Canadian life insurer Manulife Financial Corp. (MFC) hosted an Investor Day (.pdf) on November 19, during which management set forth goals for 2015 of 4 billion net income and 13% ROE. While the goals represent a complete recovery from the losses imposed by the financial crisis and recession, they appear conservative in light of analyst consensus for 2012 earnings. Management is to be applauded for realism. With reduced leverage, regulatory uncertainty, increased hedging costs, and the need to realign the company to focus on lines with less equity and interest rate risk, recovery can be expected to be gradual rather than rapid.
Manulife Financial is a leading Canadian-based financial services group operating in 22 countries and territories worldwide. The company operates as Manulife Financial in Canada and Asia and primarily as John Hancock in the United States. Market Cap is similar to Metropolitan (MET) and Prudential Financial (PRU).
Impact on Valuation, Risk and Reward
Goals are not guidance. Nevertheless, if the 4 billion net income goal is met, that implies 2015 earnings of 2.16 per share (US$). Consensus earnings for 2012 are 2.12, which may need to be adjusted downward. Applying a historical average P/E of 13.5 develops a target of 29, by year end 2015. From recent prices in the 15 area, that implies annual share price appreciation of 14%. Adding the dividend of 3.42%, expected annual returns to target date and price are 17%, sufficient to justify considerable risk and uncertainty.
Manulife's results are sensitive to equity market valuations due to guarantees on variable annuities, and also to interest rates, due to the requirements of Canadian GAAP. Investors who believe that both equity markets and interest rates are bound to rise will be attracted: all others will be repelled. Here are two snips from the 3Q 2010 Earnings Press Release:
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As a practical matter, MFC has hedged out some of the equity exposure as markets have recovered: they have also hedged out some of the interest rate exposure, out of concern for the damaging effects if they continue at current levels indefinitely. Further hedging is planned. Also, going forward the company will be shifting its mix of business to lines that are less sensitive to interest rates and equity markets.
Management is addressing the issues: as such, this is less of a pure play on economic variables than it was, and more dependent on management's handling of insurance operations.
MFC cut the dividend in half in August 2009, citing the need to maintain a fortress balance sheet. It currently stands at .13 quarterly, yielding 3.42% at a recent price of 15.08. After looking at past payout ratios and forward earnings projections, together with uncertainty about regulatory capital requirements, there is little reason to expect a raise any time soon.
Canadian vs. US GAAP
Canadian GAAP is based on mark to market, and the Canadian insurance regulations dovetail with CGAAP. The result is distressingly pro-cyclical, and creates pressure for companies to de-risk or raise capital at market bottoms. IFSR (International Financial Reporting Standards), still being finalized and expected to be implemented in 2013, likewise places a heavy emphasis on mark to market.
MFC has made their concerns known, that they might be at a competitive disadvantage if IFSR makes its way into the regulatory scheme without some modifications. It would be a rare regulator that turns a totally deaf ear to this plea, at least to judge by the past efficacy of this same argument in the US banking industry.
The company publishes US GAAP results with its quarterly financials. US GAAP, as of 9/30/2010, would have shown book value 9 billion higher.
Until recently, share prices were pressured by concerns that further dilutive raises would be required in order to maintain a fortress balance sheet and/or meet regulatory requirements. From the 3Q 2010 earnings press release:
The Manufacturers Life Insurance Company (“MLI”) reported a Minimum Continuing Capital and Surplus Requirements (“MCCSR”) ratio of 234 per cent as at September 30, 2010, an increase of 13 percentage points from June 30, 2010. The increase was primarily the result of the $2 billion of debt raised in the third quarter by MFC and deployed to MLI, coupled with strong investment related gains and underlying earnings which more than offset the policy reserve strengthening.
The supervisory target for MCCSR is 150%. Per the Investor Day presentation, the assumptions underlying the company's plans do not include net issuance of debt or equity capital.
Long Term Care Insurance
MFC is in the process of pushing through substantial rate increases in order to restore profitability to this difficult line. MetLife recently withdrew from the market, suggesting that rate increases are likely to stick. Favorable demographics create a large potential market for the coverage as baby boomers age. The challenge is find the proper mix of benefits and rates to write the business at a reasonable profit.
Manulife presents their strengths as follows:
Strong capital position
Enviable market position in Asia, retirement segments and other key growth markets
Excellent brand recognition and reputation
Superior asset quality
While Canadian prudential regulation may be a cramp with its focus on mark to market, the investor can have confidence that MFC will not be given excessive latitude, as sometimes happens in the U.S.
This is a large and complex financial, facing multiple issues. On the other hand, there are numerous global opportunities for profitable growth, in Asia and elsewhere. The analytical task of cutting through the complexity is daunting.
The overall tone of the Investor Day presentation demonstrated a strong awareness of the various issues confronting the company, together with an equally strong determination to address them and focus on restoring profitability and growth. Management has a plan; the company has ample resources; and I am investing on the basis that successful implementation will make good things happen.
Strategy and Tactics
It's possible to buy at today's price with a reasonable expectation of receiving a dividend return of 3.4% and eventual capital appreciation.
After a months long rally, markets have been vacillating before the next move. Also, MFC has just completed a strong relief rally on the information that accompanied its earnings report. There are more goodwill impairment charges to be taken, perhaps 2.2 billion in the 4th quarter. Renewed concerns about Ireland or other PIIGS and the Euro may place indiscriminate selling pressure on financials. An investor who believes management will meet their 2015 goals has many quarters to review earnings and progress on multiple fronts. Under the circumstances, accumulate while monitoring makes sense.
Beta at 2.0 and implied volatility at 42.7% suggest a somewhat bumpy ride: they also provide ample material for options strategies. The shares are optionable (no LEAPS) but the options are somewhat thinly traded with fairly wide bid/ask spread. I've been playing this situation profitably with diagonal call spreads, which still make sense to me. Long MFC Jun 18 2011 10.0 calls and short an equal number of MFC Mar 19 2011 17.5 calls would be an example, with shares in the 15 area.
Book value at 13.89 provides some margin of security, as does the dividend support.
Disclosure: Long MFC, MET and PRU