Following Prudential's withdrawal from an agreement to buy AIG's Asian life insurance operations, Morningstar senior equity analyst Bill Bergman has adjusted his fair value estimate and reviewed his analysis of the company's long-term prospects. Below is Bergman's updated research report on the UK insurer, as at June 2, 2010.
Analyst Note
On Tuesday morning, American International Group announced that it would "adhere to the original terms" of its agreement to sell its Asian AIA Group life operations to Prudential. In turn, on Tuesday evening, Prudential entered into talks with AIG to terminate the transaction. The original terms had appeared increasingly expensive to Prudential's shareholders, whose opposition to the transaction gained greater traction amid heightened turmoil in European capital markets in recent weeks.
We have had a very high uncertainty rating on Prudential in part due to the shifting probability and uncertain value of the AIA transaction. The scuttling of the deal has mixed implications for the risks facing Prudential's shareholders. AIA would have offered Prudential greater international diversification and stronger but uncertain growth prospects, together with heightened control and integration risks. We were concerned that Prudential may have been pursuing an expensive and risky growth strategy and, on balance, view the withdrawal of the offer positively for Prudential's shareholders. We have chosen to modestly boost our underwriting profitability assumptions in our downside as well as upside and base scenarios.
Prudential remains a highly-leveraged financial services firm operating in competitive markets. While an upside case is possible in a scenario that includes further recovery in its investment portfolio, we believe these shares remain appropriate only for investors with significant risk appetites.
Fair Value Estimate: 467p ¦ Uncertainty Rating: Very High ¦ Economic Moat: None
Thesis
Prudential has a long and largely successful history in consumer financial services delivery and has developed an extensive franchise serving savings and retirement needs in the United States, United Kingdom, and Asia. Prudential's roots lie in the development of a mutual life insurance and lending association in the UK in the mid-1800s, and it has grown to serve over 20 million individual customers. We view life insurance and related businesses cautiously from a moat perspective, but we respect Prudential for having developed relatively successful operations in a challenging marketplace. The firm appears positioned to gather market share after performing relatively well during the financial crisis in recent years. (Read this article for more on how Morningstar measures economic moats.)
Prudential is organised around four main business units: Prudential UK & Europe, Prudential Asia, Jackson National Life (in the US), and the asset management arm M&G Investments. Its life insurance units share common elements but face unique challenges in their various markets. Prudential is one of the largest annuity providers in the UK, and this unit has recently endured one of the recurring challenges to sustainable returns in the insurance business. Following regulatory changes several years ago, Prudential shifted its focus from with-profit policies (policyholders exposed to investment returns) to shareholder-backed policies (shareholders bearing investment risks). The timing of this shift did not work out well, to be sure, but the sting has faded with improvements in equity markets in the last year.
Prudential's Jackson National Life unit had been growing and gathering significant market share from 2002 to 2007, but its revenue was hit relatively hard in 2008 given its emphasis on variable annuity products and the exposure to the equity market. Still, Jackson looks to have been managed conservatively and well through this difficult period, and its capital held up very well compared to peers'.
Prudential's best growth prospects still appear to lie in Asia. A head start has allowed Prudential Corporation Asia to develop an impressive foothold in the region with an effective product distribution network of over 400,000 tied agents. The firm also gained a strategic boost when selling Egg, its UK Internet banking and insurance business, to Citigroup and gaining life insurance distribution rights for Citi's banking customers in Thailand, Indonesia, and the Philippines.
Valuation
We have raised our fair value estimate to 467p per share from 385p after Prudential's withdrawal of its offer to purchase AIG's AIA Group life insurance operations in Asia. While costly, we think the benefits of terminating the transaction outweigh the costs. We have lifted our underwriting profitability assumptions modestly, and raised the assumed price of a dilutive 2011 capital raise in our downside scenario. Our fair value estimate remains a weighted average of three scenarios. We have modest earned premium revenue growth assumptions averaging 4% through 2013 in our base scenario. Our assumptions lead benefits and claims to average 136% of earned premium revenue through the forecast horizon in this base case. We assume a 13% cost of equity, giving us a base-case fair value estimate of 429p, which we weight at 60%. Because Prudential operates with a high level of financial leverage, making even moderate investment losses difficult for the firm's small sliver of equity to handle, we've also factored in a 20% chance that the investment portfolio will lose some value and force the firm to raise capital in 2011, as well as modestly lower insurance profitability, diluting our fair value estimate to 205p. We also recognise a 20% possibility of an increase in the value of the investment portfolio on top of our other investment return assumptions, along with slightly better insurance profitability, increasing our fair value estimate to 845p in this upside case.
Risk
Although debt levels have come down in recent years, Prudential still operates with a high level of debt as a percentage of equity, even compared with other life insurers. Prudential also has a higher percentage of assets invested in equities compared with its peers, increasing the risk that a large market downturn will do damage to the firm's balance sheet. Also, the firm's elevated financial leverage magnifies the effects on shareholders' equity of moderate changes in revenues, investment assets, and reserve liabilities. Our uncertainty rating is very high.
Management & Stewardship
Tidjane Thiam, Prudential's CFO since 2007, has recently succeeded former CEO Mark Tucker after four years in the top spot. Prior to joining the firm, Thiam worked for five years at rival Aviva. We don't expect any significant changes in direction under the leadership of Thiam. The firm has also recently had some turnover on the board of directors, with Harvey McGrath taking over as chairman from David Clementi, who had been in the position since 2002. McGrath has decades of experience in the financial-services industry with Chase Manhattan and Man Group. Not only are we pleased to see that the roles of chairman and CEO are split, but we also welcome the majority-voting provision for the election of Prudential's board of directors.
Overview
Growth: Prudential has not been able to generate consistent growth for the better part of a decade in its operations in the mature UK and US markets. Continuing expansion into the Asian market will determine the company's growth going forward.
Profitability: We forecast that average returns on equity through 2013 will mimic their performance of the last four years. However, we expect margins to decline over time as competition in Asia and a changing UK product mix pressure the firm's pricing.
Financial Health: Although Prudential has been consistently lowering its debt/equity ratio, it is still high relative to its peers'. Even though its cash flows should be sufficient to meet interest payments, the firm's leverage leaves little cushion for equityholders to absorb blows from investment losses.
Profile: With operations in the UK, US, and Asia, Prudential is truly an international financial-services giant. It operates under its own name in the UK and Asia, and as Jackson National Life Insurance Company in the US. The firm's main products include life insurance, pension, and annuities, which it distributes via a network of independent financial advisers, bank branches, and direct marketing.
Strategy: Prudential targets the attractive demographics of the retired or approaching-retirement global population by cross-selling insurance and savings products. It operates a decentralised business platform with autonomous management in each international market. The asset-management business and emerging Asian markets will continue to present the key growth opportunities.
Bulls Say
1. Prudential is in an enviable position to capitalise on the growing Asian market's increasingly attractive demographics.
2. Jackson National Life is a low-cost operator in the US, with impressive product innovation and a relatively strong capital position, at least relative to other life insurers.
3. Prudential's multichannel distribution and widening product mix should help the firm increase share in the consolidating UK market.
Bears Say
1. Margins may come under pressure as competition heats up in Asia and Prudential's UK product mix changes in favour of lower-margin products.
2. Historically, Prudential's cash flows from operations have been inconsistent, and they could find themselves needing to raise capital at the wrong time.
3. Prudential is highly dependent on investment income for its profitability.
4. Exposure to many developing markets in Asia creates foreign exchange and geopolitical risk for Prudential.
Bill Bergman is a senior equity analyst with Morningstar.
