Friday, November 03, 2006

Manulife Q3 2006 Earnings

  
BMO Capital Markets, 3 November 2006

Investment Thesis & Outlook

We upgraded Manulife shares on July 24, 2003 (two months before the JHF acquisition) at roughly $20.50 and a quarterly dividend of $0.09. Since that time the shares have provided a total return of 99.2% versus the TSX composite of 78.4% and the TSX/S&P Life & Health index of 89.5%. Given the strong share price performance, we downgraded the shares to Market Perform from Outperform. We continue to believe that Manulife is unique in Canada, and probably in the global insurance market, given its leading market positions in North America and world class Asian platform. Moreover, we continue to believe that the company can grow EPS at 15% compounded annually over the medium to long term. This should enable the shares to outperform the broader market over the long term. MFC maintains impressive amounts of financial flexibility enabling it to raise the dividend, buyback stock and make material acquisitions should opportunities present themselves. While we are downgrading the rating on the shares, Manulife should remain a core holding in any portfolio.

Manulife reported Q3/06 fully diluted EPS of $0.62 compared with $0.47 in Q3/05, our estimate of $0.61 and consensus of $0.62. Results were driven by strong earnings in U.S. wealth management, reflecting investment gains and higher fee income, offset by somewhat disappointing results in Canada due to poor claims experience in group and less favourable impact of equity markets on segregated fund guarantees. The company did incur a $0.02 charge in the quarter related to an unfavourable resolution of a John Hancock pre-merger tax assessment and excluding this charge, MFC earned $0.64 in the quarter. ROE improved to 16.6% annualized in the quarter, it increased the quarterly dividend by 14% to $0.20 per share, and bought back roughly 17 million shares in the quarter. We expect the company to remain active in the share buyback program and dividend growth should be at least 15%.

The company combined good earnings growth with continued growth in new business, albeit at slower growth rates. While insurance sales were relatively strong across North America and most of Asia, wealth management sales were more modest. Manulife is addressing the more modest wealth management sales growth with a new redesigned VA product for Japan, two new features for its VA products in the U.S., and the introduction of Canada’s first GMWB segregated fund. We anticipate that the new VA product in Canada is likely to enjoy significant success and could challenge the established order in the Canadian individual segregated fund landscape.

Given results in the quarter, we have adjusted our 2006E and 2007E EPS to $2.45 and $2.80 from $2.43 and $2.75, respectively. As mentioned, we believe that MFC can grow EPS at 15% per annum over the medium to long term and results in Q3/06 confirm that belief. However, achieving this target in the shorter term may be challenging given unsustainable high investment gains in the institutional fixed business in 2006 and the fact that interest rates remain low. On valuation, we believe that MFC is fairly valued at 15.6x 2006E EPS and 13.6x 2007E EPS. As indicated in past research comments, we do not believe that MFC is overvalued but it is unreasonable to expect further valuation improvements from these levels. However, we note that other large cap financial services companies, like some banks, trade at comparable multiples to Manulife. In this case, we continue to believe that Manulife has much superior long term earnings and dividend growth potential than any of the Canadian banks.

U.S. Operations

Earnings in the U.S. Insurance division include individual insurance and long-term care (LTC) and increased to US$151 million in the quarter versus US$119 million in Q3/05. The increase was attributable to favourable investment results from stronger equity markets, improved new business margins and favourable mortality experience in JH Life combined with in-force growth in JH LTC. This was somewhat offset by unfavourable claims experience in JH LTC and the stronger Canadian dollar. JH Life earnings rose to US$131 million in the quarter from US$99 million in Q3/05 reflecting and JH LTC earnings were flat at US$20 million from Q3/05 and declined 29% from the previous quarter.

JH Life sales increased to US$168 million in Q3/06 from US$141 million in Q3/05, due to continued success with product innovations and good growth across all distribution channels (Table 2). The decline in sales from the prior quarter is due to seasonality and increased competition. Sales in JH LTC increased to US$38 million in Q3/06 from US$30 million a year ago, its 6th consecutive quarter of increased retail sales, which is attributable to new marketing initiatives, the addition of new distribution partners, combined with growth from existing sales channels. Since raising prices on LTC a year ago, MFC lost market share and the rising sales reflect the fact that it is recapturing lost market share.

In-force profit growth was 8% in U.S. insurance – a good result in a mature market – and sales strain was negligible in the quarter despite good sales results. Manulife continues to execute well on its distribution strategy in the U.S.

Overall, U.S. Wealth Management had another strong quarter, with earnings rising to US$250 million compared to US$166 million in the same quarter last year, but is down from US$268 million in Q2/06. The majority of the earnings growth from the prior year is attributable to favourable investment results in the fixed business and higher fee income on the rising equity markets.

Variable products contributed US$117 million to segment earnings, up from US$96 million a year ago due to higher fee income from growth in funds under management, which was somewhat offset by a less favourable impact of equity markets on segregated fund reserves and increased distribution expenses in the mutual fund segment.

Net flows for JH variable annuities continued to be strong at US$944 million this quarter, but are down from US$1.3 billion in Q3/05 and US$1.4 billion in the previous quarter (Table 2). Manulife launched two new VA products in the quarter in reaction to product enhancements from competitors. The softer sales results in the quarter are a reflection of more challenging market conditions. We doubt that Manulife can deliver the types of VA net sales growth over the next year that was delivered over the last 12 months; however, we do expect to see net sales growth but just at a lower growth rate.

Earnings in JH Retirement Plan Services (small case 401(k)) rose to US$32 million from US$27 million in Q3/05 largely due to asset growth. Assets rose 24% to US$42.3 billion versus US$34.2 billion in Q3/05 and are up 7% from Q2/06. We believe that this is an area that Manulife would like to make a large acquisition. Asset growth also benefited from US$560 million in deposits that came from the JHF operations.

JH Mutual funds recorded sales of US$508 million in the quarter, up from US$307 million in the same quarter last year and are down from US$719 million in the prior quarter, as increased market volatility had a negative impact on mutual fund sales. As at September 30, 2006, mutual fund assets under management were US$32.3 billion, up from US$28.4 billion a year ago. Results in the mutual fund operations have improved dramatically since the acquisition and we expect to see further improvement in 2006 and 2007.

We believe that the success of the JH mutual fund operations represents a window into the success that Manulife is having in reinvigorating the Hancock brand. Prior to the acquisition, John Hancock mutual fund operations had consistently reported quarterly net redemptions for five years. Since Manulife took control of these operations, it has revamped the product offering and sales force with dramatic results.

In the JH Fixed Products Group, which includes both retail and institutional, earnings rose to US$133 million from US$70 million in Q3/05 due to strong investment related gains versus losses in the prior year, and the positive impact of interest rate movements compared with interest related losses in Q3/05. Investment gains are expected to moderate after unusually strong investment results over the last few quarters. Earnings from the JH Institutional segment can be volatile from quarter to quarter. Total funds under management were US$42.6 billion, down from US$46.8 billion in Q3/05, due to net outflows of US$1.4 billion as the company continues to de-emphasize JH institutional products. We would expect earnings from this division to decline in 2007.

Overall, results in the U.S. were very good and we are projecting roughly 10% growth in 2007 from solid growth in in-force business and wealth management.

Canadian Operations

In Canada, earnings were down 3% to $229 million versus $235 million in Q3/05. The decline was largely attributable to the less favourable impact of equity markets on segregated fund reserves and poor claims experience in Group Benefits, which were somewhat offset by favourable claims experience in Individual Insurance.

Premiums and deposits in this segment declined to $3.1 billion from $3.33 billion in Q3/05, as strong sales in Group Savings and Retirement Solutions were more than offset by lower segregated and mutual fund sales in Individual Wealth Management. Sales of segregated funds were unusually strong last year and slowed in 2006 as the distribution force waited for a new segregated fund product that was launched in October 2006. In addition, proprietary mutual fund deposits have also been down, reflecting investor preference for more competitive global investment options. In response to this change in investor preference, 4 new funds were launch late in the third quarter.

Canadian individual insurance reported earnings of $91 million versus $72 million in Q3/05, and $115 million last quarter reflecting favourable claims experience. Sales in individual insurance rose 19% to $64 million from Q3/05 and increased 12% Q2/06, with growth in almost all major product categories (Table 3). Sales in individual insurance in Canada have recovered but we would expect to see more recovery in wealth management net flows over the next year or two.

Wealth management reported a 21% decrease in earnings to $70 million in the quarter from $89 million in the same quarter last year due to less favourable impact of equity markets on segregated fund reserves. Sales declined to $729 million in Q3/06 from $880 million last quarter and $1.2 billion a year ago (Table 3). The year-over-year decline is attributable to weaker sales of fixed annuities, which continued to experience net redemptions due to the current low interest rate environment, combined with lower sales of segregated funds. As mentioned above, the decline in segregated fund deposits from the prior year is attributable to the closure of Manulife’s 100% guaranteed product. The company launched a new segregated fund product featuring a guaranteed minimum withdrawal benefit in October in order to revitalize sales in this segment. Funds under management rose to $37.8 billion at September 30, 2006, from $34.8 billion at the end of Q3/05.

Earnings in the group businesses were $68 million compared with $74 million in the same quarter last year, due to poor claims experience compared with positive experience a year ago. Sales in group businesses can be lumpy and increased to $327 million in the quarter versus $184 million in Q3/05. The increase is attributable to a large case sale to Rogers Communications within Group Savings and Retirement Solutions, which was announced in the prior quarter. Premiums and deposits rose to $1.8 billion in Q3/06 from $1.6 billion in Q3/05.

Earnings in the Canadian operations continue to be well balanced between individual life, wealth management and group, and we would expect this balance to remain. We are projecting roughly 11% growth in 2007.

Asian Operations

Earnings from Asia (excluding Japan) increased 32% to US$99 million in Q3/06 from US$75 million in Q3/05, due to solid growth in both Hong Kong and other Asian territories. Earnings in Hong Kong increased to US$78 million from US$59 million in Q3/05 due to growth in in-force insurance business and strong wealth management earnings from higher fee income. Wealth management sales in Hong Kong increased in the quarter to US$222 million from US$179 million in Q3/05, largely driven by strong group pension sales (Table 4). Insurance sales in Hong Kong for the quarter totalled US$35 million, down from US$38 million in Q3/05 and up from US$30 million in the previous quarter, reflecting a shift in sales towards wealth management products.

The core business remains its agency force, where the number of agents in Hong Kong rose slightly to 3,426 from 3,287 in the last quarter. Hong Kong remains the hub of MFC’s operations in Asia and we expect earnings growth of 16% in 2007.

Earnings from all Asia territories increased to US$21 million from US$16 million in Q3/05. While relatively small, these other Asian operations represent significant future profits. The number of agents in the other Asian territories increased in the quarter to 17,072 from 16,819 in the prior quarter, which is encouraging. We continue to believe the sales force is the key to long-term growth in Asia.

Japan

Earnings from Japan were US$62 million in the quarter versus US$102 million a year earlier. However, excluding a tax gain in Q3/05 of US$54 million, earnings in Japan grew 29% due to asset growth and higher related fee income.

Sales in variable annuities totalled US$286 million, down 53% from Q3/05, reflecting the suspension of the sale of a variable annuity product. The company is launching new VA product in Japan on November 13, 2006. We expect VA sales in Japan to rebound next year.

The agent network dropped to 3,630 from 3,684 in Q3/05, as the company continues to experience some challenges recruiting new agents and is proceeding with its initiatives to enhance agent productivity. Sales of individual insurance totalled US$20 million and are not comparable to prior periods due to a change in reporting methodology, where results from prior periods were not restated. Overall, results from Japan are very encouraging. While VA sales were down in the quarter, with a distribution arrangement with BOTM/UFJ, we expect sales to rebound in Q4/06. We continue to expect results in Japan to benefit from an improving macroeconomic environment and new distribution initiatives by the company.

Reinsurance & Corporate

Reinsurance reported earnings of US$76 million in Q3/06 up from a loss of US$127 million in Q3/05. However, excluding US$165 million in losses related to Hurricane Katrina in Q3/05, earnings increased by US$38 million due to favourable claims experience, especially in Life Reinsurance. The corporate segment reported a gain of $29 million, down from $106 million in Q3/05 and up from $18 million last quarter. The decline from the prior year is due to lower investment income on assets backing capital compared to unusually strong investment results last year. In Q3/06 MFC’s results were negatively impacted by a JHF pre-merger tax assessment of $36 million, or $0.02 per share.

Given the unpredictability of earnings from Reinsurance and Corporate, we generally combine these numbers versus our estimates. On a combined basis, reinsurance and corporate earned C$115 million, which was less than our estimate of C$120 million.

Asset Quality, Capital & Buyback

Gross impaired loans increased slightly to $646 million from $611 million last quarter, but are down from $984 million a year ago. Similarly net impaired loans increased by $46 million from Q2/06, and are down $263 million from Q3/05. The company’s asset quality is improving. Provisions for future credit defaults in actuarial liabilities declined slightly to $2,710 million in Q3/06 from $2,737 million in Q2/06. The decrease reflects the impact from currency and a reduction in below investment grade bonds, which have fallen to $4.5 billion at the end of Q3/06 from $4.7 million last quarter.

Manulife’s main operating subsidiary, Manufacturers Life Insurance Company, had an MCCSR of 210% in Q3/06 versus 211% at the end of Q2/06. The John Hancock Life Insurance Company’s Risk Based Capital Ratio (RBC) remained stable at 359% over the same period. Manulife remains very well capitalized with over $3 billion in excess capital. The CTE level increased to 73 from 68 last quarter and is down slightly from 74 in Q3/05.

The company increased its quarterly dividend 14% to $0.20 per share. As well, Manulife repurchased roughly 17 million shares in the quarter and renewed its normal course issuer bid that will allow the purchase of up to 75 million shares, representing approximately 4.9% of the company’s common shares.

Valuation & Recommendation

We upgraded Manulife shares on July 24, 2003 (two months before the JHF acquisition) at roughly $20.50 and a quarterly dividend of $0.09. Since that time the shares have provided a total return of 99.2% versus the TSX composite of 78.4% and the TSX/S&P Life & Health index of 89.5%. Given the strong share price performance, we downgraded the shares to Market Perform from Outperform.

We continue to believe that Manulife is unique in Canada, and probably in the global insurance market, given its leading market positions in North America and world class Asian platform. Moreover, we continue to believe that the company can grow EPS at 15% compounded annually over the medium to long term. This should enable the shares to outperform the broader market over the long term. MFC maintains impressive amounts of financial flexibility enabling it to raise the dividend, buy back stock and make material acquisitions should opportunities present themselves. While we are downgrading the rating on the shares, Manulife should remain a core holding in any portfolio.

Given results in the quarter, we have adjusted our 2006E and 2007E EPS to $2.45 and $2.80 from $2.43 and $2.75, respectively. As mentioned, we believe that MFC can grow EPS at 15% per annum over the medium to long term and results in Q3/06 confirm that belief. However, achieving this target in the shorter term may be challenging given unsustainable high investment gains in the institutional fixed business in 2006 and the fact that interest rates remain low.

On valuation, we believe that MFC is fairly valued at 15.6x 2006E EPS and 13.6x 2007E EPS. As indicated in past research comments, we do not believe that MFC is overvalued but it is unreasonable to expect further valuation improvements from these levels. However, we note that other large cap financial services companies, like some banks, trade at comparable multiples to Manulife. In this case, we continue to believe that Manulife has much superior long-term earnings and dividend growth potential than any of the Canadian banks.

The new target price of $42 reflects 15x 2007E EPS.
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RBC Capital Markets, 3 November 2006

• A Solid Result. Q3 EPS of 62¢ was up 35% YoY, or a more sustainable 14% excluding the large prior year reinsurance hurricane losses. Foreign exchange cost 4¢, suggesting underlying constant currency EPS growth was ~20% YoY. The only unusual item was a 1¢ hit for unfavourable outcome on a tax assessment relating the John Hancock deal – arguably the underlying EPS result was 63¢, right in line with our estimate. Consensus estimate was 62¢.

• An Investor-Friendly Quarter. Return on equity was an impressive 16.6% in quarter, the highest recorded since the John Hancock deal closed. MFC also hike the dividend to 20¢ per quarter, up 14% from previous the 17.5¢ level. MFC also refreshed its normal course issuer bid at 75MM shares, roughly 5% of the float outstanding. Manulife generated 6% growth in expected profit from the in-force block, up 14% in constant currency. Manulife also grew new business Embedded Value by 32%.

• Holding Q4 EPS Expectation. Management highlighted that the recent drop in bond yields effectively eliminates the potential for year-end reserve releases from Manulife’s significant interest rate reserves. We had been anticipating this development and it does not affect our current Q4 estimate of 67¢.

• Healthy Divisional Results. MFC just registered tremendous growth in its U.S. operations, reflecting continued excellent execution on the John Hancock deal, with earnings up: 19% in the life segment; 27% YoY in long-term care, and; 21% in wealth. Earnings in Asia jumped ~30% (in USD), while the Reinsurance division contribution roughly doubled. Contribution from the Canadian operation was relatively flat, reflecting the added cost of increased life sales, and a pull-back in wealth sales.

• Valuation. We are raising our one-year price target to $46 from $43, now calculated at 14x our new 2008 EPS estimate of $3.25, just introduced. This price target is also indicated at ~2.6x our prospective book value estimated at $17.42. We set our target P/E at a 1 point premium to the sector to reflect Manulife’s superior long-term earnings growth track record (15%+) and 16-18% ROE, both exceptional for a large, integrated lifeco. We believe EPS growth may also benefit from a stabilization in the USD, and/or weakness in the CAD.
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Scotia Capital, 3 November 2006

What It Means

• A good quarter with strong bottom-line growth (EPS ex one-timers in Q2/05 was up 14%), while top-line growth was "average".

• We forecast 18.4% ROE in 2008, which justifies a superior P/BV multiple of 2.5x, and our $41 target (increased from $38). Our P/BV versus ROE regression line yields a 2.5x BVPS multiple for a forecasted 18.4% ROE (helped in part by continued 40 million shares repurchased annually through 2008).

• Manulife's premium multiple (forward P/E basis) to the group is now 7%, well above its 2%-3% average. We believe further growth in the premium relative to the group is less likely, as we expect the significant market share gains the company made in the last half of 2005 and the first half of 2006 less likely repeated in the next 12-18 months.

Strong Q3 2006

• Good quarter with strong bottom-line growth (EPS ex one-timers in Q2/06 was up 14%), while top-line growth was "average". EPS of $0.62, with $0.02 in an unfavourable tax assessment, puts the underlying number at $0.64 per share, $0.04 above our estimate and $0.02 per share above consensus. Strong equity markets in the U.S. in particular, as well as favourable investment gains and favourable claims experience, especially in reinsurance (where we estimate very favourable mortality experience boosted EPS by $0.02), all contributed to the solid bottom line EPS growth of 14%, excluding one-time items in 2005.

The top-line growth was less than what we've become accustomed to with Manulife, and perhaps was somewhat mixed. While individual insurance sales were robust in Canada and the U.S. (up 19% and 13% respectively), wealth management sales in Canada and the U.S. were more "average", with Canadian individual segregated fund sales down 42%, Canadian mutual fund sales down 24%, U.S. variable annuity sales down an unexpected 8%, U.S. variable annuity net sales down 28%, Japan variable annuity sales down 55% (largely expected) and Japan insurance sales down 31%.

• Rapidly increasing ROE. Manulife's ROE keeps increasing at a rapid clip (up 100bps in last three quarters to 16.6%), helped by part by solid EPS growth (14% in the quarter, and 13% CAGR from 2002 through 2005), but also by the rapid level of share buybacks, running at a pace of 10 million shares per quarter. With over $3.3 million in excess capital Manulife certainly has the means to continue to buyback stock as well as increase its dividend in the 15% range every nine months. The 14% dividend increase was largely expected.

• We forecast 18.4% ROE in 2008 - which justifies a superior P/BV multiple of 2.5x - and our $41 target. Our P/BV versus ROE regression line yields a 2.5x BVPS multiple for a forecasted 18.4% ROE (helped in part by continued 40 million shares repurchased annually through 2008).

• Manulife's premium multiple (forward P/E basis) to the group is now 7%, well above its 2%-3% average - more likely to contract than expand. We believe further growth in the premium relative to the group is less likely, as we expect the significant market share ains the company made in the last half of 2005 and the first half of 2006 less likely repeated in the next 12-18 months.

• Sensitively to equity markets becoming more apparent. The company's U.S. division had a strong quarter, with earnings up 40%, helped by buoyant equity markets and favourable investment experience in the U.S., whereas the company's Canadian division had a 3% decline in earnings, owing in part to more sluggish Canadian markets. With reserves for guarantees on segregated fund and variable annuity business effectively "marked-to-market" each quarter, and a large chunk of equity in its excess capital, as well as hybrid securities both in the company's corporate and fixed product portfolios, we find the company to be increasingly sensitive to equity markets in general. We estimate that each 10% move in equity markets is worth about $0.15 per share. Finally, we would expect that in the new accounting regime, when assets supporting surplus are "marked-to-market" and realized gains and losses on assets supporting surplus are immediately recognized, that Manulife's earnings will be the most volatile of the Canadian lifecos. This additional volatility, in our opinion, is a negative.

• U.S. Division up 40% in the quarter and 22% YTD (ex f/x) on strong equity markets, favourable investment experience and good claims experience. We found the 90% increase in the fixed products segment, essentially the de-emphasized fixed annuity and guaranteed & structured products segment, to be the most unexpected. Investment gains, which management indicated are less likely to recur going forward, contributed to the increase. Management expects assets and hence earnings in this largely de-emphasized segment to slowly decline going forward. As it accounts for 1/3 of the U.S. divisions earnings, we estimate a gradual decline in earnings in this segment will force earnings in the U.S. division to increase in the 9%-10% range going forward.

• Top-line growth in U.S. - starting to suggest the company is a "maintain" rather than "gain" market share play. Variable annuity sales, which we down 8% over a strong Q3/05, should get a lift form new product offerings in the fall of 2006. That said, we were quite impressed with the 19% growth in individual insurance sales, the 27% growth in long term care sales. The 401(k) sales, up just 9% excluding a one-time transfer from the John Hancock defined contribution plan, was a modest disappointment. We expect the company's top-line growth in the U.S. to be more in-line with the industry (mid-teens for variable annuity, and mid to high single digit for individual insurance). Management indicated that universal life sales would likely come under pressure in what is becoming a very competitive market. When you are the largest in the industry it is increasingly more difficult to grow exceptionally faster than the industry, in our opinion.

• Earnings for Canadian division down 3%. A weaker-than-expected quarter in Canada, with unfavourable markets and unfavourable claims experience. Segregated fund and mutual fund net flows continued to slide, and, for the first time ever, were negative. A new segregated fund product, expected to be launched in Q4/06, should help. A positive was individual insurance sales, which increased 13%, after declining over the last several quarters. All in, we expect the Canadian division to increase earnings in the 8%-10% range going forward. 15% earnings growth in Canada is a tall order, in our opinion, unless equity markets are particularly buoyant.

• Hong Kong strong - up 32% on the back of strong wealth management sales - Other Asia strong - up 31%. Hong Kong led the Asian operations (ex-Japan), with 32% YOY increase in earnings in Q3/06 on a USD basis (operations are pegged to the USD), led largely by excellent growth in wealth management sales and the associated improved fee income. Wealth management sales in this division continue to grow (sales up 24% in Q3/06 after increasing 81% in Q2/06, and increasing 107% in Q1/06) as the company benefited from recently launched new mutual funds and buoyant equity markets.

• Japan up 29% ex Q3/05 tax gain due to higher asset growth and higher related fee income. VA sales down 55% as expected but should rebound with new product expected to be launched November 13, 2006. While we believe the Japanese variable annuity market is a growth market, we note that competitors such as Hartford Life, whose variable annuity sales in Japan were down 48%, are seeing significantly increased competition in this market, particularly from domestic players. Clearly the momentum in Manulife's variable annuity sales growth is declining, but should improve somewhat with the launch of the new product in November. In addition, individual insurance sales continue to decline, down 22% in quarter and 20% YTD, as the number of agents, continues to decline, down 10% YOY and 1% QOQ. Clearly earnings in Japan are benefiting from asset growth in variable annuity, favourable markets, and a much improved investment climate. We believe a real catalyst for the division could be a potential deal with BOTM to distribute individual insurance products via the bank's branches when the industry further deregulates at the end of 2007.

• Asset quality continues to improve. Below investment grade bonds fell 5% QOQ to $4.5 million, due to sales and prepayments. Below investment grade bonds now represent 4% of the company's bond portfolio, down from 5% on Q2/06.
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TD Newcrest, 3 November 2006

Impact

Neutral. From an earnings perspective, MFC’s Q3/06 results were satisfactory, but not of the same quality we’ve come to expect from this company, as sales show some disappointing trends. Having been spoiled in the past with exceptional organic growth rates, it is surprising to see MFC experience troubles in several key divisions due to competitive forces and specific issues. That said, in a market currently looking for security, stability and yield, we believe MFC deserves to trade at a premium valuation – we are keeping our 2007 target valuation multiple at 15 times. A slight increase to earnings estimates has resulted in an increase to our price target to $43 from $42. We are lowering our recommendation from Action List Buy to Buy.

MFC's profits were up nicely in several divisions, as shown in Exhibit 2. We are slightly concerned about the overall quality of the earnings outperformance given that the weakness in the important Canadian division was offset by unusually strong reinsurance results (which are typically volatile). This issue also materialized in Sun Life and Great West’s earnings this quarter. Clearly the Canadian life insurance oligopoly isn’t behaving like one.

Sales: Not the MFC of Old

We believe MFC shareholders pay a premium for its track record of superior organic growth rates. The company enjoyed some healthy sales in a few divisions (e.g. Canada and U.S. insurance), however, other divisions that we've seen grow at 20%+ in past quarters have slowed down considerably (see Exhibit 3). In part, we believe this has translated into negative value of new business (VNB) growth this quarter, which is a major swing from MFC's past strong performance that easily outpaced its peers. The company made several announcements with regards to new product launches that should turn the tide. Given MFC’s track record of leveraging its strong product development capabilities through its best-in-class distribution, we are optimistic it can improve on lackluster results and improve its VNB growth. That said, markets where it has seen significant declines, such as U.S. and Japan VAs, have become intensely competitive, and the significant revenue synergies with John Hancock have largely been realized for over a year.

Capital Deployment Should Provide Effective Support for the Stock

MFC continued its healthy buyback pace this quarter, repurchasing $389 million worth of shares. It also increased its annual dividend 14% to $0.80. Over the past twelve months, MFC has returned 73% of its operating earnings to shareholders via dividends and buybacks. We believe this level of return of capital should continue, providing effective support to the share price and satisfy investors seeking yield alternatives.

Justification of Target Price

Our $43 (up from $42) price target equates to 15x our 2007E EPS. We believe the following elements justify the premium: (1) if MFC makes a large acquisition, we believe its stock price will benefit; (2) aggressive buy back program; (3) growth potential in Asian regions; and, (4) in our view, it has the best long-term growth prospects of the group.

Key Risks to Target Price – Overall Risk Rating: Low

(1) U.S. dollar deterioration relative to the Canadian dollar; (2) confusion with US GAAP reconciliation; (3) sudden interest rate spikes; (4) significant downturn in equity markets; (5) regulatory scrutiny into industry sales practices; (6) potential for underpriced business translating into margin deterioration; and, (7) inability to source meaningful acquisitions

Investment Conclusion

Perhaps we’ve just gotten too spoiled in the past, and have unrealistically come to expect MFC to produce stellar earnings and market share growth every quarter. This was certainly not a bad quarter for sales, but the negative VNB trends during the period are quite concerning, which speaks to lower volumes, and also likely lower margins the company is earning on its sales. Certainly in Canada, competition seems to have heated up in several areas, and internationally, several large players seem to be toughening their resolve.

While removing the stock from our Action List to reflect the slower sales momentum and stock valuation, we definitely emphasize that MFC remains in our opinion one of the best companies in Canada, and has established an international platform that we expect will provide superior long-term shareholder value. We are looking forward to seeing how sales trends develop over the next two quarters.
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