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Principal Financial Group, Inc. (NYSE:PFG)

Q1 2010 Earnings Call

May 4, 2010 10:00 am ET

Executives

John Egan - Vice President, Investor Relations

Larry Zimpleman – Chief Executive Officer

Terry Lillis - Chief Financial Officer

Dan Houston - U.S. Asset Accumulation and Life and Health Insurance

Jim McCaughan - Global Asset Management

Norman Sorensen - International Asset Management and Accumulation

Julia Lawler - Chief Investment Officer

Analysts

Steven Schwartz - Raymond James

Andrew Kligerman - UBS

Jimmy Bhullar - JPMorgan

Suneet Kamath - Sanford C. Bernstein & Co. Llc

Ed Spehar - Banc of America/Merrill Lynch

Randy Binner - FBR Capital Markets & Co.

John Nadel - Sterne Agee & Leach

Thomas Gallagher - Credit Suisse

Operator

Good morning and welcome to the Principal Financial Group first quarter 2010 financial results conference call. There will be a question-and-answer period after the speakers have completed their remarks. (Operator Instructions).

I would now like to turn the conference over to John Egan, Vice President of Investor Relations.

John Egan

Thank you. Good morning and welcome to the Principal Financial Group's quarterly conference call. As always if you don't already have a copy, our earnings release, financial supplement and additional investment portfolio detail can be found on our website at www.principal.com/investor. Following a reading of the Safe Harbor provision, CEO, Larry Zimpleman; and CFO, Terry Lillis will deliver some prepared remarks. Then we'll open up for questions.

Others available for the Q&A are Dan Houston, U.S. Asset Accumulation and Life and Health Insurance, Jim McCaughan, Global Asset Management, Norman Sorensen, International Asset Management and Accumulation and Julia Lawler, Chief Investment Officer.

Some of the comments made during this conference call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act. The company does not revise or update them to reflect new information, subsequent events or changes in strategy. Risks and uncertainties that could cause actual results to differ materially from those expressed or implied are discussed in the company's most recent annual report on Form 10-K filed by the company with the Securities and Exchange Commission. Now I’d like to turn the call over to Larry.

Larry Zimpleman

Thanks John and good morning to everyone on the call. As most of you probably already know, John Egan recently joined The Principal as our new Investor Relations Officer. He is replacing Tom Graf who will be retiring later this month after 38 years of service with the organization. I’d like to take this opportunity to thank Tom for his significant contributions over the course of his career and to welcome John to the company.

Moving to results, first quarter was a very solid start to the year for The Principal as we delivered our best operating earnings quarter in two years and our best net income quarter in 2.5 years. Each of our growth engines delivered strong improvement in assets under management which coupled with ongoing expense discipline produced strong operating leverage.

It was a quarter in which the continuous implementation of our strategy even during the crisis began to show positive results and a quarter in which our investment portfolio continued to perform well and in line with our expectations.

Compared to the same period a year ago, we achieved strong improvement across a range of key measures. At $256 million, operating earnings were up $92 million or 56%, driving earnings per share up 25%. Net income was up $78 million or 69% as realized capital losses remain manageable and continue to emerge as expected.

Assets under management were up $57 billion or 24% to $293 billion. As of quarter end, we had recovered more than three-fourths of the drop in assets under management from our high as of yearend 2007 to our low on March 31, 2009.

Book value, including other comprehensive income per share, was up 212%. This reflects continued improvement in net unrealized losses including nearly $1 billion of pretax improvement in the first quarter for fixed maturity securities primarily from narrowing credit spreads.

In addition, on a sequential basis, total company operating return on equity improved to 11.5%, up 90 basis points from year end after improving 40 basis points in the fourth quarter. While down from a year ago, this reflects our May 2009 equity raise, the full impact of which will be realized next quarter.

Overall, across a broad range of measures, from the bottom line measures of operating earnings and net income, to top line items like sales, flows, and assets under management, results are emerging in line with or better than our expectations for the businesses.

While we’re benefiting from improvement in the credit and equity markets, we believe the results demonstrate continued strong execution of our diversified business strategy. This has enabled us to deliver very solid results even as high unemployment continues to affect each of our employee benefit businesses.

As the economy improves we expect to see an acceleration of our growth given that small and medium businesses have historically been the primary source of job creation. Terry will follow my comments with further detail on the quarter including a discussion of the investment portfolio. I’ll focus my comments on execution, our ongoing progress implementing our strategy to grow our asset accumulation businesses in the US, Latin America, and Asia, and our global asset management business.

On execution, our ongoing progress implementing our strategy to grow our asset accumulation businesses in the US, Latin America and Asia and our global asset management business. As I mentioned, operating earnings improved substantially from a year ago. Our growth engines, the US accumulation businesses, Principal International and Principle Global Investors contributed $90 million of our $92 million improvement, more than doubling from a year ago on a combined basis.

These gains reflect improvement in the investment markets, the depth and breadth of our asset management and accumulation offerings and our increasing momentum with key third party distribution alliances. The gains also reflect the ongoing positive benefits of our prior expense actions and continuing expense discipline which is producing strong operating leverage as assets under management continues to build.

In the first quarter 2010, the US accumulation businesses delivered $950 million of positive net cash flows, down from a year ago when we had a single large retirement sale but solidly better then the past three quarters. On $1.7 billion of sales in the first quarter, full service accumulation delivered $640 million of net cash flow. Total retirement suite accounted for 63% of sales during the quarter based on assets and continues to provide a competitive advantage in the marketplace. Driven by our steady improvement in sales, transfer deposits for the first quarter were 9% higher than our result for the last two quarters of 2009 combined.

Full service accumulation sales pipeline and “activity” continues to build steadily as advisors renew their focus on growing their businesses, though still down from 2008 levels. However, small business owners reported little pickup in their sales or confidence in March with only one of the ten components of the small business optimism index showing improvement.

The environment also continues to pressure recurring deposits which were down 5% or $170 million from a year ago. The good news is that many of these pressures our easing. For the first time in four quarters we saw a sequential increase in total eligible plan participants. And plan sponsors are beginning to restore matching contributions and we’ve seen a small number of employers re-hire eliminated positions. As a quick reminder, second quarter has historically been our lowest quarter of flows for this business with seasonally low sales resulting in seasonally low transfer deposits.

Moving to principal funds on $2.1 billion of sales, we delivered $110 million of net cash flows in the first quarter. This was our best quarter of flows since June 2008 and compares to an industry in outflow for the quarter. Excluding money market, principal funds achieved net cash flows of approximately $170 million for the quarter and more than $600 million over the trailing 12 months. Principal funds long-term sales improved 15% from a year ago.

This reflects continued success with our national channel of outside broker dealers, our largest distribution channel for funds which delivered a 35% improvement in sales from a year ago. It also reflects good success with recent product launches such as our global diversified income fund which captured $210 million of new investments in its first quarter of active marketing.

Global asset management had unaffiliated out flows of $1.2 billion in the first quarter. Institutional search activity in the US and around the world remains subdued and substantially below 2008 levels. Over the past couple of quarters, we’ve also seen out flows from our stable value funds due to rebalancing as well as rebalancing out of equities as some institutions have taken gains after the market run up.

But here again, we see an improving picture. Unaffiliated deposits increased more than 20% from year end including more than $1 billion of funding during the quarter from new clients. Recent new client wins have covered a wide range of offerings from large and small cap growth to [Asia] equities to fixed-income for clients in the US, Europe and Asia. We’re also seeing search activity pick-up in a number of areas. In North America where consultants are estimating that search activity will pick up by 10% in 2010 and in Latin American, Asia and the Middle East, where we’re seeing significant pick-up in search activity from sovereign investors.

Moving to Principal International, first quarter net cash flows was $700 million excluding money market withdrawals in India. Over the trailing 12 months Principal International’s net cash flows exceeded $3 billion or 13% of beginning of period assets under management. As announced last Friday, we signed a definitive agreement to renew our joint venture with Banco Brazil for an additional twenty-three years. Brasilprev is a pension market leader in Brazil reflecting the strength of Banco Brazil’s distribution platform as the largest bank in Latin America and The Principal’s expertise in retirement.

Our joint venture has enjoyed remarkable success in its first ten years, including compounded annual growth and operating earnings of 25% over the past five years and 30% compounded annual growth in assets under management. We believe that future opportunity is even greater as a result of recent acquisitions by Banco that further expand their distribution platform as well as their client base which now stands at 54 million customers. As an early sign of this, customer deposits since signing the Memorandum of Understanding in October 2009, are up 57% compared to the same period a year ago.

I mentioned earlier that we’ve continued to execute our global asset accumulation and asset management strategy even in the face of the financial crisis over the past two years. As another example of this, about a year ago we expanded our distribution relationship with Bank of America Merrill Lynch which previously covered mutual funds, separately managed accounts and nonqualified deferred compensation to also cover defined contribution plans and our offshore [Dublin] funds.

Over the trailing 12 months this relationship has produced $1.1 billion of sales on a combined basis. This translates into 27% growth over the same period ending a year ago and illustrates the competitive advantages we gain by offering multiple asset management and accumulation products on alliance partner platforms.

I’d also like to comment on our current equity and excess capital positions. At $8.7 billion at quarter end, stockholders equity is at its highest level for the principal as a publicly traded company. This reflects improvement in asset valuations, capital raising activities in 2009 and growth in retained earnings. Excess capital at $1.8 billion is also a historical high for the company.

This means that we are at one of the strongest financial positions in our history which is a positive that some environmental uncertainties remain. While we’re committed to holding higher levels of capital in the future, we believe our strong earnings profile and improved market fundamentals will present an opportunity to increase shareholder value over time. As always, we’ll look at capital deployment options in a disciplined and thoughtful way.

I’ll take one more minute to cover three unrelated areas. First, we believe that US commercial real estate have bottomed and that the rebound in the REIT and CMBS pricing will continue to provide additional positive momentum. This momentum will ultimately bring positive cash flows to the market.

Second, we’re seeing good results and positive feedback around our America Rebuilds Media and Advertising Campaign. Individuals are increasing their focus on financial planning and their commitment to savings. We expect this to have a very positive impact on The Principal brand.

Finally, I’d like to mentioned that we’ve been fortunate to receive some very important, third party recognition in 2010. For the eighth straight year, we were named a top 50 Company by the National Association of Female Executives. We received two [Lipper] fund awards for consistent multi-year performance and achievement that showcases our investment expertise and long-term view.

Brasilprev was recognized as the number one company in the pension segment for customer service. And The Principal was recognized again by the Ethisphere Institute as one of the world’s most ethical companies, one of only three financial services companies to make the list.

We believe these awards demonstrate the true character of the organization and that The Principal remains a company that customers and investors can rely on.

Terry Lillis

This morning I’m going to focus on three areas, operating earnings and how results are emerging as the economic recovery builds, net income, including the continued solid performance of the investment portfolio, and a strong capital position.

Starting with first quarter 2010 results, total company operating earnings improved $92 million or 56% compared to a year ago quarter. This reflects 20% higher average assets under management, prior expense actions and ongoing expense discipline. Against 19% growth and fee revenues from a year ago, we kept operating expenses essentially flat.

Our three asset and accumulation segments drove the improvement in operating earnings from a year ago. U.S. asset accumulation earnings improved $64 million or 69% on $22 billion or 16% higher average count values. Full service accumulation earnings increased $25 million or 49% from a year ago to $76 million for first quarter 2010, primarily due to a 24% increase in average account values.

Individual annuities earnings increased $26 million from a year ago to $31 million for first quarter 2010. The improvement reflects an 11% increase in average account values and $17 million in higher amortization in a deferred policy acquisition costs for first quarter 2009, primarily due to unfavorable equity market performance in that period. Principal funds earnings increased $8 million from a year ago to $10 million for first quarter 2010, primarily due to a 27% increase in average account values.

Principal International’s earnings improved $21 million up 123% from a year ago quarter. Roughly one-third of the improvement reflects strong performance on a local basis. The remainder reflects improvement from the unfavorable macro-economic conditions that dampened prior year quarter results. Principal International had added more than $12 billion of assets under management over the trailing 12 months to reach a record $35.7 billion at quarter end.

The gain reflects not only strong investment performance and favorable currency movements but also continued strong net cash flows as Larry noted. Principal global investors’ earnings improved $5 million or 76% on 13% growth and average assets under management. Excluding real estate where asset values declined modestly from a year ago, investment management fees increased 21%. At the same time PGI reduced total compensation costs by 2% and held total expenses flat. At $70 million in the first quarter compared to $72 million in the prior year quarter, earnings for the life and health insurance segment were also solid.

Individual life earnings were $31 million compared to $23 million a year ago. The increase reflects growth in the block of business and ongoing expense management. Premium deposits for the division are up 13% from a year ago reflecting a strong increase in single premium universal life sales and steady improvement in UL and BUL renewal deposits. The health division had operating earnings of $26 million in first quarter compared to $32 million a year ago. The change primarily reflects a decline in the insured medical covered members.

The division continues to invest and building proprietary networks and improving claims management in order to improve pricing and gain traction on both new sales and retention. Specialty benefit earnings were $14 million compared to $17 million in first quarter 2009. The decline from a year ago primarily reflects unfavorable group disability claims experience. We do not view this is a systemic issue. Incidence is down and we view the higher average new claims we experienced this quarter as a temporary phenomenon.

In thinking about our run rate for total company earnings on a go forward basis, investors should consider several items. There is seasonality in certain businesses. The health division has seasonally high earnings in the first quarter with losses in the fourth quarter and specialty benefits earnings are low in the first quarter reflecting seasonally higher group life and dental plans.

I’d reiterate our expectations that earnings for the life and health insurance segment will be essentially flat in 2010 compared to 2009. However, there are some unknowns around cost of compliance with health care and regulatory reform that could influence results for the health division and the segment.

I’d also remind you that the definitive agreement related to Brasilprev changes are economic interest in the joint venture reducing Principal International’s earnings run rate by approximately $10 million to $12 million per quarter after tax starting in the third quarter, with about half of that impact in the second quarter. Reflecting this change in earnings run rate, we expect segments return on equity a year in 2010 to be approximately 9%, returning to 11% in 2012.

As one final item, investment only earnings benefitted by about three cents per share in the first quarter primarily from a receivable recovery and our opportunistic early redemption of medium term notes. At $191 million in the first quarter, total company net income was solid as well. Net realized capital losses were $57 million, a fifth consecutive quarter of very manageable losses in the $50 million to $60 million range.

This reflects strong asset liability management which enabled us to avoid forced selling and broad asset diversification which lengthens the period over which losses emerge in a downturn making losses more manageable. Losses on fixed maturity credit related impairments in sales improved 21% from a year ago quarter is lower losses on corporate bonds more than offset higher losses on CMBS and residential asset backed securities.

Losses on commercial whole loans were also down from a year ago, a drop of 42% and at $11 million, our lowest quarter of losses since year end 2008. We continue to expect credit related losses to improve and estimate they will be approximately $100 million lower in 2010 after tax then in 2009.

Let me quickly cover our limited sovereign exposure to Portugal, Ireland, Italy, Greece and Spain. As of March 31, it totaled $70 million. In addition, we have no exposure to Greek or Portuguese banks. Let me also comment on a risk based capital ratio and capital position. As of quarter end, we estimate our risk based capital ratio to be in the range of 440% to 450%.

We also have substantial cash at the holding company providing additional flexibility. Relative to a 350% RBC ratio, we had $1.8 billion of total excess capital at quarter end, about $1 billion at the life company and about $800 million at the holding company. Given the strength of our balance sheet, investors are re-focusing their intention on our growth prospects.

So let me close with a few thoughts on the strength of our position going forward. PGI starts a second quarter with $212 billion of assets under management, 17% higher than this time a year ago. Combined account values for full service accumulation and mutual funds, totaled $132 billion, up 30% from a year ago.

Finally, Principal International goes into the second quarter with a record $36 billion of assets under management, an increase of 52%. This increase in assets under management and account values positions our fee-based businesses, businesses that are not capital intensive and do not rely on general account guarantees, for continued strong revenue growth in 2010.

This concludes our prepared remarks.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Steven Schwartz - Raymond James & Associates.

Steven Schwartz – Raymond James & Associates

First Larry you’re talking about sales and what’s going on and things seem to be improving. I want to ask how important is that, how indicative is that? We’ve missed, in a sense, we’ve missed the first quarter renewal. We’re going into the lowest cash flow quarter of the year. How meaningful is that statement really?

Larry Zimpleman

Okay Steven, didn’t know if there was a question there or not. I would say that we’ve been commenting over the last couple of quarters that we have been seeing increases in what we call created pipeline which is sort of the new business that’s dropping into the pipeline. Again there are several cuts that we could take. But we’ve been seeing increases in creative pipeline.

So, I guess I would take a bit of exception to the notion that we sort of missed the first quarter renewal. I think that we have seen a participation in the first quarter renewal when you saw the $1.7 billion. So, I think it is meaningful. I think again you’re seeing that creative pipeline pick up.

Just to give you a sense of it in the first quarter the creative pipeline was up about 36% or so. So, I think we’re again we’re seeing this build quarter by quarter. We’re seeing it build in terms of new sales. We’re seeing it build in terms of transfer deposits. So, I think we are definitely riding the wave that’s going along. I don’t think there’s any indication we’ve missed any of that.

Steven Schwartz – Raymond James & Associates

Well I guess my question is do we see that creative pipeline come through the next three quarters or do we wait again for the annual renewal periods beginning January 1?

Larry Zimpleman

The answer to that would be is that we in time will see that come through. Again, these typically the lag time on employer-based retirement sales is somewhere around 2 to 3 quarters so again just because it goes into pipeline this quarter is may well be a 7/1 or 10/1 sort of effective date. But we are seeing actual close rates are continuing to actually increase a bit. I think our close rate was a little over 10% in the first quarter which is again well within the norm probably a little bit to the high side. So again, I’d say every indication here continues to look positive.

Steven Schwartz – Raymond James & Associates

Okay good. And then if I may is there any big exposure outside of Greece and Portugal, Ireland, Italy, Spain?

Larry Zimpleman

Maybe I’ll have Julie cover that if that’s okay Stephen?

Steven Schwartz – Raymond James & Associates

That would be great.

Julia Lawler

Well we don’t have a lot of exposure outside to banks at all other than the Spanish banks. And our US exposure to Spanish banks is about $175 million. But I would say that really is exposure to the two largest global banks domiciled in Spain which would be Banco [Santander] and [BBD Bank] so we’re very comfortable with those exposures.

Operator

The next question will come from Andrew Kligerman – UBS.

Andrew Kligerman – UBS

Just shifting over to the health and specialty areas starting with the health insurance. It looks like you had a seasonally favorable loss ratio, but membership count came down by 21% year over year. The [laps] rate was 13%. Maybe a little color of stabilizing the number count?

Larry Zimpleman

Okay I didn’t know again if you want to go with both of those yet I’ve…

Andrew Kligerman – UBS

I’ll go with the special. I’ll follow up with specialty in a second.

Larry Zimpleman

Okay well I’ll make a couple of comments and then have Dan talk about the health membership. Again I think we’ve said consistently over the last couple of years that there are two elements to the rebuild if you develop our health strategy.

The first element is to run the business in a profitable way to control the loss ratio and I think the experience of the last several quarters has indicated we’re very much in good shape on that.

The second element which is a little bit more difficult is ultimately stabilizing and growing the membership base. We think that that should happen probably sometime in basically should stabilize that in 2010 and we would be hopeful that we’ll start to see membership growth in 2011. But we’ll see if Dan wants to add anything there.

Dan Houston

Yes, maybe just a couple of comments. When we did our analysis on the cases that we actually lost we saw that the average loss ratio in the cases lost were 122% so, again we lost the right cases. We’re being more thoughtful in our renewal efforts. The best way for us to turn around this business is to make some modest investments in certain areas.

One is around network development which we’re doing in Tennessee, we’re doing in Georgia, we’re doing in Texas. This will take several years for us to turn this business unit around but the network development clearly is a big part of that turnaround strategy as well as renegotiating some of our leased networks.

And then maybe the last comment is related to the healthcare reform. We don’t have all the answers today and we’re studying that very closely. And again this minimum loss ratio is one of the key drivers that we’ll have to respond to very quickly here in the course of the next couple of quarters.

Andrew Kligerman – UBS

And then just tying in the specialty difficult loss ratio of 84.5%. I think during the commentary you implied that it was more of a blip. But as I take a step back and I look at the pressures on number count and health I know you’re saying your, it sounds like your fixing it or it may even be fixed, but any change in the thinking about whether or not to retain these businesses? Are they really a cross sell and perhaps they should be divested?

Larry Zimpleman

I’m not sure if your comment or your question was really in regard to specialty benefits or health or all of the above.

[crosstalk]

Andrew Kligerman – UBS

I think both, I think just both.

Larry Zimpleman

Yes. Let me just make a couple of comments generally. Again I think that one of the reasons quite frankly Andrew that we have come through the financial crisis in ’08 and ’09 in my opinion better than many of our peers is because the balance and the risk diversification that we have in our businesses. And one big element of that is the risk based nature of those businesses.

So, I actually look at 2008 and 2009 and I think it was actually very beneficial for the organization to have those businesses and to have the relative stability of the operating earnings that they provided. And I’m very very much aware of that as we go forward. And I would be very concerned about anything that would tend to cause the loss in the diversification.

Second thing is obviously I think we continue to do a good job of managing it financially or at least remain above a 15% level which I think is a very very strong performance.

And third I’d just say that any sort of sale that would result from those businesses and I don’t know why I do that since I like the diversification and the return, but any sale that I would make of those would end up being a dilutive sale by the time I ended up paying taxes, losing the covariance benefits and then having to deal with orphaned overheads.

So, it doesn’t seem to me given the significance of those businesses to our S&B strategy that I can find very much reason to want to do that.

Andrew Kligerman – UBS

Thanks Larry and just two or three quick stats. Just statutory operating in net income and then any potential RBC charge coming on commercial mortgage loans. I know the NAIC is thinking about raising the charge on that so, just those stats?

Larry Zimpleman

Yes I’m not sure if you’re asking for first quarter. You wanted stat numbers-

Andrew Kligerman – UBS

[inaudible]

Larry Zimpleman

--I assume you’re asking first quarter and-

Andrew Kligerman – UBS

Correct.

Larry Zimpleman

Again I’d say we’re studying that. We have a different view of that as do many of our peer companies in the ACLI. I think the significance of that would be around $250 million to $350 million. That’s not insignificant but again it’s about 25, 35 basis points. I’ll have Terry cover the statutory.

Terry Lillis

The statutory [inaudible] operation was about $140 million as the first quarter and the net income was about $59.4 million.

Operator

The next question will come from Jimmy Bhullar - JPMorgan

Jimmy Bhullar - JPMorgan

I had a question first on your health business. You did mention the seasonality and I’m just trying to get an idea on how seasonally, like is this going to be similar to the first quarter of last year or is it going to be similar to how 2008 or 2007 looked in terms of earnings? What I mean is in the first quarter of last year I think in the health business it accounted for about 84% of the earnings in 2009 and if you use that as guidance then that would imply earnings of about $30 million this year in the health business so, not sure if you can comment on that?

Second I had a question on 401k flows. Your commentary on the pipeline has been relatively positive for a while and the sales haven’t really gone through. So I was wondering if you could maybe speak about what is it that’s causing people, clients to be reluctant who are in the pipeline from actually just putting business towards Principal?

Larry Zimpleman

I guess I’ll start with your second one I guess and maybe I just see it a little bit differently. But I think at $1.7 billion of sales in first quarter I think that’s a significant improvement and it does reflect I think all of the elements that we have been talking about over the last couple of quarters. As again we understand this business well. We get creative pipeline. That leads to opportunities. That leads to close ratios. That leads to business. That leads to transfer deposits.

So, I think all the elements are working and I think again it’s just a matter of understanding this takes two to three quarters but I think at $1.7 billion that’s a very very solid result and does I think back up all the comments we’ve made.

In terms of health I guess what I would say and maybe Dan will want to comment, but I would say you’re not out of the ballpark with the estimate that you gave.

Dan Houston

That’s correct. That’s probably a pretty good estimate. The other thing that I would remind you of that we’re doing in 2010 that we didn’t necessarily execute on. 2009 is the deployment of this network development. Again this does take resources and it requires you to be on the ground and the markets to be identified with personnel. Working with doctors, working with hospitals, obtaining the appropriate discounts, renegotiating with existing lease networks and then some technology investments we're making to get ourself up to speed on claims processing and data management.

Jimmy Bhullar - JPMorgan

And you mentioned the expected slowdown in the second quarter because of seasonality. But just to get an idea on what your flow expectations are, I think the past couple of years about half of your flows roughly in the 401k business have come in the first quarter. Is it reasonable to assume that the relationship won't be too different this year, or are you expecting a big ramp up in the second half?

Larry Zimpleman

Well this is Larry, Jimmy. I guess I would say that all that depends on your view of the economic recovery. And I think that in your view of when, particularly the SMV sector, is going to start to see recovery. And I think that a reasonable expectation would be is it will probably be a little bit more of a back loaded year.

But that's again, not based on anything other than I think a working assumption that the recovery will be somewhat slow and steady, but will build over time. And therefore we will see continuing increases as each quarter goes forward. But we will see seasonally low sales in the second quarter and we'd probably see it build a little more toward the end of 2010.

Operator

Your next question comes from Suneet Kamath - Sanford C. Bernstein & Co. Llc

Suneet Kamath - Sanford C. Bernstein & Co. Llc

I wanted to focus on the FSA segment again. If I look at the revenue margin, and by that I mean the fees to average, as it's under management. It seems like we're continuing to see some downward pressure there. Based on my math it was 82 or 83 basis points in the first quarter versus 86 full year 2009, and something in the 90 to 100 basis point range in prior years.

So can you provide any color in terms of what's going on there? And what are your expectations in terms of this margin going forward? Should we continue to expect it'll gravitate downward, or is there the chance that it might build back up? And then I'll have a separate question.

Larry Zimpleman

This is Larry. I'll make a more general comment, and then maybe Terry can deal with the specifics. But in terms of overall ROA, if you did the math this quarter I think it's somewhere around 31 basis points. Which is pretty consistent with I think the general range that we've communicated, which is sort of we say somewhere in the range of 28 to 32 basis points. So I think, again, things look to be very, very much along the historical trend we'd expect. I'll let Terry comment on your first part.

Terry Lillis

This is Terry. If you look at the revenue as a percent of the account value, you're seeing a change in the mix of the account value going from a few years ago it was low in terms of general account, which has a higher revenue per account value. And then you saw during the financial crisis more focus on that, and actually an increase about a year ago in terms of the general account as a percent of the account value.

What you're seeing now as the economy's recovering is that general account is actually declining, and it's not only in terms of absolute dollars, but in terms of a percentage of the account value as well. So those higher revenue dollars coming from the general account type of investment is declining, as both a dollar amount as well as a percent. So that's contributing to that revenue decline as a percent of account value.

Now that being said, there's less cost of providing the interest credited to them, so there's an offset in the benefit claims' settlement as well. So that gets down to the point where Larry had talked about, is the return to profitability. Is even though you're seeing a decline in the revenue, you're seeing a decline in the expenses as well and improving the margin overall.

Suneet Kamath - Sanford C. Bernstein & Co. Llc

I'm just looking at page 35 of your supplement where you show the FSA assets under management, and you show the general account. And to be honest, it looks like it's pretty close to $10 billion for the past several quarters, and even if I go back to '09, '08 and '07, you're still in the ballpark of $9 billion to $10 billion. So is that really the driver?

Larry Zimpleman

Yes. What you see Suneet, Terry's point is that for example, a year ago it was $10 billion on 78. Today it's about $9.8 billion on 100. So that's the point where it's declining as a percentage and declining in absolute amount. So that was really the point of his comment.

Suneet Kamath - Sanford C. Bernstein & Co. Llc

And then the second question on FSA goes back to something that Dan mentioned on the last call which was some comments about aggressive pricing, and I think in particular Dan, you called out one insurance company that's in the 401k business that took down some big jumbo cases with, I think you described it as aggressive pricing. Has that moderated at all in the current quarter or are you still seeing that pressure?

Dan Houston

That's correct. We're seeing what I would consider to be kind of a normal competitive environment [inaudible] a lot of conversation around the competitiveness. As you know, there's some regs coming out here in May for employers and in the fall for participants.

So people will certainly be part of the discussion. I would also say that as investment markets continue to return and our investment performance in our, for example lifetime funds has improved. Income funds performance has improved. That puts us in a more favorable position than it did certainly a year ago.

Suneet Kamath - Sanford C. Bernstein & Co. Llc

So some of that activity that you talked about last quarter has kind of run its course.

Dan Houston

I'm hopeful that that's true. Yes, we don't seem to be having the exact same pressure we did a quarter ago.

Operator

Your next question comes from Ed Spehar - Banc of America/Merrill Lynch.

Ed Spehar - Banc of America/Merrill Lynch

Just two quick questions. Larry, on FSA fund flows, we have had periods in the past where fourth quarter flows as a percent of assets have been close to first quarter, below but close. And I guess without pinpointing any specific number, given the flows in the first quarter and given what you see in terms of the trends, is a reasonable guess still at this point that you can at least have a couple percent positive flows for the year?

Larry Zimpleman

This is Larry. I didn't know if you had a couple. And again, I think that's in the range of reasonableness. Again, a lot of this will depend on the economic recovery building over time and the speed with which SMBs come back to the market. Advisors are coming back to the market, that's slowly happening. And so again, I think that's a reasonable expectation for 2010, yes.

Ed Spehar - Banc of America/Merrill Lynch

And then Terry, on the comments you made about international and the ROE guidance. It seems to suggest that you're going to end 2010 at an earnings level that's slightly below the first quarter, despite the earnings give up from the change in the JV ownership. And then grow earnings at sort of a 15% to 16% compound annual rate over the next couple of years; is that sort of in the ballpark?

Larry Zimpleman

Actually, I'm going to have Norman Sorensen cover that since those are his businesses.

Norman Sorensen

Basically the change in ownership [inaudible] entails going from 26% ownership to 25% ownership. That is our largest operation in Latin America, and therefore the ROE will be impacted the rest of the year. So in the second, third and fourth quarter, mostly the third and fourth quarter, we will take about a $10 million to $12 million reduction in earnings. That will affect ROE of course. ROE is expected to end around 9% this year.

The growth in the business, however, will be impacted positively by the growth in the network of Banco Brasil. So the bank is acquiring another 5 million to 6 million customers through networking engagements and other acquisitions. So the growth of the business will recover to the 16% to 20% of revenue.

Ed Spehar - Banc of America/Merrill Lynch

I guess the question is overall, if I'm looking at the equity for this business, I think it was around $1.3 billion, based on the numbers in the supplement, at the end of the first quarter. With the change in the owners, what's going on with Brasilprev, do we need to adjust the equity at all or does that just build based on the earnings expectations going forward?

Norman Sorensen

Equity will continue to build around our earnings expectations. The equity does not decrease from that level.

Ed Spehar - Banc of America/Merrill Lynch

And maybe one last quick one for Terry. Terry, on the RBC going from 426 to the estimated range of 440 to 450 in the 1Q, is that the kind of normal sequential movement we would expect to see for the balance of the year, everything else being equal?

Terry Lillis

There's a lot of moving parts Ed, in RBC calculation. As you look for it a lot of things can happen. But right now what we're seeing is an improvement from 425 to 440 or 450 is because of the strong growth in the statutory capital. The risk based capital is basically offset. We had some drift, we had some sales, we had some freed up capital from the IO scale back as well as organic growth. And they all kind of netted off each other. So depending on what happens in the future, you'd expect to see a 440 to 450 RBC later in the year as well, but a lot of things can happen as you build up the statutory surplus as well.

Ed Spehar - Banc of America/Merrill Lynch

But wouldn’t you expect the RBC ratio to continue to move upward considering the statutory earnings and realize losses expected to be sort of at the kind of level they were in the first quarter?

Larry Zimpleman

Yes exactly. And that’s why I was saying that the statutory earnings are going to improve throughout the year. You’ll have to see what happens on the organic growth as well as any drift but we’re not anticipating any drift so you’re absolutely right you would expect to see it go up.

Terry Lillis

Yes I think the $140 million would be sort of normal expected somewhere in the range of normal expected quarterly statutory earnings. So, on that basis that would be, that’s again $140 million is about 14 basis points.

Larry Zimpleman

I’d add one more comment. We do have financial flexibility as well and we have as we pointed out $1.8 billion of excess capital above a 350 RBC range and moving that around the geography of it may have an impact on the RBC ratio as well, but it’s more geography of that excess capital.

Operator

The next question will come from Randy Binner - FBR Capital Markets & Co.

Randy Binner - FBR Capital Markets & Co.

I hope this isn’t too redundant on and as the questioning there but as it relates to excess capital to me the commentary from Larry was a little more open possibly to capital management.

But I was just wondering if we should think about a capital or a cash buffer that you’d want to keep [inaudible] if you had kind of an explicit RBC goal for year end ’10?

Larry Zimpleman

Randy this is Larry. I’d say that there is no specific goal that we have for RBC for 2010. These things are managed in a real time environment but having said that I think that we’re in a very, in my view we’re in a very favorable position on this and as Terry just said I think we have a lot of capital flexibility.

Having said that I don’t think that there’s any senior management team or any board of directors that can come out of a set of years like 2008 and 2009 and not conclude that one of the learning’s that you’re going to have coming out of that is that you’d probably be holding somewhat higher levels of capital going forward than you have in the past.

And I think historically what we’ve said is that we had sort of in the old days a targeted level of excess capital $400 million to $800 million and you can think that the levels going forward will be somewhat higher than that. But at the same time I don’t know that would be $1.8 billion. But we still have a number of quarters. We’ve got to see an economic recovery that takes hold. We’ve got to see stability in the drift which we actually saw in the first quarter. And then finally what I’d say is I think that so long as the four rating agencies all continue to have the US life insurance industry on a negative outlook I think we’ll need to see some changed views of the outlook going forward by the rating agencies in order to get them more comfortable around capital management as well.

But it’s sort of like the [fed] with their discussion of extended period and maybe we’re moving to where extended period is maybe not quite as extended as it used to be.

Randy Binner - FBR Capital Markets & Co.

Understood. And just a couple of follow-ups there. I guess yes, I mean more specifically with the comments earlier on the call and the NAIC proposal or at least the proposal over a couple of States for the higher base rate on CRE Mortgages. The 25% to 35% you quoted it seems a little bit higher than what some of the other companies are saying. Would that kind of take covariance and other assets into play when you estimate the RBC impact to that potential change?

Larry Zimpleman

I think it just reflects the little bit higher level percentage of commercial mortgages, but Julia do you have any comments?

Julia Lawler

Yes. When we calculated that that’s a pretty blunt instrument so, that’s why we have a pretty wide range and so right now again, we want to iterate it’s not decided that’s what it’s going to be and the industry is working closely with the NEIC on a different proposal but that’s why we gave the range.

Randy Binner - FBR Capital Markets & Co.

All right. If I can do one more I mean where I guess with potential capital management because you had a dividend that was higher before. Is there any preference by the board or yourself of dividend versus buy-back if the economy does support that decision?

Larry Zimpleman

We’ve never had a particular view on that one where now that’s the boards never really had a specific dividend policy or [inaudible] so, again I think the board will take a look at that later in the year and we’ll take into account a lot of factors what peer companies are doing, what the environment looks like, what our level of earnings has been in the meantime, but there’s certainly, this has been a good quarter. It’s a very very solid start to the year as I indicated and again so far the business is emerging in line with or slightly better than what our expectations would have been.

So, I guess I’ll leave it there and see how the rest of the year goes.

Operator

The next question will come from John Nadel - Sterne Agee & Leach

John Nadel - Sterne Agee & Leach

Terry, I was hoping we could talk about items in the first quarter results that you would highlight as things we should not be expecting and to run right into second quarter. I know you touched in your remarks about life and health and principal international and investment only. I was hoping you could also address the sustainability of the earnings and [inaudible] annuities it appeared and maybe you already touched on this in response to a question earlier on the makeshift in FSA but on both FSA and annuities it looks like the benefits expense and [inaudible] remain below what you’d have at least historically talked about as a long-term normal assumption?

Terry Lillis

John you’ve got a lot packed into that.

John Nadel - Sterne Agee & Leach

Well how about let me, are FSA and annuity earnings sustainable? How’s that?

Larry Zimpleman

My view is that they are sustainable so market levels remain. But I’ll have Terry comment on that.

Terry Lillis

Yes John. As we look at the $0.79 EPS for this quarter and we attempted to normalize it by saying we took $0.03 off because of the investment only business and a few favorable items there. We think that $0.75/$0.76 is a real good run rate for a first quarter earnings number.

John Nadel - Sterne Agee & Leach

Okay.

Terry Lillis

You know we don’t want to get into the point where you take that times four because there is seasonality of some of the businesses. For example; the health businesses as we talked about earlier-

John Nadel - Sterne Agee & Leach

No doubt.

Terry Lillis

--you are going to see a decline in earnings or not necessarily a decline in earnings but less earnings in the last three quarters than you do in the first quarter.

John Nadel - Sterne Agee & Leach

Yes.

Larry Zimpleman

You also in the seasonality of our group life in our dental business that has seasonally low earnings in the first quarter and you should see some pick-up in that throughout the year.

The investment

[crosstalk]

Is scaling back and we’re not going to go ahead and make any estimation of the opportunistic [MP] and buy-backs that we’ve had in the first quarter so, that you need to take into consideration.

John Nadel - Sterne Agee & Leach

Okay.

Terry Lillis

And as [inaudible] mentioned earlier the change in ownership in Brazil [inaudible] will have more of an impact in the third and fourth quarter more in that $10 to $12 million range and then half of that in the second quarter.

So, that kind of says that 75/76 normalized first quarter number will decline over the year, you know, but at the same time, but Larry made a comment was the operational leveraged that we’re seeing the operational efficiency that we’re seeing in the full service accumulation business and the other accumulation businesses such as PGI as well. You’re going to see that continue as the market moves up the revenues increase, will not see expenses grow as fast as revenue growth.

John Nadel - Sterne Agee & Leach

Okay, that’s really helpful. Then just a quick data point and follow up to the question on RBC. Assuming in the move from 426 to an estimated 440 to 450 that there was no dividend from the life company to the holding during 1Q. Do you expect any dividends during the remainder of the year as your cash balance of the holding company’s sufficient?

Terry Lillis

Yes John this is Terry. You know the cash balance that we have at the holding company is sufficient as you know. We have very little need for cash at the holding company. We have our debt as well as our preferred shares and any comments stock dividends that we do year-end. We don’t have a maturity of any debt until 2014 so, little need for it.

But we do have the capability and we do have the flexibility to move over $600 million out of the life company to the holding company and we just have to determine what is the best place for that, what is the best use for that capital. But we do have that flexibility between now and the end of the year as you are absolutely right we didn’t do anything in the first quarter in terms of dividend or a return of any [inaudible]

John Nadel - Sterne Agee & Leach

So is it fair to say then Terry, that you might decide to take a dividend out of the life company despite not necessarily needing that cash with the holding company just because if you go through this whole year and you don’t you lose that opportunity?

Terry Lillis

That’s absolutely right because it does give us that financial flexibility to have it in –

[crosstalk]

Terry Lillis

-- life company, and as you know, we do have limitations as to how much we can move out of the life company in a given year.

Operator

Your next question comes from Thomas Gallagher - Credit Suisse

Thomas Gallagher - Credit Suisse

My two questions are first, on SFA net flows, do you expect the normal seasonality just between 1Q and 2Q that we’ve been seeing for the last two or three years that is about a little more than $1 billion reduction of net flows sequentially, or is there something different about this cycle because you might be seeing more of a cyclical improvement .

For Terry, on t he full service accumulation income statement, are the revenues on the general account product just net investment income or do you also earn fees there? Then I’ll have a follow up on that.

Larry Zimpleman

I guess on the first one what I would say, Dan may want to comment, I think you would want to line up generally normal historical trends around net flows between 1Q and 2Q. The only thing that could be maybe a slight positive helping those is that again, we saw some drop off in recurring deposits last year as a result of primarily reduced or eliminated matches. Those have come back to some degree in 4Q and to some degree in 1Q.

So again a little bit of it will depend on how much additional lift we get from matches that have been suspended or eliminated in 2009 but that will be restored coming into 2010. We still haven’t seen the full impact of that, but I think that covers flows and maybe Terry can cover the second question.

Terry Lillis

You’re generally right that the revenue off of the general account is typically the net investment income. There is some through pricing. There are some fees but they’re very minor, so for all intents and purposes, you’re absolutely right.

Thomas Gallagher - Credit Suisse

Just to follow up and I realize you may not have an explicit number so general would be great. The after tax ROA you think you’re making on the general account, would it be substantially higher than your 28 to 32 basis points, understanding there’s obviously going to be capital you need to hold, but can you give me order of magnitude, what kind of ROA you think you make on that particular offering?

Terry Lillis

You’re absolutely right, there is a more risk associated with the general account and so you’d expect higher ROA on it. The order of magnitude is you’re looking at 60 to 75 basis points of after tax profitability on that type of business versus a mutual fund which doesn’t have as much risk associated with it and therefore less capital need as well.

Dan Houston

The only clean up I would do on that is remember that from an ROE perspective, the general account wouldn’t be or have as high of an ROE as it does when it’s in separate accounts. The other thing I’d say is obviously there is much more free cash flow coming off of it when it ‘s in separate accounts. So it ‘s really a trade off of somewhat higher revenue and what appears to be somewhat higher margins for a lower ROE and less free cash flow. So those are the kind of tradeoffs that are involved.

Operator

We have reached the end of our Q&A. Mr. Zimpleman, your closing comments please.

Larry Zimpleman

Thank you again t o all of you for joining us and we appreciate your continuing interest. We’re going to stay very, very focused on execution in the coming months. Again, we’re very pleased. We have a strong start to 2010 but we know there remains many challenges and we look forward to seeing many of you in the coming months. Thanks for your ongoing support.

Operator

Thank you for participating in today’s conference call. This call will be available for replay beginning at approximately 8 pm eastern time until end of day May 18, 2010. 66747663 is the access code for the replay. The number to dial for the replay is 800-642-1687 for the US and Canadian callers or 706-645-9291 for international callers.

Thank you, you may now disconnect.

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Source: Principal Financial Group, Inc. Q1 2010 Earnings Call Transcript
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