Wednesday, May 02, 2007

Sun Life Q1 2007 Earnings

  
BMO Capital Markets, 2 May 2007

Investment Thesis & Outlook

Since upgrading SLF to Outperform in June 2005, the shares have provided a respectable total annualized return of 14%. We are downgrading the shares to Market Perform due to their recent relative share price outperformance and expectations that ROE improvements in the U.S. could take longer than expected.

When we upgraded the shares 20 months ago, SLF traded at 1.6x book value per share and we believed that there was valuation upside potential based on a rising ROE. ROE improved at SLF due to improve performance in some businesses, better internal capital management, and a consistent buyback program. In a report released on April 30 titled, 'The Key to Higher ROE Rests in the U.S.' we argued that further ROE improvement would need to come from the U.S. operations to close the ROE gap that exists between SLF and the rest of the large capitalization financial services companies in Canada. While we remain very encouraged by the top-line results in both Canada and the U.S., the expectation of continued heavy new sales strain from U.S. individual life for the balance of 2007 has reduced our confidence that this ROE gap can be narrowed, at least in the near term.

Despite the market's reaction to the company's results, we believe that there were some very encouraging trends in the Q1/07 results that bode well for future growth. Specifically:

• Top-line growth was strong in both Canada and the U.S. Net redemptions of domestic VAs declined again, to $133 million from $351 million in Q1/06 and $153 million in Q4/06. The new income storage product should sell well in the U.S.

• VNB rose 13% in the quarter and 18% for SLF’s non-MFS operations.

• Premiums and deposits in Canada, excluding managed fund sales (McLean Budden), rose to $4.5 billion from $3.8 billion in Q1/06.

• MFS reported 34% pre-tax margins and $0.2 billion in net inflows. Moreover, AUM is up 6% in April versus average AUM of US$189 billion in Q1/07.

• In-force profits rose 19% and in-force pro├× ts + earnings on surplus (both of which we would consider high quality earnings) represented 92% of operating pre-tax earnings.

• Total AUM rose 10% to $445.6 billion, adjusted for the impact of new accounting rules which added $4.5 billion to total AUM.

The concern on the results is a reflection of three issues in our view.

• Quarterly results included some unusual items including $0.07, or $43 million, in writedown of the Clarica brand, $0.03 or $18 million in early termination fees on some notes (both of these issues were pre-announced) and $0.03 or $17 million associated with tax provisions for withholding taxes.

• Assumption changes added $163 million (pre-tax) to earnings, representing 23% of pre-tax operating earnings. This result is greater than the total assumption changes for annual results in 2005 and 2004 and 86% of the result in 2006. We estimate that $40 million came from the U.K., $20 million from Group benefits in Canada and a smaller amount from Group wealth in Canada.

• The large contribution of assumption changes was mostly offset by a significant jump in new sales strain to $152 million in the quarter from $60 million in Q1/06 and $108 million in Q4/06. A significant portion of the strain came from the U.S. individual life (estimated at roughly $60 million). While we were hopeful that SLF was closer to addressing the high strain, management was cautious in their guidance that this situation could persist for most of 2007. U.S. individual life earned US$5 million in the quarter and given that the offshore life business remains extremely profitable but represents less than 20% of the business, the core U.S. life business is facing growing pains over the next two to three quarters.

We reduced our 2007E and 2008E EPS by $0.10 to $3.90 and $4.30, respectively. The majority of the decrease reflects a higher Canadian dollar. Our previous estimates used $0.85 and the current estimates use a F/X rate of $0.90. We also reduced our earnings projections for U.S. individual life to US$5 million per quarter from US$14 million per quarter. We reduced our target price modestly to $55.50 from $57.00, which represents a target multiple of 13x 2008E EPS, which is consistent with past target multiples, and 1.85x 2007E BVPS (excluding OCI) of $30.00, which is a slight decrease in target multiple to 1.9x.

Conclusion & Recommendation

Since upgrading SLF to Outperform in June 2005, the shares have provided a respectable total annualized return of 14%. We are downgrading the shares to Market Perform due to their recent relative share price outperformance and expectations that ROE improvements in the U.S. could take longer than expected.

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Scotia Capital, 2 May 2007

Event

• Sun Life reported Q1/07 EPS of $0.96 EPS. We peg underlying EPS at $0.93, for a $0.01 miss from our estimate and a $0.03 miss from consensus.

What It Means

• We believe the current stock price does not reflect the fact that the U.S. new business strain issue will likely be substantially eliminated by 2008, nor does it reflect the increasing momentum in the company's top-line and asset growth, where Q1/07 results were exceptional.

• We believe far too much attention was given to the issue of U.K. reserve releases (added $0.07 EPS to the quarter) other U.K. one-timers (added $0.02 EPS to the quarter) and U.S. individual insurance new business strain (negatively impacted EPS by $0.06 in the quarter).

• Trading at 11.4x 2008E EPS (cheaper than all other Canadian lifecos, cheaper than the five major Canadian banks, and cheaper than all major U.S. lifecos except Genworth) with 12% EPS growth through 2008, we believe SLF is compelling value.

Details

• Missed our estimate by $0.01 but missed consensus by $0.03. Sun Life reported Q1/07 EPS of $0.96 EPS, $0.02 per share above our estimate, and in-line with consensus. We peg underlying EPS at $0.93, for a $0.01 miss from our estimate and a $0.03 miss from consensus.

• Solid top-line growth and solid asset growth. In every individual insurance segment (Canada, U.S. and Asia) sales were higher than we expected (up 16% in Canada, 83% in U.S. and 31% in Asia). In every group insurance segment premiums were higher than we expected (U.S. up 15%, Canada up 8%). In every wealth management segment assets were higher than we expected (helped by 13% growth in Canadian individual wealth management sales, 39% growth in U.S. variable annuity domestic sales, 62% growth in U.S. variable annuity net sales, 16% growth in MFS mutual fund sales and a US$500 million swing in MFS total net sales to positive US$200 million).

• We believe the current stock price does not reflect the fact that the strain issue will likely be substantially eliminated by 2008, nor does the current stock price reflect the increasing momentum in the company's top-line and asset growth. Overall the $0.96 reported EPS (15% EPS growth, or 12% ex f/x), as per management, reflected the underlying and ongoing earnings power of the company. The fact that expected profits on in-force business were up 19% YOY, building on the 18% in 2006 (twice the growth level of Manulife) speaks to the quality of earnings, in our opinion. We forecast 12% CAGR EPS growth through 2008. We believe far too much attention was given to the issue of U.K. reserve releases (added $0.07 EPS to the quarter) other U.K. one-timers (added $0.02 EPS to the quarter) and U.S. individual insurance new business strain (negatively impacted EPS by $0.06 in the quarter).

• We peg the underlying EPS at $0.93 (see Exhibit 1). We were expecting new business strain of $0.02 per share in the U.S. individual insurance segment, slightly less than the $0.03 per share in Q4/06, as we believed a recent debt offering would have served to alleviate the issue to some extent and provide a partial funding solution to what clearly are onerous AXXX reserves required for U.S. statutory purposes. Such was not the case. The strain was $0.05-$0.06 per share, and higher than in Q4/06 due to business mix reasons (sales of the universal life product contributing to the strain issue were up 40% QOQ), and the debt was not used to provide any funding arrangement. As such, we are reducing our 2007E EPS estimate by $0.05 to reflect higher new business strain than initially expected, but assuming a funding arrangement is in place by the end of 2007 we are leaving our 2008E EPS estimate unchanged.

• We believe consensus, at $0.96 was at least $0.02 too high - making the apparent "miss" larger than it really was. There is a bit of seasonality in this business that we believe the Street may not understand. Over the past 5 years Q1 operating EPS has averaged 23.5% of the full year EPS, which would imply $0.94 in Q1/07 using the $4.00 2007 consensus estimate. We were $0.05 above consensus for 2007E EPS and $0.02 below consensus for Q1/07E EPS.

• Lots of talk about new business strain in the U.S. - it’s a timing issue and not a profitability issue - furthermore it's largely a 2007 issue, not a 2008 issue. New business strain is a loss at issue of a policy to the extent that the initial acquisition expenses (commissions, etc) are not fully offset by other income statement items (premiums, investment income, change in reserves) because reserves may be unusually high at policy issue, largely caused by onerous U.S. regulatory requirements (AXXX reserves). The higher the sales the higher the level of strain. The strain merely shifts the timing of the profits of the product; profitability is the same over the life of the product, it's just that strain defers the time until profits reach the bottom line.

• Once a funding arrangement is put in place, which the company conservatively expects to be by the end of 2007, a significant chunk of the strain ($0.05-$0.06 per quarter) will go away (we've conservatively estimated one-half, or about $0.03 per quarter, will go away). The company is actively looking for AXXX funding solutions and reiterated its expectation of having one in place by the end of 2007. Once the mechanism is in place, which effectively securitizes deferred profits allowing the timing of which to be altered and "fronted" to some degree, a large portion of the U.S. individual insurance strain ($0.05-$0.06 per quarter) will immediately go away (we've conservatively estimated one-half will go away, in all likelihood it could be more). One possible solution/mechanism to alleviate the strain of AXXX reserves is through a separate reinsurance captive company Sun Life would set up in South Carolina, Vermont, or perhaps "offshore". While the company continues to actively pursue a funding solution, two pricing actions, effectively price increases, one in January of this year and another in April, would help alleviate the strain issue to some extent. Given the normal six month lag for pricing to impact the bottom line, we expect some modest improvement in strain in Q3/07 and Q4/07. But it's not until the funding arrangement is put in place (we expect Q3/07 or Q4/07) that the strain issue will be effectively dealt with.

• In addition to $0.10-$0.12 improvement in YOY EPS we expect to see when the funding arrangement is put in place, we believe there could be an additional $0.05 to $0.12 EPS boost as the funding arrangement is applied retroactively to business written in 2007. Why penalize the stock now when not only could strain go away in 2008, but the hit to earnings in 2007 due to stain could be added back in 2008? Once the funding mechanism is put into place not only will we see the benefit of a significant decline in new business strain in the U.S. individual insurance (we estimate the impact will be about $0.10-$0.12 in 2008), but we believe we could also see the additional benefit of a reserve release that would "recapture" the earnings "hit" due to strain in 2007. Depending on the funding mechanism the company sets up, we could see the hit to earnings in 2007 due to strain, which the company has been "warehousing", perhaps positively impact the bottom line in 2008. That means in addition to the $0.10-$0.12 YOY EPS benefit due to the significant reduction in strain, we could see another $0.05 to perhaps $0.12 in additional EPS in 2008, as a reserve release due to the funding mechanism being applied retroactively essentially adds to earnings in 2008 and thus nullifying the losses due to strain in 2007. This additional $0.05-$0.12 EPS in 2008 is currently not in our estimates.

• We believe the U.S. division (20% of the bottom line), with an excellent and proven track record (14% earnings growth CAGR from 2002-2006) will be able to effectively deal with the strain issue by the end of 2007. Other challenges facing this division were effectively dealt with, such as the spread compression issue (U.S. annuity earnings declined 17% from 2002 to 2003 but subsequently increased 40% CAGR from 2003 to 2006) and the variable annuity sales issue (a revamping of wholesalers in 2005 helped Sun Life become the second fastest grower in its market share in Q3/06 and Q4/06, with Q1/07 so far tracking ahead of its peers). We believe its asset growth and top-line growth, combined with the additional benefit of Genworth acquisition ($0.05 per share accretion in 2008), will translate into a conservatively estimated 11%-12% CAGR earnings growth, ex f/x, through 2008 (excluding the additional impact of $0.05 to $0.12 in potential reserve release as the funding arrangement is retroactively applied). We expect a 5% decline in earnings for the U.S. division in 2007, and a 29% increase in earnings in 2008. We continue to believe the company will be able to augment its organic growth with a series of tuck-in acquisitions similar to the Genworth deal.

• Multiple versus the group looks attractive. Sun Life is trading at a 6% discount to the average forward (NTM) P/E multiple of the Canadian lifeco group, well below its 3.5% average discount over the last seven years and its 2% average discount over the last three years. We believe valuation is compelling at these levels.
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Bloomberg, Sean B. Pasternak, 1 May 2007

Sun Life Financial Inc., Canada's third-biggest insurer, recorded its slowest profit growth in six quarters because of costs to scrap its Clarica brand. The stock had its biggest one-day drop in nine months.

First-quarter net income rose 1.2 percent to C$497 million ($447.9 million), or 86 cents a share, from C$491 million, or 84 cents, a year earlier, the Toronto-based company said today in a statement. Revenue rose 5.1 percent to C$5.58 billion.

Operating profit rose 13 percent, matching analysts' estimates, after equity gains in the U.S. and Canada increased fund sales at Massachusetts Financial Services Co. and CI Financial Income Fund. Canada's Standard & Poor's/TSX Composite Index rose 2 percent in the quarter, and industry fund sales have risen nine straight months, according to the Investment Funds Institute of Canada.

``As long as the equity markets hold up, MFS should continue to do well for them,'' said Ian Nakamoto, director of research at MacDougall, MacDougall and MacTier Inc. in Toronto, which manages the equivalent of about $3.9 billion, including Sun Life shares.

Shares of Sun Life, the first of Canada's three biggest insurers to report first-quarter results, fell C$1.60, or 3 percent, to C$51 in 4:10 p.m. trading on the Toronto Stock Exchange.

Chief Executive Officer Donald Stewart said that the U.S. insurance businesses require an increase in regulatory capital, which will take the rest of 2007 to complete.

``One or two of the analyst reports I saw were perhaps more optimistic about timing than the real situation,'' Stewart said today in a telephone interview. ``These structures take some time to put in place.''

Earnings from MFS, the Boston-based fund unit, climbed 38 percent to C$72 million, as the unit's assets under management exceeded $200 billion for the first time. Overall Canadian profit from insurance and fund sales increased 6.8 percent to C$250 million, while U.S. insurance profit dropped 22 percent to C$98 million because of declines in its individual and group life products.

Stewart said today that the company isn't considering taking MFS public. Last year, the company considered selling part of the business before scrapping that plan.

Profit in Asia, where Sun Life has operations in Hong Kong, India and other countries, increased 58 percent to C$38 million.

Sun Life said net income was reduced by C$43 million for costs to scrap its Clarica brand of insurance products, which the company acquired in 2002.

Excluding one-time items such as Clarica and costs to retire debt, profit was 96 cents a share, matching the average estimate of 11 analysts in a Bloomberg survey.
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