Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Prudential Financial (NYSE:PRU)

Q1 2011 Earnings Call

May 05, 2011 11:00 am ET

Executives

Edward Baird - Chief Operating Officer and Executive Vice President of International Businesses

Eric Durant - Head of Investor

Richard Carbone - Chief Financial Officer, Executive Vice President and Chief Financial Officer of Prudential Insurance

Mark Grier - Executive Vice President of Financial Management

John Strangfeld - Chairman, Chief Executive Officer, President and Member of Executive Committee

Analysts

Andrew Kligerman - UBS Investment Bank

John Nadel - Sterne Agee & Leach Inc.

Randy Binner - FBR Capital Markets & Co.

Nigel Dally - Morgan Stanley

Suneet Kamath - Sanford C. Bernstein & Co., Inc.

Edward Spehar - BofA Merrill Lynch

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the First Quarter 2011 Earnings for John Strangfeld [Prudential Financial, Inc.] [Operator Instructions] And I would now like to turn the conference over to Mr. Eric Durant. Please go ahead.

Eric Durant

Thank you, Cynthia. Good morning. Thank you for joining our call. Today's presenters are indeed John Strangfeld, CEO; Rich Carbone, Chief Financial Officer, Mark Grier, Vice Chairman. Then joining John, Rich and Mark for our Q&A will be Charlie Lowrey, Head of our U.S. businesses; Ed Baird, Head of our international businesses; and Peter Sayre, Controller and Principal Accounting Officer.

Now this commercial. In order to help you to understand Prudential Financial, we will make some forward-looking statements in the following presentation. It is possible that actual results may differ materially from the predictions we make today. Additional information regarding factors that could cause such a difference appears in the section titled Forward-Looking Statements and Non-GAAP Measures of our earnings press release for the first quarter of 2011, which can be found on our website at www.investor.prudential.com.

In addition, in managing our businesses, we use a non-GAAP measure we call adjusted operating income to measure the performance of our Financial Services businesses. Adjusted operating income excludes net investment gains and losses as adjusted, and related charges and adjustments, as well as results from divested businesses. Adjusted operating income also excludes recorded changes in asset values that are expected to ultimately accrue to contract holders, and recorded changes in contract holder liabilities, resulting from changes in related asset values. Our earnings press release contains information about our definition of adjusted operating income. The comparable GAAP presentation and the reconciliation between the two for the quarter are set out in our earnings press release on our website. Additional historical information relating to the company's financial performance is also located on our website. John?

John Strangfeld

Thank you, Eric. Hello, everyone. Thank you for joining us. We had a strong and eventful first quarter. Our earnings per share for the quarter increased 17% from last year's first quarter based on after-tax adjusted operating income of the Financial Services business. We produced an annualized ROE of 11.4% for the quarter on the same basis. GAAP book value per share reached $63.50, up 16% from a year ago. In a few moments, Rich and Mark will review the quarter with you in detail.

In brief, our financial results are solid and broadly based, and our sales and flows demonstrate excellent and continuing commercial momentum. In our Annuities business, our competitive position and expanding distribution have driven strong sales and flows, leading to substantial growth of business with attractive returns. In Asset Management, we are benefiting from higher fees driven by growth in Assets Under Management, as well as the absence of significant credit-related charges, which affected results a year ago.

In our U.S. Protection businesses, results were down modestly from last year, reflecting less favorable group disability claims experienced in the current quarter. Our international businesses are producing sustained organic growth, including an increasing contribution from Life Insurance Protection business sold through the bank channel at Gibraltar Life.

Current quarter results also include the first month of operations at the Star and Edison businesses we acquired in February. The addition of these companies will significantly strengthen our franchise in Japan, where we are already a market-leading farm life insurer. In spite of the earthquake and tsunami disaster in Japan, business integration is proceeding well, in line with expectations, and with no material surprises. We applaud our dedicated staff in Japan, as well as our associates in the U.S., who have kept us on track through this difficult period. Largely because of recent increases in Japanese and U.S. interest rates, our estimation of the earnings contribution over time of Star and Edison is modestly higher than our earlier expectations.

In April, we reached agreement to sell our Global Commodities business in a transaction that is expected to close later this year. When completed, this transaction will free for redeployment approximately $400 million in capital. Broadly, on the subject of capital, we are at a very strong position, with both capacity and flexibility in capital deployment. We are highly focused on capital management, and we recognize the importance of capital deployment in the achievement of our 2013 ROE aspiration of 13% to 14%. We look forward to a fulsome discussion of capital and capital management at our Investor Day next month.

And with that, I will turn it over to Rich.

Richard Carbone

Thanks, John and good morning, everyone. As you've just heard from John's remarks, and as you've seen from yesterday's release, this was a good quarter. Common stock earnings per share was $1.69 based on adjusted operating income, a 17% increase over the $1.45 from the prior year. The list of significant discrete items affecting current quarter results is fairly short and easy to digest.

Let's start with annuities. Favorable markets resulted in a benefit of $0.06 per share from the release of a portion of our reserves to guaranteed minimum debt and income benefits, and $0.03 per share from an unlocking that reduced amortization of deferred policy acquisition and other costs, also, from the result of favorable markets. In International Insurance, Gibraltar Life had a benefit of $0.22 per share for the partial sale of our indirect investment in the China Pacific Group. Going the other way, Prudential of Japan results include a charge of $0.03 per share, representing our estimate of claims within the Japanese Life Planner business from the March earthquake and tsunami. Since Gibraltar Life, including the Star and Edison businesses, report on a one-month lag basis, their claims from the disaster estimated at about $55 million pretax or about $0.08 per share, will be included in the second quarter results.

Gibraltar Life results also include transaction and integration costs related to the Star/Edison acquisition and amounted to $0.06 per share. In total, the items I just mentioned had a net favorable impact of about $0.22 on our earnings per share for the quarter. Taking away this $0.22 from our reported results, would bring EPS down to $1.47. Analytically, I would not stop there in analyzing our earnings.

In thinking about our operating performance for the current quarter, I would note that our results include a full quarter of financing costs and share count dilution from the Star/Edison acquisition, but only 1 month of earnings from these businesses. If I extrapolate 1 month of results, excluding onetime charges, for Star/Edison over a full quarter, that would equate to about $0.10 per share for the additional 2 months. This would suggest a baseline EPS of $1.57.

Now moving on to GAAP results. We reported net income of $589 million or $1.20 per share for the first quarter compared to $536 million or $1.15 per share a year ago. GAAP pretax results include amounts characterized as net realized investment losses of $360 million in the quarter. This amount reflects $364 million net decline in the value of derivatives and other items on our balance sheet driven by changes in interest rates and foreign currency exchange rates during the quarter.

Impairments and credit losses were $96 million for the quarter, including about $30 million for subprime holdings with the remainder spread across a number of asset classes. Our general account subprime holdings and amortized costs were $3.1 billion as of the end of the quarter, down from $4 billion a year ago. The realized losses I mentioned totaling $460 million were partially offset by gains of $47 million from product-related hedging activities and net gains from other general portfolio activities.

Book value per share on a GAAP basis amounted to $63.50 at the end of the first quarter and this compares to $54.63 a year ago. Gross unrealized losses on general account fixed maturities were $3.3 billion at the end of the quarter. And we were in a net unrealized gain position of $4.6 billion. Book value per share, excluding unrealized investment gains and losses and pension and post-retirement benefits, increased $5.84 from a year ago, reaching $60.98 at the end of the quarter.

Now on to capital. And I'm going to provide a little more detail than I have in the past to try and improve the transparency on this subject. First, I will focus on our insurance companies. We are continuing to manage our insurance companies to capital levels, consistent with what we believe are AA standards. As of year end, Prudential Insurance reported an RBC of 533%, with total adjusted capital or TAC of $12 billion on a statutory basis. Since RBC is an annual calculation, I won't be providing an update for the quarter. However, I can tell you that the key drivers of statutory capital have not materially changed since year end, and we have not taken a dividend from Prudential Insurance so far this year.

Our Japanese insurance companies will soon report solvency margins as of their fiscal year end. We are confident that the solvency margins for both Prudential of Japan and Gibraltar will be comfortably above their benchmarks for AA ratings. Since Star and Edison came to us adequately capitalized at closing, the acquisition did not have a material impact on our overall capital position.

Now let's look at the overall capital position for the Financial Services businesses. We benchmarked Prudential Insurance to a 400 RBC ratio. We compare that -- we compare the $12 billion of tax that I just mentioned and reported at year end, with the amount needed to produce a 400 RBC ratio. That would mathematically work out to an excess of about $3 billion. Adding that capital capacity at the --adding the capital capacity at the parent company and other subsidiaries to that PICA [The Prudential Insurance Company of America] excess, I would estimate that total on-balance sheet capital, over and above the amount we need for our target statutory capital ratios, to be in the range of $4 billion to $4.5 billion. This is based on year-end data, and giving effect to the Star/Edison acquisition, and the pending sale of Global Commodities, which frees up about $400 million of capital.

All this capital, the $4 billion to $4.5 billion, would be available as a buffer in a stress situation. However, and this is more in line with how we have talked about capital in the past, when we think about capital that is available for offensive purposes or market opportunities over the near term, we consider the nature and volatility of items that affect statutory capital, particularly that, that resides in that excess, the over $400 million. These considerations influence our views of immediately spendable capital, which is in the range of $2.2 billion to $2.7 billion, again, based on year-end RBC data, and giving effect to the Star/Edison acquisitions and the pending sale of Global Commodities. This view is comparable to how we have estimated the net on-balance sheet capital capacity or excess capital of $1.8 billion to $2.3 billion that we reported to you at the end of last year and in all prior periods. The remainder of the $4 billion to $4.5. billion, the portion we don't count as immediately spendable, is available as a buffer for stress scenarios, and would be supplemented in those conditions by other contingent capital sources, including certain committed lines and our capital hedge program. Since many of the inputs, and I mentioned this earlier, since many of the inputs to our capital capacity are based on annual calculations, I would not want to provide a current quarter update for this range other than to say we are comfortable that it has not materially changed through the end of the first quarter.

Now turning to the cash position at the parent company. Cash and short-term investments at the parent, excluding cash from short-term borrowings and commercial paper, amounted to roughly $2.6 billion at the end of the first quarter. We would expect to utilize a portion of this amount for tax payments and other operating purposes during the year. After these uses, we expect the remainder to exceed our $1 billion liquidity target, which represents approximately 18 months of fixed charge coverage.

Now I'll turn it back over to Mark to review the businesses for the quarter.

Mark Grier

Thank you, Rich, and John, and hello, everyone. Thanks for joining us today. I'll start my discussion with the U.S. businesses. Our Annuity business reported adjusted operating income of $292 million for the first quarter compared to $244 million a year ago. The reserve true-ups and DAC unlocking that Rich mentioned had a net favorable impact of $59 million on current quarter results. This includes a benefit of $40 million from the release of a portion of our reserves for guaranteed minimum death and income benefits, and a further benefit of $19 million from reduced amortization of deferred policy acquisition and other costs. In both cases, reflecting favorable market performance. Results for the year-ago quarter included a net benefit of $99 million from a favorable DAC unlocking, reserve true-ups and refinements related to reinsurance contracts. Stripping out these items, annuity results were $233 million for the current quarter compared to $145 million a year ago.

The $88 million increase, and what I would consider underlying results, reflects new business and the benefit of market performance on account values, contributing to growing fees and lower guaranteed benefit costs. Average variable annuity account values have increased by $23 billion from a year ago, driven mainly by over $16 billion in net sales. Essentially, we have higher returns on a growing base.

Nearly all of our variable annuity sales include our highest daily or HD living benefit features. And all of the variable annuity living benefit features we now offer come packaged with an auto-rebalancing feature, where customer funds are reallocated to fixed income investments to support our guarantees in the event of market decline. This product-based risk management limits the potential cost of our guarantees, as well as the expense we incur to hedge equities and interest rate risks.

Auto-rebalancing performed well during the financial crisis, protecting client account values from severe decline, and effectively returning funds to client-selected investments as markets recovered. At the trough of the market, more than 3/4 of account values for our auto-rebalancing products had been moved to fixed income accounts by our algorithm, which operates at the contract level on a daily basis. As of the end of the first quarter, less than 10% of account values subject to auto-rebalancing remained in the designated fixed income accounts. As a result of strong sales, driven by the popularity of our highest daily living benefit features, both the profitability and the risk profile of our overall variable annuity book of business have been consistently improving.

Comparing the base earnings of $233 million for the current quarter, with the year-ago base earnings of $145 million that I mentioned, produces an increase of about 60%, more than double the increase in average account values over the same period. At the same time, we are improving our risk profile. The proportion of our variable Annuity business with living benefits that has our auto-rebalancing feature is nearly 80% as of the end of the first quarter. This compares to about 70% a year earlier. For the overall book of variable annuities, auto-rebalancing now covers about 60% of account values compared to less than 1/2 a year ago, and about 1/3 if we look back 2 years.

Our gross variable Annuity sales for the quarter reached a record high $6.8 billion compared to $4.9 billion a year ago, with solid increases in each of our distribution channels, independent financial planners, buyer houses, banks and insurance agents. In late January, we introduced the next generation of our Living Benefit product feature called Highest Daily Income or HDI. This feature continues the basic design of our HD6 product, including auto-rebalancing and other product-based risk management, such as minimum age at purchase and asset allocation requirements. But this product offers a 5% annual roll up for protected value rather than the 6% offered by our HD6 product, and lower payouts at some age bands.

Fees for the rider were increased by 10 basis points for individuals to 95 basis points. While it's reasonable to assume that a portion of our first quarter sales represented accelerated purchases due to the anticipated product changeover, we believe our updated product is being well received in the marketplace, and continues to offer a superior value proposition for clients focused on retirement income security.

The Retirement segment reported adjusted operating income of $172 million for the current quarter compared to $169 million a year ago. Current quarter results benefited from higher fees, driven by growth in account values, both in Full Service Retirement and in the remainder of the business. Overall, Retirement account values were $215 billion at the end of the quarter, up $31 billion from a year ago. However, higher expenses, driven largely by non-linear items such as legal and business development costs, largely offset the increase in fee income in the comparison of year-over-year results. In Full Service Retirement, gross deposits in sales were $4.8 billion in the current quarter compared to $5.6 billion a year ago. We focus on the mid-to-large case market, where RFP activity has been limited, as employers have been focused on issues such as healthcare. Net full-service flows were about breakeven for the quarter, with persistency at a solid 96%.

Strong sales in the investment-only market where we have grown sales of stable value wrap products to plan sponsors on a stand-alone basis, brought net additions for the overall Retirement business to $4.6 billion for the quarter compared to about $850 million a year ago. The Asset Management segment reported adjusted operating income of $154 million for the current quarter compared to $83 million a year ago. While most of the segment's earnings come from Asset Management fees, more than half of the improvement for the quarter came from more favorable results from commercial mortgage activities. Results for the year-ago quarter were negatively affected by credit and valuation charges, amounting to roughly $30 million on interim loans we hold in the asset management portfolio. These charges have abated as commercial real estate values have improved, and current quarter results benefited from gains of about $15 million on sales of foreclosed properties, where we realized more than the carrying value of the loans.

The remainder of the improvement in results came mainly from higher asset management fees, driven by growth in Assets Under Management. The segment Assets Under Management increased nearly $100 billion from a year ago, including $15 billion of primarily U.S. dollar general account assets from the Star and Edison acquisitions. The remainder of the increase in Assets Under Management was driven by positive net flows in both Institutional and Retail business for each of the past 4 quarters, as well as cumulative market appreciation. Adjusted operating income for our Individual Life insurance business was $96 million for the current quarter compared to $91 million a year ago. Mortality experience was less favorable in relation to our average expectations in both periods, but improved in relation to the year-ago quarter, driving the increase in results. While mortality experience fluctuates from one quarter to another, cumulative experience for the past 4 quarters has been essentially in line with our expectation.

The Group Insurance business reported adjusted operating income of $40 million in the current quarter compared to $53 million a year ago. The decrease in earnings was driven by unfavorable results from Group Disability. We are continuing to see an elevated incidence of new disability claims, which more than offset the benefit of increased claim terminations in the current quarter.

Group Insurance sales for the quarter were $500 million, including $392 million for Group Life. This compares to a total of $346 million a year ago. Most of our Group Insurance sales are recorded in the first quarter based on the effective date of the business. Current quarter Group Life sales included a major case win, which contributed about $180 million. More than half of this sale and about 70% remaining Life sales in the quarter were voluntary business, representing coverage purchased by employees or association members rather than employer-paid insurance.

Turning now to our International businesses. Gibraltar Life's adjusted operating income was $342 million in the current quarter compared to $164 million a year ago. As Rich mentioned, Gibraltar's results for the current quarter include income of $153 million from the partial sale of our investment in China Pacific Group by the Carlyle consortium. As of the end of the quarter, our remaining investment in China Pacific has a cost of about $40 million, with market appreciation of roughly $250 million, which is included in the $4.6 billion of net unrealized gains on our balance sheet.

Going the other way, Gibraltar's results for the quarter absorbed $39 million of transaction costs for the Star and Edison acquisitions that we closed in February, and an additional $8 million of integration costs. We continue to expect about $500 million of integration costs over a 5-year period to achieve targeted annual cost savings of $250 million after the business integration is completed. We are, of course, in early days of the integration, but it is off to a solid start, and we have not experienced a major disruption from the disaster in Japan in March. Excluding the China Pacific gain, and the transaction in integration costs, Gibraltar's adjusted operating income was up $72 million from a year ago. This increase includes a contribution of $34 million from the initial month of operations of the acquired Star and Edison businesses, higher net investment spreads, reflecting growth of Gibraltar's fixed Annuity business, and business growth driven by Protection products, including the growing book of Life Insurance Protection business distributed through the bank channel.

Sales from Gibraltar Life based on annualized premiums in constant dollars were $347 million in the current quarter. This represents an increase of $185 million from a year ago, including $85 million from the first month of production through the distribution that came to us in the Star and Edison acquisitions, and $100 million of organic growth in Gibraltar. The Star/Edison acquisition brought us more than 7,000 new life advisors, about 60 additional bank distribution relationships, and an established independent agency channel, with about 5,000 independent distributors.

The $85 million initial sales contribution included $23 million from the renewal of a large block of third-sector business sold through the independent agency channel. The remaining $100 million of the sales increase, excluding the Star and Edison contribution, included $70 million from the bank channel, driven mainly by sales of Life Insurance Protection products. Sales through Resona Bank, one of Japan's largest banks and a recently added distribution partner, contributed about $25 million to current quarter sales.

Current quarter bank channel sales reflected accelerated purchases in advance of an announced rate increase on yen-denominated single premium whole life products, which are popular in that channel. The Life Advisor and independent agency channel's registered sales increases totaling $30 million, excluding the Star and Edison contributions. Current quarter sales benefited from strong demand for our recently introduced cancer whole life products.

Our Life Planner business reported adjusted operating income of $330 million for the current quarter compared to $327 million a year ago. Current quarter results included a charge of $19 million, representing our estimate of claims from the earthquake and tsunami in Japan. Excluding this charge, results were up $22 million from a year ago, tracking continued business growth mainly in Japan.

Sales from our Life Planner operations, based on annualized premiums in constant dollars, were $286 million in the current quarter, up $42 million or 17% from a year ago. The increase was mainly driven by strong sales in Japan, where we are benefiting from increased demand for Retirement income products and in Korea. International Insurance sales on an all-in basis including Life Planners, Life Advisors, the bank channel and independent agency distribution, were $633 million for the first quarter compared to $406 million a year ago.

Corporate and other operations reported a loss of $272 million for the current quarter compared to a $210 million loss a year ago. The greater loss in the current quarter was mainly a result of higher expenses. The expenses within Corporate and Other, include non-linear items such as corporate advertising and benefit plan. In addition, interest expense on our capital debt increased from a year ago due to the $1 billion of debt financing we applied toward the Star and Edison acquisitions.

To sum up, results from our U.S. Retirement Solutions and Asset Management businesses are benefiting from sustained positive net flows, driven by our strong competitive position and attractive value propositions. Growth in account values and Assets Under Management is driving favorable comparisons to year-ago results, and contributing to run-rate performance in those businesses. Results from our U.S. Protection businesses were negatively affected in the quarterly comparison by less favorable group disability results.

Our International businesses performed well, and are benefiting from expanding distribution across multiple channels. And the addition of the Star and Edison businesses we acquired in February has strengthened our market-leading business in Japan and enhanced our prospects for growth in a market where we have enjoyed sustained success based on serving lifetime financial security needs.

Thank you for your interest in Prudential. And now, we look forward to hearing your question.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question will come from the line of Andrew Kligerman with UBS Securities.

Andrew Kligerman - UBS Investment Bank

First question, so what's the game plan with the $2.2 billion to $2.7 billion? What can we expect with that over for the next -- for the balance of the year?

John Strangfeld

Well, Andrew, I think that falls in the category of capital management, capital deployment and our thinking around that, and that's a subject matter we're intending to focus a lot of time and attention on in June.

Andrew Kligerman - UBS Investment Bank

Focus on it in June. So you won't tell us whether you're going to use it for repurchases or dividend increase any time in the near term?

John Strangfeld

June is near-term.

Andrew Kligerman - UBS Investment Bank

Join us in June, and we'll discuss it then? That's what you're saying. Okay? All right. We'll move on. Timing of sales in Japan, given the terrible disruptions there, what can we look for in the second quarter, same thing with the shift from the HDI6 in the U.S. to HDI5 (sic) [HD5], what do you think the second quarter's going to look like, is there going to be a real slowdown there?

Eric Durant

Andrew, this is Eric Durant. First, let me take the opportunity for me to express our sympathy to all of those affected by the extraordinary tragedy that you reference in Japan. And as far as the second quarter, I had the opportunity to be there last week, and was pleasantly surprised to see that the momentum that we've now had more than 7 quarters, averaging over 25%, continues almost unabated so far into the second quarter. And while, obviously, it's too soon to be giving numbers out, I will tell you that the observations that I was able to make would be consistent with the momentum we've seen up until now. And I would also say that, that applies not only on sales but fortunately, the progress that is being made regarding the integration in the merger. Obviously, for a couple of weeks, there was enormous distraction there, but all of the work teams reported, again as recently as last week, that they're either on schedule or close enough to it that they see no need for any shift in the target dates.

Charles Lowrey

Andrew, it's Charlie Lowrey. In terms of HDI versus HD6, and what we expect in the second quarter, I think it's fair to say that sales will be lower than they were in the first quarter. We had a tremendous first quarter. But the second quarter, obviously, won't incorporate the surge that we had in the first quarter, which was about $1 billion. Secondly, HDI does have some different terms, and there's additional competition coming into the market, with product that tries to resemble our product, which we believe is kind of a corroboration of our approach, which we've been saying all along about the product we have in the marketplace. The last thing I'd say, and this is to the same quarter as well, is that we don't look at market share specifically. But what we do is to look at the profitability of our product going forward, and the market share falls out where it may. You've seen that in how we dealt with Individual Life, and you'll see that with how we deal with Annuities as well.

Andrew Kligerman - UBS Investment Bank

So you are -- you're willing to let your absolute value, your volume decline if it gets too competitive, is what you're saying?

Charles Lowrey

Yes, we will.

Andrew Kligerman - UBS Investment Bank

Okay. And then just one last quick one. In Asset Management, you had that nice $15 million gain on the sale of foreclosed properties, and I know in that division, you've been de-risking, you've reduced co-investments and seed capital, interim loan businesses. So just kind of looking out for the balance of the year, can we expect gains like that, $15 million gains in the upcoming quarters, or should we modeling for basically nothing?

Charles Lowrey

It's an interesting question because within ITPICM, which is the line you're referring to, Investments, Transactions, Proprietary Investment and Capital Management, there will be a little bit of lumpiness by definition that, that occurs in this business. So there will be some volatility. What we've been trying to do over the course of the past couple of years is to lower the amplitude of that volatility as we go forward. So I don't think it's fair to say that you won't see any. But I think the degree of volatility you saw a couple of years ago has been significantly ameliorated, and that you will see less volatility as we go forward.

Andrew Kligerman - UBS Investment Bank

Got it. And I assume just based on what you're seeing in Commercial Real Estate, that the -- I should err on the side of things being more positive?

Charles Lowrey

I think so. In other words, if you look at the past few quarters, we've had foreclosures, sales of foreclosed assets, some of which have been positive, some of which have been slightly negative. But what that means is that we feel pretty good about the marks we have within the interim portfolio.

Operator

Our next question will come from the line of Nigel Dally with Morgan Stanley.

Nigel Dally - Morgan Stanley

First, you mentioned the outlook for Star/Edison, the earnings that modestly improved from your prior expectations. Hoping we can put some numbers around just how much it improved. Second, with the effect of the regulatory backdrop, one of your peers this morning expressed some optimism that the large insurers may escape systemically important designations, what is it in your views? Also, if you were to receive that designation, how would that impact your capital flexibility, would a 400% RBC ratio still be the right benchmark? And then last, on corporate expenses, while I think everyone appreciated that they were going to be up on higher debt comp and lower pension, the magnitude of the increases are a lot larger, I think, than a lot of people expected. So perhaps some additional color on those, other non-linear factors that you mentioned, leading to the escalation, and what would you be thinking about as a good run rate moving forward?

Richard Carbone

Yes, Nigel, it's Rich. On Star/Edison, we can keep this really simple. Let's go back to when we announced the deal. We said we thought accretion in 2012 would be about 5%, driven off of a $0.40 EPS number. Today, now that we've finished our purchase accounting, there are 2 things that are different. One, you know about, we issued less shares and the second one, you also know, that rates went up. So there's less of a discount -- there's less of a premium on the bonds that we need to amortize. The impact of both of those 2 will give us about a $0.55 increase in EPS in 2012 or 7% accretion, again, based on -- and this is important, it was based upon the average street estimate for 2012 that was outstanding back there when we announced the deal. So $0.55, 7% accretion, 2012 versus 5% and $0.40 accretion in 2012. Let me add -- you also asked -- I'm going hand it over to Mark in a second, but Corporate and Other. Corporate and Other has got a lot of cats and dogs in it. This quarter may be a little high because we had some extra legal fees. We had some extra philanthropic activities, the tragic event in Japan. We donated $5 million for that. But if I was to moderate that a bit, it would be maybe $10 million, so the $272 million is down to $262 million. I don't think it's worth counting the number of angels that can dance on the head of a pin here.

Mark Grier

And then Nigel, on the systemically important financial institution designation, this could take the rest of the day if we wanted to. I'll try to keep it short. As you know, winds are blowing both directions around thoughts on SIFI designation overall, meaning how many should there be, and how broad should the suite be that puts companies into that category, with some arguments that there really aren't very many, and some other arguments that the more the merrier. So that's highly uncertain at this point. I believe that there are very strong arguments that insurance companies should not be considered systemically important for the purposes of the regulatory intent, but that debate has yet to play out. So I would say we're unsure about the likely status, and you'd stay tuned, and see what the direction is in Washington over the next 6 or 8 months. With respect to the practical consequence, you mentioned the RBC ratio, and that will lead to an important question about the ongoing role of the functional regulators relative to the Federal Reserve if we were designated a SIFI. As you know, having that designation would carry with it Federal Reserve regulation at the holding company, with some notion of enhanced standards for companies that are SIFIs as opposed to the general company regulated by the Fed as a bank holding company. I think the signals that we have indicate a pretty constructive approach to addressing the development and calibration of metrics that would be used to look at a company like Prudential, if it were to become a SIFI. So I'm optimistic that the thinking and the implementation will reflect an understanding of the differences between insurance companies and other financial institutions, and that will also be an environment in which the functional regulators, meaning the state, who focus on those RBC numbers that you mentioned, will also have an important role, and then functional regulation of the insurance companies will remain more or less as it is. So that's a long way of saying that I think the approach will be responsible, and I would not expect a significant disruption to our earnings power in the event that we were designated a SIFI, but I'd add that it is uncertain.

Nigel Dally - Morgan Stanley

That's very helpful.

Operator

Our next question will come from the line of Suneet Kamath with Sanford Bernstein.

Suneet Kamath - Sanford C. Bernstein & Co., Inc.

I have a couple questions on your U.S. Retirement business. First, on the Annuity business, with regard to the $233 million of AOI sort of normalized for the first quarter, I try to track this on a quarterly basis, and I think the fourth quarter comparable number was around $199 million. So sequentially, those earnings went up by 17%, and I think the average AUM was up less than that. So I'm just trying to understand what's going on here. I mean, can you help us think about the ROAs [return on assets] as some of your competitors do, maybe on the new products that you're offering relative to the old products, or just trying to understand what's giving you such sort of positive operating leverage, and then I'll have a follow-up.

Charles Lowrey

I think the positive operating leverage just comes from the scale of which we're operating, and the profitability of the products. As I said earlier, we don't go after market share per se. What we really look at is risk-adjusted returns to us and obviously, providing good product to the customers. And I think as a result of that, we look at the profitability of the product, and we're pleased with that.

Richard Carbone

And the other part in there, the margin is going to expand because as the balances grow and the future profitability expectation increases, and you guys know this, it came back to drops, [ph] and DAC amortization reduces over time. So that will add to the margin expansion.

Suneet Kamath - Sanford C. Bernstein & Co., Inc.

Okay. And any color around the actual ROAs of the new business versus the old business, because we can't see the equity that you allocate to this business on a quarterly basis. So I'm wondering if you can maybe provide the return on assets?

Charles Lowrey

Sure. Let me do that in terms of as we think about it, if it's okay with you, the return on equity. But the question really is, how do we think about the business. And we think about it in terms of 3 different cohorts. We have the legacy kind of non-algorithmic business. We then have the HD series or the legacy HD series, and then the HDI. And given the interest rate increases that have taken place, the increases in the equity markets and the decreases in the VIX or the volatility, we've been -- this has been a very good environment for us. So we're happy with the legacy business, and that's a non-algorithmic business, where we expect low to mid-teens returns on that business. We're very happy with the HD series, especially the surge business, where we expect to hit targeted returns of mid-to-high teens. And we're even happier with the HDI product that we're writing now, which is exceeding our return expectations.

Suneet Kamath - Sanford C. Bernstein & Co., Inc.

Okay, and that's all predicated on a 2% market appreciation per quarter kind of number?

Charles Lowrey

Yes.

Suneet Kamath - Sanford C. Bernstein & Co., Inc.

Okay, got it. And then my follow-up question, my second question is on the Retirement business, the Institutional side. What is driving those net flows in Institutional products? They're quite strong in the past couple of quarters. And I know rates are up a little bit, but I just kind of thought about this as a very rate-sensitive businesses. And I'm just wondering where that new business is coming from, if you could just maybe put some color around the products and maybe some of the spreads that you're getting there?

Charles Lowrey

Sure. Well, this is the investment-only stable value product really, and it's more fee-based than spread-based. But this is the case, I think, where we have jumped into a vortex that was left when banks and some insurance companies left the market in terms of stable value. And we and a couple of other firms jumped in the business when we thought we could get very good risk-adjusted returns, and so we've taken a business from 0 to $23 billion in about 18 to 24 months. We entered a very good business, which has given the rates that we can charge, and that we think are appropriate, very good risk-adjusted returns for us that are accretive to ROE, substantially accretive to ROE.

Suneet Kamath - Sanford C. Bernstein & Co., Inc.

And so that's like on a 15% kind of ROE business that you're writing?

Mark Grier

We're not going to be more specific than Charlie just was, Suneet.

Charles Lowrey

But substantially is an important word in that sentence.

Suneet Kamath - Sanford C. Bernstein & Co., Inc.

Understood. And the guys that have exited the business, I mean, I was talking to another major player in that business, and they were saying that they actually have seen some new entrants, former players actually come back in, are you seeing anything like that?

Charles Lowrey

We're seeing discussion of former players come back in, but we really haven't seen a lot of those players come back in. I mean these were some of the investment banks, it was AIG, it was others. There's talk of some of them coming in, but we still see a very good deal flow.

Suneet Kamath - Sanford C. Bernstein & Co., Inc.

Okay, that's helpful.

Operator

Our next question comes from the line of Randy Binner with FBR Capital Markets.

Randy Binner - FBR Capital Markets & Co.

Great. I wanted to ask about your outlook for debt maturities. They're fairly significant. I think it's around $468 million in '11, and then $850 million in '12. A lot of folks have focused in on the Moody's debt-to-cap ratio, and maybe that focus has been overdone relative to coverage and other items. So just wanted to get a thought on how you're planning to proceed with those, and if we should think about you retiring, or putting down those debt obligations as it relates to capital management?

Richard Carbone

Yes, the $350 million of capital debt maturing in December, we will refinance that in December or prior. We may pre-refund it. We don't intend on paying that down, and you got -- you're right, it's about $850 million. In 2012, half of that is operating debt, and about half of that is capital debt. The capital debt will be refinanced, the operating debt, it depends upon the business conditions at the time. We are focused on the Moody's ratio, but we're not wedded to it. We're focused more on our cash flow capabilities at the holding company to service our debt, and to have a cushion against servicing all our debt.

Randy Binner - FBR Capital Markets & Co.

That's very helpful, and just one other quick detail on capital management. I know that last year, there was a large payment up from PICA to the holdco [holding company] in the second quarter. Is that a regular occurrence? Should we expect to see something similar in the second quarter of 2011?

Richard Carbone

We have made an application to the State Insurance Department for a $1.2 billion dividend, and we expect a piece of which is extraordinary, and a piece of which is ordinary. The ordinary is just by way of application. But the other one requires approval. We expect approval. That's $1.2 billion within the next couple of months.

Mark Grier

And part of the scheduling answer, Randy, is that yes, that's typically when we do it.

Randy Binner - FBR Capital Markets & Co.

Okay. So that's up in the second quarter. And then one more if I could, just back to the big -- kind of the bigger excess capital number, meaning the $4.5 billion. $3 billion was, I think, you said at PICA, and then $1 million to $1.5 million was in other places. Can you break out where the $1 million and the $1.5 million is kind of versus, I guess it would be holdco cash or in Japan?

Charles Lowrey

That's where it is. It's holdco cash and Japan, and the larger piece of it would be at the parent.

Operator

Our next question comes from the line of Ed Spehar with Bank of America Merrill Lynch.

Edward Spehar - BofA Merrill Lynch

Two questions. Rich, I appreciate the additional color on capital. But going back to the comments, when you talk about an excess capital number of $4 billion to $4.5 million, and then you talk about a spendable capital number of $2.2 billion to $2.7 billion, with the comment that the difference is the buffer for stress scenarios. The question is why isn't that then just considered a 480% RBC requirement, because what is the environment where you don't carry the buffer for stress scenarios? And if it is 480%, I mean, are you pricing your business based on a 480% RBC ratio, and then I have one follow-up.

Richard Carbone

Let me flip your terminology there, Ed. The total capital capacity is the $4 billion to $4.5 billion. The excess capital is the $2.2 billion to the $2.7 billion. That difference in between the number that you've thrown out, the 400%, and let's make believe, the 480%. Add those assets that are supporting that capital become cash, they're going to drop into the excess capital capacity. We're not holding 480%. So let me explain it by way of example. There are a couple of items that count in our statutory capital that are included in the calculation, and let's call the calculation the gross capital capacity. But they're not readily spendable or, said another way, the cash flows are not predictable. So because they're not predictable, we're not putting them into the excess capital number, but they're going to turn into cash. Some of these items are subject to -- also, some of them get volatile. They bounce around. The easiest example is the deferred tax asset. A benefit for RBC, but not immediately collectible in cash, but will turn into cash over time. As that asset turns into cash, and it gets monetized, it's going into the excess capital number. If we have none of that stuff above 400%, all of the capital above 400% is going in that $2.2 billion to $2.7 billion number.

Edward Spehar - BofA Merrill Lynch

I guess, Rich, to me, that's a very different explanation than saying the difference is a buffer for stress scenarios. I think that's a very different answer.

Richard Carbone

The difference is not a buffer for stress scenarios. It is not intentional. It's just there now. And so if something happens, it's going to chew up the deferred -- the first thing it's going to chew up, it's going to chew up that sort of, I hate to use the word, the non-cash projections of capital above the 480%. It's not an intentional buffer. It's just coincidental at this point in time. If it goes away, and everything above that 400% is -- the cash flows are predictable, or all of the attributes above the 400%, that's going in the excess.

Mark Grier

And the observation that Rich made that it would be available as a buffer is a nuance that, I think, maybe the difference between the way you're thinking about it right now, and the way Rich is talking about it, it would been available. In an RBC world, in a stress scenario, if you're calculating RBC, that's in it.

Richard Carbone

It's not being intentionally kept. If all of those DTAs [deferred tax asset] became cash and all of the DTAs got us to 400%, but above that was all cash assets, they're going in the excess capital of $2.2 billion to $2.7 billion, and bumping that up.

Charles Lowrey

So in its current form, it wouldn't be viewed as being spendable, but it would be viewed as being a buffer. Over time, it converts from the one to the other.

Richard Carbone

Yes. I don't mean to belabor this, I am not holding that as extra capital for contingency.

Edward Spehar - BofA Merrill Lynch

Okay, I think that is very good news. I'm not sure that that's been -- it's well understood. And I guess maybe to follow-up then on that, how quickly does that $2 billion number sort of convert to cash?

Richard Carbone

Well, that's part of the problem, right? Because the biggest piece being the DTA, okay, so we've got a deferred tax asset on the books, where did it come from? It came mainly from those book losses, the losses we took for book purposes in 2009, right? But they didn't hit the tax return. So we didn't get a real reduction from them yet. So we stuck up a DTA. As we sell those assets or there is bankruptcy, they will become tax deductions and that asset will monetize. We believed, up until now, the intrinsic value of those assets was greater than the market. So we didn't sell them. We can trigger that DTA, and get the cash when we know the intrinsic value and the market value are the same. So it's not going to be forever.

Edward Spehar - BofA Merrill Lynch

I mean just to follow-up, there's really no reason for you, if you believe that there's intrinsic value there, obviously, there's no reason to do anything until the cash piece is gone, correct? But I mean, the ability to turn the whole thing to cash if you want is -- it's there, if I'm understanding this correctly?.

Richard Carbone

Yes.

Charles Lowrey

Yes, that's correct.

Operator

We have time for one final question, and that will be from the line of John Nadel with Sterne Agee.

John Nadel - Sterne Agee & Leach Inc.

I think this is the second quarter in a row I'm getting in under the wire. So Rich, I just wanted to follow up real quick on the extrapolation you did for the additional $0.10 as we look out to the following quarter, and adding the extra 2 months of Edison/Star. I guess just a couple of quick questions on that, one, does that mean we should assume that integration costs will remain at around $50 million quarterly? And then secondly, I just want to also confirm that, that does not contemplate any synergies in those estimates yet.

Richard Carbone

Let me let Ed talk about the synergies. But the lion's share of the onetime cost in the first quarter, which is why I am loathe to annualize them and Ed knows better than I, how are they going to come in, was the transaction costs. Now those transaction costs obviously go away, but they're going to get replaced by real integration costs, and Ed may have a better...

John Strangfeld

The other thing I'd add to that, John, just to jump in, is when Rich described what he did-- this is John -- we're not authoring our point of view regarding the economics of the outlook of Star/Edison in terms of its operating attributes. What we were describing earlier was the change associated with the different share assumption and associated with the [indiscernible]

John Nadel - Sterne Agee & Leach Inc.

Understood.

Richard Carbone

Just to say this one, [ph] John, I think that the real economic that you need to focus on is the improvement in the accretion from 5% to 7%. And Ed, maybe you want to talk about where the onetime costs are going to...

Edward Baird

Just to remind people what those numbers are, the onetime expense is $500 million, spread over the 5 years, and the expense synergies savings are $250 million once we hit the run rate. Those are not spread. I just want to get back to your assumption. They're not spread evenly quarter-by-quarter. So no, you can't put in a flat 50 or whatever number, because they're not that level. They're more lumpy than that. And the expense synergies start to really kick in, in a material way next year in 2012, not in 2011.

John Nadel - Sterne Agee & Leach Inc.

Okay. And just if I recall, on the $500 million of costs, I believe you guys indicated that about $400 million of that $500 million would be spent between the periods 2011 and '12. And so it seems to me that in the costs that you guys bore in the first quarter results, the vast majority of the transaction costs, we've really seen very little, at all yet, of the true integration costs, correct?

Richard Carbone

That's correct, yes. That's right.

John Nadel - Sterne Agee & Leach Inc.

Then I guess just the -- and not to belabor the point on the $2.2 billion to $2.7 billion, but if I think about that, and I compare that to the year-end numbers that you provided us, $1.8 billion to $2.3 billion, so we're up about $400 million that's maybe coincidentally, maybe not, the $400 million that's freeing up from the commodities business sales. Should I -- in other words, do we read into that, that your first quarter results didn't produce any excess capital? I suppose that could be the case, given a very strong organic growth, but maybe you can comment?

Richard Carbone

No. You can't because I was giving out all that information as of 12/31, 12/31/10. The original assumption that the difference -- the only difference I did was, that is -- I added the $400 million from Global Commodities. That is not an estimate for 3/31/2011. And you're correct in assuming that there was earnings and other stuff's happening.

John Nadel - Sterne Agee & Leach Inc.

I was trying.

Operator

Thank you. And ladies and gentlemen, today's conference call will be available for replay after 1:30 p.m. today until midnight, May 12. You may access the AT&T TeleConference Replay System by dialing (800) 475-6701 and entering the access code of 194706. International participants may dial (320) 365-3844. And those numbers once again (800) 475-6701 or (320) 365-3844, and enter the access code of 194706. That concludes your conference call for today. Thank you for your participation and for using AT&T Executive TeleConference service. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Prudential Financial's CEO Discusses Q1 2011 Results - Earnings Call Transcript
This Transcript
All Transcripts