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Principal Financial Group, Inc. (NYSE:PFG)

2012 Guidance Conference Call

December 01, 2011 10:00 am ET

Executives

Daniel Houston - President of Retirement, Insurance and Financial Services

Larry Donald Zimpleman - Chairman, Chief Executive Officer, President, Chairman of Executive Committee, Chairman of Principal Life, Chief Executive Officer of the Principal Life and President of Principal Life

Terrance J. Lillis - Chief Financial Officer, Chief Accounting Officer and Senior Vice President

James Patrick McCaughan - President of Principal Global Investor

Norman R. Sorensen - Chairman of Principal International Inc

John Egan - Vice President of Investor Relations

Analysts

Jay Gelb - Barclays Capital, Research Division

Thomas G. Gallagher - Crédit Suisse AG, Research Division

A. Mark Finkelstein - Evercore Partners Inc., Research Division

Suneet Kamath - Sanford C. Bernstein & Co., LLC., Research Division

Edward A. Spehar - BofA Merrill Lynch, Research Division

Christopher Giovanni - Goldman Sachs Group Inc., Research Division

Eric N. Berg - RBC Capital Markets, LLC, Research Division

John M. Nadel - Sterne Agee & Leach Inc., Research Division

Operator

Good morning, and welcome to the Principal Financial Group 2012 Guidance Conference Call. [Operator Instructions] I would now like to turn the call over to Mr. John Egan, Vice President of Investor Relations.

John Egan

Thank you, and good morning. Welcome to the Principal Financial Group's 2012 Guidance Conference Call. Yesterday, we issued a press release, detailing our 2012 earnings per share guidance range. The release and supporting slide presentation for this call are available on our website at www.principal.com/investor. Following the reading of the Safe Harbor provision, CEO, Larry Zimpleman; and CFO, Terrance Lillis, will deliver some prepared remarks, then we will open up the call for questions. Others available for Q&A are Dan Houston, Retirement Investor Services and U.S. Insurance Solutions; Jim McCaughan, Principal Global Investors; Norman Sorensen and Luis Valdes, Principal International; 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. Risk 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 and quarterly report on Form 10-Q filed by the company with the Securities and Exchange Commission.

Now I'd like to turn the call over to Larry.

Larry Donald Zimpleman

Thanks, John. Before Terry provides details around our 2012 earnings per share guidance, I'd like to reiterate a few key points from our prior calls. Overall, we are pleased with the continuing momentum of our businesses. That momentum has been building throughout 2011, and is reflected in strong year-to-date results in our businesses. Despite a slow economic recovery and market headwinds, business fundamentals such as sales, client retention and cash flows remain strong, and we're optimistic that this momentum will continue in 2012. Additionally, the continued successful execution of our strategy positions us for continuing growth in the U.S. and the international markets where we operate.

In 2011, we closed on 3 global acquisitions, which contributed to the growth in Principal Global Investors and Principal International. We will continue to look for strategic opportunities, and combine this with our strong organic growth as we further develop our diversified platform. Finally, our financial position remains strong and our business model generates increasing amounts of free cash flow, which provides us with the ability to put more capital to work as we clearly demonstrated in 2011. Year-to-date, we have deployed $350 million in strategic international acquisitions, $450 million in share buyback and $250 million for the annual common stock dividend, which is a 27% increase over last year.

On top of that, we announced last night that our board authorized an additional $100 million share repurchase program. We're very proud of what we've accomplished in 2011, and think this is a great template for our capital deployment strategy going forward. We'll continue to be diligent in our evaluation of all our capital deployment opportunities as we look to continue to grow and increase the value of the enterprise. All in all, we believe our growth profile and shift toward a fee-based business model presents a compelling longer-term investment opportunity. We continue to monitor regulatory issues, and remain confident in our ability to execute on our strategy.

As I look at our business makeup, our current geographic footprint in the current world economy, I am more confident than ever that we are positioned well with the right products and services in the right markets. This will help us grow and further differentiate the Principal in 2012 and beyond.

Terry will now provide the details about our 2012 earnings per share guidance. Terry?

Terrance J. Lillis

Thanks, Larry. This morning, I'll focus my comments on our earnings per share, EPS guidance for 2012 and the assumptions we used, our modest impact from the low interest rate environment, our capital deployment strategy in 2012, the new deck accounting guidance and its impact on our businesses, and an update on our projected investment losses.

Last night, we issued our 2012 operating earnings per share guidance range of $3.05 to $3.25. The key drivers of our earnings are the growth in assets under management and our operating leverage potential. To assist you today, we prepared a few slides outlining our 2012 guidance that I'll reference throughout my prepared remarks.

Slide 4 list the key assumptions we used to develop the 2012 guidance range, which includes an average S&P 500 Index of 1,275 in 2012, resulting in an 8% to 10% growth in average assets under management, and assumption that the low interest rates as of September 30, 2011, will continue throughout 2012, $800 million to $900 million of total deployed capital in 2012. This would include common stock dividend, strategic acquisitions and opportunistic share repurchase, which may result in a diluted weighted average common share count range of 300 million to 305 million in 2012, an estimated earnings reduction of $35 million to $45 million in 2012 due to the new DAC guidance, which will be adopted January 1, 2012, and operating losses for the Corporate segment of $120 million to $130 million.

Let me provide additional detail on these assumptions. The fifth slide, titled Key Drivers - Equity Markets, shows actual performance of the S&P 500 through November 16, 2011, and assumes a 2% total return growth per quarter after that through 2012. Using this outlook, the average S&P 500 will increase slightly in 2012 over 2011, while our average assets under management will grow at 8% to 10% during the same time period. This reflects the continued momentum in terms of business fundamentals such as strong sales, retention and net cash flows.

Taking a look now at Slide 6, if interest rates remain low, our earnings will grow, but at a slower rate. As we said in our third quarter earnings call, our shifting business model means that we now have a much higher portion of earnings coming from less capital intensive, more fee-based businesses. Our long-term growth in earnings assumptions is 10% to 12%, and could be marginally offset if lower interest rate environment persists. With the low interest rate environment factored in, we would expect earnings to grow at the low end of the range. Our capital deployment strategy in 2012 will look very similar to what you saw in 2011. We will continue to be diversified, disciplined and look for the right opportunity.

Slide 7 shows the capital deployed in 2011, and outlines what we have planned for 2012. We feel this strategy reflects the strength of our financial position, as well as our commitment to returning capital to shareholders. In 2012, we anticipate deploying $800 million to $900 million of capital on dividends, strategic acquisitions and opportunistic share repurchase.

Slide 8 highlights the impact related to the new DAC guidance set to go into effect on January 1. As we said in our third quarter earnings call, the application of this guidance will result in less capitalization of acquisition cost, resulting in increased current period expenses. The retrospective application of this guidance will also result in the reduction of our deferred acquisition cost asset, as well as eliminate any future amortizations associated with the deferred acquisition cost assets, written off as of the beginning of the year.

We currently estimate that adopting this new guidance will result in a net $35 million to $45 million after tax reduction in 2012 operating earnings. The allocation by business segment is approximately 45% to Full Service Accumulation, 30% to Individual Life, 15% to Individual Annuity and 10% to Principal International. In addition, we're also providing prior and new expected quarterly DAC amortization ranges by business. These estimates are based upon the current operating assumptions and current interpretation of the guidance, and are subject to change. Going forward, however, there will be less earnings volatility of Full Service Accumulation since there will be a lower DAC assets subject to true-ups from equity market returns and experience adjustments.

Slide 9 is our most recent projection of investment losses, which remain in line with prior projections and are manageable. In closing, Slide 10 summarizes everything we talked about today. If we use current 2011 consensus as a starting point, underlying EPS for 2012 is growing at 18%, including the new DAC guidance impact results in the 2012 EPS range of $3.05 to $3.25. As Larry said, the underlying fundamentals of our business remains strong, as does our financial position, both which position us for a long-term growth.

Now I'd like to open the call up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from Jay Gelb with Barclays Capital.

Jay Gelb - Barclays Capital, Research Division

Jay Gelb from Barclays. I just want to get a sense in terms of how you're getting to the end assumption of 8% to 10% asset under management growth, and what that implies for flows by the major business segments?

Larry Donald Zimpleman

Jay, this is Larry. I'll make a high-level comment on that, and Terry and other business unit heads may want to comment. But in general terms, what we're assuming there is that the flows will be about -- in total, they'll be about $6 billion for the U.S. retirement business. But between Full Service Accum and mutual funds, will be about $6 billion to $8 billion in Principal International, and that will be somewhere in the range of $10 billion or so for Principal International -- I'm sorry, Principal Global investors. The last piece, Principal Global Investors. Does that help, Jay?

Jay Gelb - Barclays Capital, Research Division

It does. And your confidence in those numbers are based on pipeline?

Larry Donald Zimpleman

Well, let me have --let me just ask maybe each of the 3 business heads to comment a little bit. I'll start with Dan Houston. Dan?

Daniel Houston

Yes, Jay, pipeline does look good. We mentioned that in the third quarter earnings call as well. And frankly, what we like about the quality of the pipeline right now for Full Service Accumulation, it's not limited to just the large case that's actually the small, medium and large across both for profit, not for profit. So I'm as optimistic today as I was a couple -- a month ago or so when we had our third quarter call. Our mutual fund business continues to be attractive to the marketplace. We have a lot of the asset classes covered that the alliance partners are looking for. So again, feel really good going into the first quarter of 2012.

Jay Gelb - Barclays Capital, Research Division

Okay. And then looking at this page, which is the long-term earnings growth potential, what do you think is a reasonable target for return on equity with that type of growth value?

Larry Donald Zimpleman

Well, Jay, I mean, we just reiterate what I think what we've been saying here on a consistent basis, which is that we would see our ROEs, setting aside again the impact of EITF, which is sort of a one-time impact, roughly 30 basis points. But beyond that, we would see a sort of a normal organic growth of the business, giving us a 50 to 80 basis point ROE increment every year.

Jay Gelb - Barclays Capital, Research Division

Off of a, what, 10% base line?

Larry Donald Zimpleman

Off of roughly a 10% base, yes.

Operator

Your next question comes from Ed Spehar with Bank of America.

Edward A. Spehar - BofA Merrill Lynch, Research Division

I was wondering if you could go into a little bit more detail, I apologize if I missed this. But on the $800 million to $900 million of capital that you expect to deploy in 2012, we don't know what share price you might be assuming. But even if we look at that low end of the average shares, it looks like maybe that's assuming a few hundred million dollars of buyback? And the dividend is probably a few hundred -- less than a few hundred million? I mean, are you building in some expected earnings contribution from acquisitions? Or how are you factoring in that full $800 million to $900 million in the guidance?

Larry Donald Zimpleman

Sure. I'll make a couple of comments, and then ask Terry to comment more deeply, Ed. This is Larry. So I guess the -- it's always difficult, obviously, to project really the categories of strategic acquisitions, as well as share repurchase. So certainly, anytime you try to do a projection like this, there's some level of uncertainty built into that. I think, again, the best kind of insight, I guess, that I can give you on that is to really look at what happened in 2011, which again was a greater level of return of capital to shareholders than we project in 2012 because the reality, Ed, is that we are in the process of rightsizing the capital of the organization over time. And we've always had a strategy, where this is going to take 2 to 3 years to happen. Now the good news is because of the strength of our operating earnings and the increasing amounts of free cash flow, we can -- we will always be able to return significant amounts. But 2011, we're sort of coming off a year that was actually a greater amount of return to shareholders than frankly what we would have on a going-forward basis as we sort of rightsize the capital. Now maybe I'll ask Terry to comment a little more around what underlies the guidance.

Terrance J. Lillis

No, Larry, you're absolutely right. Ed, one of the things that you have also to take into consideration is the growth in the organic business as well, and there is some of our earnings that are attributable to that. And then what we've talked in the past, it's about 1/3 of our net income, and that's probably closer to that 25% to 30% of our net income as well, but Larry is absolutely right. It is a thoughtful deployment of acquisition activity that as we look out into the future, the dividends was a little bit more than $200 million, as you said, slightly under $200 million in 2011. And then the share buybacks are those, there's that RIA stat that will adjust accordingly based upon the timing throughout 2012.

Norman R. Sorensen

This is Norman, Ed. One of the things that we did, obviously, is continue to build scale in our strategic core, core businesses, which is the Defined Contribution business. And in Mexico, for example, we acquired, as you know, in the third quarter the HSBC AFORE business. That's immediately accretive. It will give us somewhere between $0.02 and $0.04 per share this year, and somewhere in the range of $0.06 to $0.08 per share next year.

Edward A. Spehar - BofA Merrill Lynch, Research Division

One follow-up, if I could. Is the -- but do you have in your guidance some assumed earnings contribution from what looks like $200 million to $300 million of additional capital deployment beyond what might be built in for the combination of share repurchase and dividends, which like I said, looks like it's in the neighborhood of $500 million to $600 million?

Larry Donald Zimpleman

Yes. As a general answer to that, Ed, what I would say is because -- and you know this as well as anyone, because of the way accounting works, the reality is, is that any contribution to earnings in the current year, in which you'd acquire a new business, would be relatively modest. And I would say relative to having a $305 million to $325 million range wouldn't move you one way or another outside of that range. So I don't see that -- while we expect to do strategic acquisitions in 2012, they aren't necessarily a big contributor to the 2012 EPS itself because it's going to take a year or 2 under any -- almost any circumstance for an acquisition to be accretive. The HSBC AFORE acquisition that Norman referenced with the $0.02 to $0.04, that's probably as good as you could ever get, and that's only $0.02 to $0.04. So that just gives you some insight.

Edward A. Spehar - BofA Merrill Lynch, Research Division

Okay. Just sorry, one last quick one on this is that if -- what is this sort of -- what is the point when you look at this and say we spent more on buyback again next year like we did this year? I mean, obviously, I think you view the stock as very attractive at the current level. I suspect you assume it goes up next year when you figure out what your average shares are going to be. But if it -- how do we think about, let's say, the stock doesn't go up, and how do we think about that versus acquisitions?

Larry Donald Zimpleman

Yes. I'm obviously not going to get -- I mean, it would be impossible for me to sit here, Ed, and try to predict at what levels of share price we do, how many repurchase of shares, et cetera. Again, as Terry said, I actually look at it the other way around. The issue here is more the long term that -- building our business over the long term. So I really look at it more as what's going to be the opportunities around the appropriate strategic acquisitions, the organization over the long term, and then to the extent we have capital deployment capabilities beyond that, we are always looking at the possibility of an opportunistic share repurchase. And I would say in that sense, we've sort of migrated our capital management philosophy a little bit over the years in the sense that we're more focused now around opportunistic share repurchase as compared to just simply returning excess capital through share repurchase. So there is quite a list of strategic acquisitions out there. And I think with our $800 million to $900 million capital deployment budget, we have the opportunity to play in that space. And I think we have the responsibility to build long-term shareholder value and look at those strategic acquisitions.

Operator

Your next question comes from Suneet Kamath with Sanford Bernstein.

Suneet Kamath - Sanford C. Bernstein & Co., LLC., Research Division

I wanted to circle back again on the 8% to 10% average growth in AUM because it seems to me that the environment that you're laying out here in terms of essentially flat equity markets and low interest rates relative to September 30 levels would suggest a continuation of kind of a weak economy, certainly on the interest rate side. So I guess I'm just struggling with, again, this 8% to 10% because the $23 billion or so of flows that you talked about when you sort of added sort of separated it by segments seems quite a bit higher, I think, than what you guys have done historically. And if you think about an environment where things are still kind of choppy or uncertain, again, I'm just struggling with where that growth is coming from, so any color you can provide on that would be helpful.

Larry Donald Zimpleman

Sure, Suneet, this is Larry. So let's talk about that in a little bit more detail. If you actually go back and look, certainly, let's talk about 3 periods, we'll talk about sort of before the financial crisis, the financial crisis and then 2011. Certainly, before the financial crisis, you saw that we -- our net cash flows would have been very strong. They might not have been quite at that level, but they would have been very, very strong, but there would have been more of those coming out of the U.S. retirement business, predominantly Full Service Accumulation. Obviously, during the financial crisis, everything took a hit. Cash flows went down. If you look at 2011, what we're forecasting for 2012 is generally consistent around net cash flows. So for example, we're assuming FSA net cash flows are at about the same level in 2012 as 2011, but one area -- the 2 areas where we are expecting increased flows would be in Principal International and in Principal Global Investors. So maybe what I'll do is turn and ask both Norman and Jim just to make a couple of comments about why that we might see some better net cash flow in those 2 areas of the business. So I'll start with Norman.

Norman R. Sorensen

Suneet, the emerging market economies have been growing, as you know, a lot faster than the U.S., the European, Japanese economies. We've seen our business particularly in Defined Contribution pensions and mutual funds grow very quickly there. The growth typically is about 2 or 3x faster in AUM than the U.S. and Europe. So on a trailing 12-months basis through the third quarter, we generated about $6 billion, $6.5 billion in AUM. We expect certainly the trends to continue in that range or higher.

James Patrick McCaughan

And from a Principal Global Investor's point of view, I would point out that the flows have -- the inflows have improved quite a lot, and the pipeline has improved quite a lot in 2011. The investment managers are showing big outflows of those who are dependent on core products, U.S. large comp, core multi-sector, fixed. Those are the difficult areas. Because of our multi-boutique structure, we have a lot of highly added value satellite mandates with strong performance, which are really in the sweet spot of where institutional investor demand around the world is going. I would mention, particularly emerging markets that are -- we are strong in both debt and equity. I've mentioned all the yield-based products, whether it's preferred, our high-yield teams, commercial market mortgages and, of course, emerging market debt. Those are all areas that are seeing a lot of investor interest. And then, of course, real estate, which is in the principal specialty for at least 2 decades, and where investor interest is being spiked at the moment. So we see ourselves as building, I think, in a very good position. And as evidence of that, I'd really point to the way the pipeline has been building up, so -- and as Larry said, this is not out of our order with what happened in the 2006, 2007, 2008 period. It's really more back to that. And at the time when we have managed to shift our product range very much more in line with client demand than have most investment managers.

Suneet Kamath - Sanford C. Bernstein & Co., LLC., Research Division

Okay. That's helpful. Maybe for Terry, if you could just give us maybe a rule of thumb as we think about that 8% to 10% growth in AUM on average. What would sort of a point, a percentage point of that translate into just a high level in terms of EPS?

Terrance J. Lillis

In terms of EPS, I think that's in line with what we forecasted range for EPS next year is in that $305 million to $325 million. And as you look at AUM and a return on that assets under management, you're typically in that 30 basis points for the total company.

Larry Donald Zimpleman

So every $1 billion would be about 30 basis point of earnings.

Operator

Your next question is from John Nadel with Sterne Agee.

John M. Nadel - Sterne Agee & Leach Inc., Research Division

Just a quick one on the flows. I just want to confirm that the flows that you're sort of targeting at $22 billion, $23 billion. So that's all organic, right? That's not assuming any M&A?

Larry Donald Zimpleman

That's correct, John.

John M. Nadel - Sterne Agee & Leach Inc., Research Division

Okay. And then on the DAC impact by segment, if I look on Slide 8, just 2 quick questions. First is should we think about the DAC that's being written off as a similar percentage by segment as the earnings impact?

Larry Donald Zimpleman

Yes, I'd say that's true.

John M. Nadel - Sterne Agee & Leach Inc., Research Division

And then focusing specifically there on Full Service Accumulation, just curious as to why that particular segment is hit harder from an earnings perspective? And what it means for your ROA guidance there?

Larry Donald Zimpleman

Yes. Well, first of all, I'll talk about the impact on the DAC aspect. A lot of the DAC associated with this, as we changed the rules, it's more successful, and what is defined as successful is in terms of what you're paying externally as much as anything. Since we're dealing a lot with advisors, some of the DAC that we're amortizing were more internal costs in the past. And as a result of the change in the DAC accounting, we're going to end up amortizing or capitalizing a lot less at this point in time, which is the significant reason why there is more impact on that. So Dan, you can talk about the ROAs?

Daniel Houston

Certainly. Yes, I mean, when we look at the post-EITF impact on ROAs, you kind of get in that 24% to 26% range. And again, back to net cash flow, we would anticipate in 2012 somewhere in that 3% range for Full Service Accumulation.

Larry Donald Zimpleman

And, John, let me just make a couple of additional comments around that. Because if you just -- if you looked at the Full Service Accumulation having a 2012 sort of ROA somewhere in that 24% to 26% basis point range, that still reflects at that point an overall return on equity in the 25% to 30% range, and it reflects a return on revenue that's about 30%. So I think we need to put it in the context that those metrics, those financial metrics, would be among the best that you could find anywhere in the financial services space. So that is still an exceedingly attractive business with increasing growth prospects. So, again, I want to put that all in perspective.

John M. Nadel - Sterne Agee & Leach Inc., Research Division

Yes, I was just looking for the numbers. I understand it's really not an economic. It's an accounting change, and not really a change in your business. Is it -- should I compare, though the 24% to 26% to what? To the 28% to 30% or the 30% to 32%? Which one do I compare that to?

Daniel Houston

The 28% to 30%.

Operator

Your next question comes from Chris Giovanni with Goldman Sachs.

Christopher Giovanni - Goldman Sachs Group Inc., Research Division

I wanted to see in terms of M&A if you could comment in what type of opportunities you're currently seeing out there? And if we should expect similar types of deals that we saw in 2011? And then additionally, how big is your appetite in terms of willingness to take on maybe something larger?

Larry Donald Zimpleman

Well, Chris, this is Larry. I'll start. There's a lot sort of packed into that, so I'll try to be reasonably brief. I would say that we are, first of all, we're extremely pleased with the M&A that we've been able to do in 2011. I simply can't think of a year in the 40 years I've been part of the organization, that I would look at and say it's more successful for us in terms of M&A than 2011. So to be candid, it's going to be a little difficult to sort of repeat that act in 2012, although we're going to try. Again, Norman and Jim may want to comment. At a very high level, what we're seeing is what you see sort of reported in the press, which is to say that European financials are under stress. And so they have a need either to raise capital or to retreat back to core operations. So many other businesses that are non-core outside the European area is often something that they would consider. The second general area that I'd say that we see, which again is reported regularly, is that I think the Latin American opportunities are more prevalent today, both because I think people perceive that the value of those properties may have increased, and because Latin America has not been hit as hard in the recent financial crisis. So those businesses have continued to perform on a relatively stronger basis. So those would be the 2 areas from which we're seeing things. And then, of course, there's always the ongoing sort of opportunities that Principal Global investors has around boutiques. So let me see if Norman or Jim have any additional comments they want to make.

Norman R. Sorensen

Chris, this is Norman. Basically, as you know, outside the United States, our core businesses, and that's what we engage in as Defined Contribution pensions, mutual funds and asset management on a local basis. The opportunities, on a bite-sized basis, basically, in the $100 million to $200 million around these markets, our 10 markets outside the United States, continue to emerge. Obviously, it all depends on deal flow. But we are fairly, fairly optimistic that these opportunities will continue to emerge.

James Patrick McCaughan

Chris, it's Jim here. We are seeing a lot of potential partners among boutique asset managers. The experience of 2007 to 2009 has led many self-contained boutiques to realize that they're better off with a distribution partner that offers global distribution, and also offers some of the comfort and oversight of a very capable large organization. Clients want that now. So the market in terms of potential boutique asset management partners is really quite fertile at the moment. The kind of boutiques we're looking for are very much like Finisterre and Origin; good at investing and providing services that our clients, whether it be U.S. retirement and mutual funds, international retirement or the global institutional clients. It's the client -- it's providing services those clients want. And so I would be disappointed if we don't find a similar small group, rather as we did this year with Finesterre and Origin next year of boutique asset managers. Areas we continue to look -- income-based assets, emerging markets, hedge fund of funds, the ability to put together different investment products for an outcome, these are areas that we're looking at very intensely. As regards to bigger possible consolidations, I think the trouble with many of them is that they're part of larger banks that haven't been often terribly focused in their management. We've looked at several. I would handicap those as less likely, but something that we continue to look at in case we find a sort of step function larger target. But it's not something that we're particularly adamant we're going to find. But we would be remiss if we didn't look at them as they are released by parents that either need the capital, or don't see the strategic alignment with asset management.

Operator

Our next question is from Mark Finkelstein with Evercore.

A. Mark Finkelstein - Evercore Partners Inc., Research Division

I guess just one clarification going back to John's question. So the ROA outlook of 24% to 26%, the adjustment on that, is that purely due to the accounting? Or are there any other areas of adjustment that we should think about?

Larry Donald Zimpleman

Mark, this is Larry. I would say that there -- I think if you just did the math, right, if you just did the math, I think it wouldn't quite get you to that entire difference. Again, what we're trying to do here is to recognize that the economy in the U.S. is going to continue to be pretty soft. So we're assuming again flows sort of at the same level as they were in 2011. And there are things that -- there are other economic factors that impact that margin for 2012. So for example, if we were to see more increase in recurring deposits, that would be a positive relative to that ROA. So our 24% to 26% isn't assuming much of an increase in recurring deposits. So it's a combination of both the EITF accounting plus our sort of conservative view around the economics of what's going to happen in 2012.

A. Mark Finkelstein - Evercore Partners Inc., Research Division

Okay. And then, I guess, just on the M&A strategy, in 2011, you did 2 deals, kind of boutique-y deals. They fit certain, I think, very specific niches. I mean, is there any change in the strategy? Or, like are there areas that you feel like from a product set or product offering that you actually need to fill in terms of the lineup? Or is it purely just opportunistic in finding the right group of guys that may overlap with existing strategies?

Larry Donald Zimpleman

Yes, I mean, Jim touched on that in the answer to Chris' last question, but maybe I'll just have him comment on that again.

James Patrick McCaughan

Yes, it's not so much, Mark. It's not so much need to have. I'm very pleased with the investment platform we've got. It's got very strong capabilities across a broad range of client needs. It's much more about augmenting the platform with -- in the areas that we particularly like, like emerging markets, global equities, income-based products. Those are really the areas that are going to continue to be areas where we need to have choices for our clients, excellent choices for our clients. And that's really what we're focused on in looking at the potential partnerships.

A. Mark Finkelstein - Evercore Partners Inc., Research Division

Okay. And then just one clarification actually, I think historically, you've talked about 65% of net income is a free cash flow number that can be used for dividends, buybacks, M&A, what have you. And then you used a number of 25% to 30%. You may have used the word operating earnings. Is that just the definitional difference between net income versus operating earnings? Or are you raising kind of the ratio of free cash flow?

Larry Donald Zimpleman

We -- well, first of all, operating earnings and net income are definitional differences, right? Operating earnings are the -- the operating earnings off of the businesses. Net income, obviously, includes among other things, recognizes investment losses, investment portfolio losses. So at the end of the day, the net cash flow maybe the cash flow that we have -- our capital management strategy is tied to net income. And so what is happening over time as our businesses migrate to a fee-based model, Mark, is we are able to have a higher percentage of net income be available for redeployment over time. So as you said, the $65 million may have been a historical number that is increasing over time as our business model is moving to more fee-based earnings.

Operator

Your next question is from Thomas Gallagher with Credit Suisse.

Thomas G. Gallagher - Crédit Suisse AG, Research Division

I just wanted to circle back on capital management. The -- I just want to understand how we should be thinking about this going forward? The high end of your capital management, $900 million, that's actually almost equivalent to your earnings guidance on a per-share basis. Now, obviously, if we assume that was a sustainable number and we didn't include any drawdown of excess capital, that would be a -- you'd essentially be using -- all of your earnings would be free cash flow now. Now, clearly, I know you're not saying that. So should that being said, should I think about what you're going to do with capital management as being a partial drawdown of on-balance sheet excess plus retained earnings? Or anyway that's my first question.

Larry Donald Zimpleman

Sure, Tom. This is Larry. Again, we talked about this earlier. So again, during the period of the financial crisis, obviously, it was a smart thing for any financial services organization to be carrying higher levels of capital in the organization than what has been necessary. And I think we've been consistently communicating our excess capital positions and indicating that of that excess capital, which for example, at the end of the third quarter, was about $1.5 billion that of that $1.5 billion, it was our belief based on our analysis of the risk characteristics of our business that we would retain a target of about $1.15 billion, meaning that we'd have about $350 million at the end of the third quarter that was potentially available for redeployment. So that would -- so going -- we don't intend to just go out and lank it, use that $350 million all at once. So for example, last night, we announced $100 million share repurchase. We'll obviously, have earnings help to replenish that during Q4. So this rightsizing of the capital management position, as I said earlier, is something that will take 2 to 3 years. So right now, we sort of have the benefit, which I think shareholders don't fully appreciate that we're actually deploying capital back to them, even greater than the net income. Obviously, that can't be sustained over time. But the earnings will grow. And so my nonscientific guess at this is that our annual capital deployment will probably be in that sort of $750 million to $900 million range on a consistent basis kind of going forward, and then building over time after we've rightsized the capital of the organization.

Thomas G. Gallagher - Crédit Suisse AG, Research Division

Got it, Larry. So yes, so bottom line is here, you were -- the amount of money you're returning to shareholders could be close to net income for the next several years just because you're sort of gradually drawing down on that access? Is that the right way to think about it?

Larry Donald Zimpleman

That's correct, Tom. And again, I think that for whatever reason, I think, perhaps, there's not a clear understanding of the strength of the capital generation, along with the rightsizing and what that means in terms of capital deployment possibilities.

Thomas G. Gallagher - Crédit Suisse AG, Research Division

Okay. And then I just had a specific numbers question. If I look at the $700 million or so of capital management x dividends, that's on the high end of the range, and if I just assumed you ratably bought back stock over the course of the year and I assumed it didn't go toward acquisitions, I would get something like a 5% to 7% earnings lift from that. That's my numbers, not yours. But if I understood that what you were saying correctly and if I just look at the share count you're assuming, it looks like what's in your 2012 earnings projection is something well below a 5% to 7% earnings benefit. So I guess my first question is a, is that right? And b, can you quantify how much of an earnings lift is embedded within that capital management figure because it's not entirely clear to me?

Larry Donald Zimpleman

Well, this is Larry. I'm not sure we collectively -- either individually or collectively, Tom, followed the question. If the question really is how much of the lift in EPS from 2011 to 2012 was as a result of share repurchase, is that more your question?

Thomas G. Gallagher - Crédit Suisse AG, Research Division

Yes. So Larry, just based on the 2012 capital management assumption in your guidance, how much earnings growth of your 17% earnings, I guess, that was organic earnings growth of 17%? But how -- of your EPS guidance, how much on a percentage-growth basis year-over-year is coming from capital management?

Larry Donald Zimpleman

Well, yes, so in going roughly from 2011 to 2012, I think you would -- I think that's, again, an apples-and-apples basis, I think that 17% growth in EPS would be about right. And so I would say more like 7 percentage -- 7 points comes from, if you will, share repurchase, the impact of share repurchase, and 10% sort of comes from the growth of the businesses.

Thomas G. Gallagher - Crédit Suisse AG, Research Division

Okay. That's great, 7% and 10%.

Larry Donald Zimpleman

You bet.

Operator

Your next question comes from Eric Berg with RBC Capital Markets.

Eric N. Berg - RBC Capital Markets, LLC, Research Division

I'd actually to like to start with a question about the DAC and then return for my second question, my follow-up to the cash flow issue. I'm on Slide 8 on the right-hand side, and I'm just trying to interpret the exhibit, maybe Terry or another member of the financial team can weigh in. Let's just take one row as an illustration. Are you saying here that if the amortization, the DAC expense in FSA was $20 million to $25 million per quarter pretax, that under the new regime, accounting regime, it will fall to $0 to $5 million per quarter, is that how to read the table?

Terrance J. Lillis

Yes, Eric, this is Terry. That's exactly right. What we've said in the long term is on a normal period, Full Service Accumulation would have had $20 million to $25 million currently. Now you've seen that volatility because of equity markets, because of experience, et cetera. But over a longer period of time, $20 million to $25 million of amortization was appropriate. In the future, because we written-off so much of the DAC asset because of the change in the EITF rule, the amortization now should fall into that $0 to $5 million, which is we see as a positive because although you'll still have volatility to DAC accounting, the magnitude obviously will be considerably smaller.

Eric N. Berg - RBC Capital Markets, LLC, Research Division

So, Terry, if the -- this is such a rudimentary question, it's almost embarrassing. If the earnings, if the reported GAAP earnings under the new accounting regime will be higher than under the old accounting regime owing to lower amortization, why is the ROA going down?

Terrance J. Lillis

You will see the ROA going down because of the capitalizations, which is also an expense item, which isn't taken in into consideration here in the short term on growing companies, will offset that reduction in amortization. The reduced capitalizations will actually increase the expenses more in 2012 than the reduction in the amortizations.

Eric N. Berg - RBC Capital Markets, LLC, Research Division

Got it. Okay, so net-net, so to speak, the earnings in the business will be lower than would otherwise have been the case?

Terrance J. Lillis

Exactly.

Eric N. Berg - RBC Capital Markets, LLC, Research Division

Okay. If I could ask a second question, going back to cash flow, I'm sort of struggling a little bit too with this whole issue of the arithmetic. And then ultimately, what I'm going to -- my ultimate question is going to be what -- why wouldn't next year be so much better than that this year internationally and in Jim's business? But in any case, this is in summary how I'm thinking of things and you can tell me whether I'm thinking of them correctly or not. It looks like you're looking for very little help from the stock market. I think the increase in the averages is about 1.8%. Overall, you're looking for an increase in average assets of, call it, 9%. That, to me, means that the great growth, the great bulk of the growth in the average assets will be driven by organic growth. I think along the way, Dan said he's looking for 3% organic growth in FSA, which in turn would imply that in Jim's business and in Norman's business, you're looking for much more than that overall growth of much very, very robust organic growth in Jim's business and in Norman's business. So my question is am I putting all the pieces together correctly? And if so, why will Norman's business and Jim's business grow organically, so much more rapidly next year than this year?

Larry Donald Zimpleman

Eric, this is Larry. So again, let's take this by pieces. We talk about U.S. retirement. We talk about Principal International. We talk about Principal Global Investors. U.S. Retirement includes both FSA and mutual funds. Dan was talking about FSA having net cash flows in the 3% to 4% range, and you'd again expect maybe a couple of percent of net cash flow for mutual funds, okay? So that is -- that would be an assumption and a projection, that's very consistent with what 2011 experience is going to be. So we're not forecasting great changes in the business environment or the economic environment as it relates to the U.S. businesses, okay? I think that's a reasonable kind of estimate. On the international side, if you look at Norman's businesses, if you look at net cash flow on a current sort of 12-month basis, it's actually 13% of beginning of period assets, okay? And we have been talking to analysts for a considerable period of time about the opportunities in emerging markets and the opportunities we have for growing assets in those emerging markets, which has been coming through in the business in excess, frankly, of the long-term rate. Because we would believe in the long term, we'd see net cash flow more in the 8% to 10% of beginning assets range. You have about $65 billion to $70 billion of assets. So that gives you sort of the longer-term net cash flow there. The area, I would say, Eric, that will come under the potentially the greatest improvement in net cash flow is in PGI. And Jim has commented many, many times in the prior earnings calls that the institutional market has been the slowest to come back, post the financial crisis. So maybe I'll have Jim address why if it's been the slowest, what gives him optimism about why institutional investors are kind of be returning to the scene.

James Patrick McCaughan

Yes, but thanks, Larry. Thanks for the question, Eric. We are seeing institutional investors around the world start to move much more than they did and particularly, in terms of the committed satellite products that we have through our multi-boutique structure. It's the emerging markets, the yield-based assets, the real estate. So those are areas, where we see an increase in the pipeline, and where that's been factored into the projections for the guidance. So the a positive side of this, which is the flows are getting much more back to pre-financial crisis levels far out, and that's partly because our product range is well-suited to where the client demand is going. There is a second point to this that I didn't mention earlier, which is that in late 2010, early 2011, we had a couple of large assets for core low-fee clients, who departed us. We obviously look at potential clients at risk with a very fine microscope on a regular basis. As far as we can see, although we still have some of those core mandates, which long term, may be strategically vulnerable, our performance bluntly in those areas is a lot better than the more vulnerable competitors. So this is really being -- the net flow is being affected by 2 things. It's the outlook in terms of the pipeline, which we see improving, and it's the outlook in terms of existing client retention, which we also see improving. And it's those 2 things put together, make it look maybe a bit more spectacular than it feels within the business.

Larry Donald Zimpleman

Did that help, Eric?

Eric N. Berg - RBC Capital Markets, LLC, Research Division

It definitely does.

Larry Donald Zimpleman

We'll make a closing comment. Thanks to all of you for joining us for today's call. While we acknowledge the challenges in the economy and the continuing volatility in the markets, we obviously remain very optimistic about 2012 given the current momentum of our businesses. And we look forward to seeing many of you on the road in the months ahead.

Operator

Thank you for participating in today's conference call. This call will be available for replay beginning at approximately 12:00 p.m. Eastern time until the end of the day on December 8, 2011. The number to dial for the replay is (855) 859-2056 for U.S. and Canadian callers, or (404) 537-3406 for international callers. The access code for the replay is 27371066.

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