuations have expanded a full multiple point in the last three months, now trading at 13.9x consensus forward earnings – this represents a break-out from the 11x to 13.5x range since spring 2002, when Canadian government 10-year bond yields fell below 5%. Despite the strong price performance, lifecos continue to trade at only a 3% premium to the banks (as has been the case through much of the year), and well below the 14% premium since demutualization. We expect lifecos to outperform the banks in a modestly rising interest rate environment.

Manulife remains Top Pick. We believe the earnings momentum and valuation outlook for insurers remains positive. We believe MFC is positioned to continue gaining ground in the U.S. high-net-worth life and annuity markets, particularly capitalizing on the early distribution success through the newly acquired John Hancock channels. We also expect continued success in Asian markets, where the focus on wealth products is also showing tangible gains in select markets (Japan, Hong Kong and Singapore), particularly as more bancassurance business models develop across the Asia platform, including in Hong Kong. Finally, while not expected to be significantly profitable in the near future, MFC’s rapid but disciplined Chinese city build-out should start attracting value as one of the best-developed foreign lifeco platforms in that country.

Sector Price Performance and Valuation

Canadian lifecos outperformed in Q4, and in line for 2005. Canadian lifecos advanced 9% in Q4 to lead comparable financial indexes, and were well ahead of the TSX Composite and S&P500 at 2% each. For the year, the Canadian lifecos finished up 20%, in line with the Canadian banks, U.S. lifecos and the TSX Composite. Manulife was the top-performing lifeco for the second consecutive quarter, up 10% in Q4 and 23% in 2005 to lead the group.

Trading at a 3% premium to the banks. The Canadian lifecos are trading at 13.9x consensus forward earnings, above the 13.3x average since demutualization. The lifecos are trading at a 3% premium to the Canadian banks, still below the average premium of 14% since demutualization.

We find a strong negative correlation between lifeco forward P/Es and 10-year bond yields, but the relationship breaks down at yields below 5¼%, we believe due in part to spread compression on fixed rate products. Historical data show that lifeco valuations are capped at 14.5x forward earnings for 10-year yields below 5¼% – current 10-year rates are at 4.15% in Canada and 4.51% in the U.S. We see expansion of relative P/E from the current 103% towards 115%, and see movement to levels above 15x forward P/E with yields between 5.25% and 6.00%. Every 10% expansion in the lifeco-bank relative valuation from current levels adds 1.3 multiple points to the lifecos.

In our view, the dampening effect of persistently low interest rates (just now breaking higher) on lifeco product spreads and ROE, combined with the Canadian banks’ higher relative dividend yield and lower USD exposure has kept lifeco relative P/E valuation at bay. Looking forward, we envision stabilization of both interest rates and USD volatility as catalysts for recovery in EPS and ROE, leading to revaluation of the lifeco sector. This is already underway, with lifecos having moved to a 3% premium to the banks, up from par at October 2005 month-end.
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