Analyst note
(09/03/2010)
On March 1, 2010, Prudential announced it had reached an agreement with American International Group to purchase AIG's AIA life insurance operations in Asia. The acquisition is expected to close in the third quarter of 2010. Prudential's consideration would total nearly $36 billion, including $25 billion in cash and the balance in various Prudential equity interests. Prudential plans to raise the cash component through a rights offering and new senior debt.
AIA is one of the largest life insurance and asset management firms in Asia, dating back to the early 1900s. AIA has over 20 million policies in force. The firm appears relatively well-capitalised, as AIA claims its solvency ratio runs twice as high as statutory requirements. In an SEC filing in early March, Prudential reported that AIA produced a return on equity of 15% in 2009, with an operating margin of 16% and net profit of $1.7 billion in 2009 as well.
Although it appears that Prudential may pay a relatively high price for a relatively strong life insurance franchise, our fair value estimate is unchanged. AIG does not break out financial results separately for AIA, and we're awaiting that disclosure.
Read my initial reaction to the acquisition news here.
Fair value estimate: 385p ¦ Uncertainty rating: Very high ¦ Economic moat: none
Thesis
(24/02/2010)
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 Kingdom, United States, 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.
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 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
Our fair value estimate is 385p. Our fair value estimate is a weighted average of three scenarios. We have modest earned premium revenue growth assumptions and project a 5% premium growth rate fading to 3% growth in 2013 in our base scenario. Our assumptions lead benefits and claims to average 138% of earned premium revenue through the forecast horizon in this base case. We also assume a 13% cost of equity, giving us a base-case fair value estimate of 367p per share. We weight this base scenario 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 103p. We also recognise a 20% possibility for a 2% increase in the value of the investment portfolio on top of our existing investment return assumptions, along with slightly better insurance profitability, increasing our fair value estimate to 723p 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.
