Manulife: A Canadian Insurer With Compelling Growth Potential And Yield

Oct.25.13 | About: Manulife Financial (MFC)

Summary:

The author sees a 26% upside for Manulife due to its attractive Asian exposure and positive leverage to rising interest rates. The encouraging sales trends in its U.S. and Canadian divisions further enhance the positive outlook on the company. The current dividend yield of 3%, which is higher than the 10-year treasury yield of 2.5%, provides investors with adequate income while they wait for future growth.

About the Company:

Manulife Financial (NYSE:MFC) is the largest life insurance company in Canada by market capitalization. Manulife operates in Canada, U.S.(under the John Hancock brand) and Eastern Asia. Manulife generates 43% of its earnings from the U.S., 28% of its earnings from Canada and 29% of its earnings from Asia.

Manulife's shares underperformed since 2010 because it was facing charges on legacy products sold prior to the financial crisis that guaranteed high returns for policyholders. Because of the Fed's zero interest rate policy, long term rates were pushed to record lows and a low interest rate environment is the worst enemy of a life insurer. Nonetheless, the shares rallied this year and is up 40% YTD because management has rebuilt the balance sheet, re-positioned its sales mix towards non-guarantee products and increased its hedged book to lower its market exposure. Management continues to target core earnings of $4 billion (around $2.22 per share) and ROE of 13% by the end of 2016. Fiscal 2012's core earnings were $2.2 billion (around $1.22 per share) and adjusted ROE for 2012 was 9.5%.

Investment Thesis:

Manulife provides excellent exposure to growth in Asia and the rising interest rate environment. Manulife operates in Japan, H.K, Philippines, Singapore, Indonesia, Taiwan, China, Vietnam, Malaysia and Cambodia. Many of these Asian countries have GDP growth much higher than the 2% rate in U.S or Canada. Even if China's growth slows down, other countries like Vietnam, Thailand and Philippines are still growing rapidly, experiencing growth above 5%. In addition, the rise of the middle class in these country will increase demand for financial products which is beneficial for Manulife. The company has spent millions building its distribution channels such as partnering with local banks and other financial institutions. The author believes a lot of these efforts have not bear fruit yet and are not reflected in the current financial statements. Early indicators of success includes a 129% year-over-year increase in wealth product sales. Moreover, insurance sales in Asia also grew rapidly from $1,066 million to current $1,440 million. The economies of scale of its Asian business can provide enormous operating leverage in the future.

Also, Manulife will benefit substantially from a rising interest rate environment. Rates may be low now, but tapering will take place sometime next year and yields will gradually rise. In Manulife's latest quarterly report, a 100 basis point parallel shift in the yield curve will add $300 million to earnings (around $0.17 per share). Manulife's shares has jump considerably since Chairman Bernanke suggested tapering back in June and the share price did not retreat even after the Fed delayed tapering in September. Despite the delayed taper, rates will ultimately rise, which is positive for Manulife's bottom line thanks to the mark to market nature of IFRS accounting.

Finally, its businesses in Canada and U.S. are gradually improving. The company increased pricing on various products and defended its margins. Insurance sales are strong in Canada, experiencing 19% year-over-year growth in the latest quarter. U.S. insurance sales also improved. Sales of wealth products in U.S. and Canada are experiencing rapid growth with year-over-year increase of 59% and 26% respectively. Overall, improvements in the North American economy will lead to additional insurance and wealth sales, boosting Manulife's bottom line in addition to its Asian growth.

Valuation:

The intrinsic value of the shares, calculated by the author, is $22.75 or 1.75 times the current book value of $13. Before the crisis, Manulife traded at a price to book multiple of around 2. A 1.75 multiple is not unreasonable given the factors discussed above. The calculated intrinsic value of $22.75 is 26.4% higher than the current share price of $18. For U.S. investors, the price target is in Canadian Dollars because Manulife's reporting and functional currency is in Canadian Dollars. The $22.75 target translate to a price target of $21.88 for MFC's NYSE listed shares using today's USDCAD rate of 1.04. A rising interest rate environment and robust growth in its Asia business will lead to further multiple expansion. The stock is trading at 11.4X forward earnings and 1.4X book , not expensive despite the 40% gain YTD. Investors can also enjoy a 3% dividend while they wait, which is much higher than 10-year treasury yield of 2.5%.

Risks:

Falling rates and equity prices pose the biggest risk to Manulife. However, management has implemented important measures to combat low interest rates. The company's AFS bond portfolio will alleviate some mark to market losses as rates decline. Also, the management lowered earnings sensitivity to interest rates. Back in 2009, the company could lose up to $2,000 million (around $1.11 per share) if rates drop 100 basis points. However, with the current hedges in place, the company is only expecting a bottom line hit of $500 million or (around $0.28 per share), effectively reducing the interest rate sensitivity by 75% since 2009. If the company liquidates a portion of its AFS bonds, it can completely offset the $500 million loss. Also the company had zero equity hedges back in 2009 but 81% of its equity exposure is now hedged. The company also reduced its sale of guarantee products significantly and currently focuses mainly on fee-based products. All in all, the risk management activities implemented by management since 2009 will help Manulife mitigate the impact of lower rates and equity prices.

Table 1: MFC Quick Facts

Dividend Yield

2.9%

Normalized P/E (E=Adjusted Earnings)

14.0X

Forward P/E

11.4X

P/B (Most Recent Quarter)

1.4X

Adjusted ROE (Average Last 4 Quarters)

10%

MCCSR (Most Recent Quarter)

222%

Click to enlarge

Source: Company Q2 Report. MCCSR is a capital ratio. Canada's regulator,OSFI, requires insurers to have a ratio of at least 150%

Disclosure: I am long MFC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is for informational purposes only and does not constitute an offer to buy or sell any securities discussed in the article. The stock mentioned in this article does not represent financial advice. The target price presented in this article are based on current information and are subject to change without further notice. Investors are recommended to conduct further due diligence before committing capital to any investment