About two months and a half ago, I published an article that argued MetLife (NYSE:MET) was in a good position to grow shareholder value despite onerous regulations from the Fed. The Street shared my sentiment and rated the firm a "strong buy." Since then, the stock has fallen by 17.1% while the S&P 500 fell by only 5.7%. We still maintain that the firm is undervalued and will benefit from an improving stock market and greater-than-expected level of buyback activity. Prudential Financial (NYSE:PRU) is another insurer that is rated a "strong buy", but I remain more reserved on the stock due to poor execution and low organic growth.
From a multiples perspective, MetLife is the cheaper of the two. It trades at a respective 5.8x and 6x past and forward earnings while Prudential trades at a respective 7.5x and 6.8x past and forward earnings. Prudential's net debt to market value ratio is much lower at 0.6, but still raises a concern over whether the Fed will approve of a more aggressive capital allocation policy. Prudential currently offers a dividend yield that is 60 basis points higher than its competitor at 3%. With 2012 share repurchases up in the air and high betas of around 2, the firms certainly have the potential to drive high risk-adjusted returns.
At the third quarter earnings call, Prudential's CEO, John Strangfeld, noted disappointing performance:
"Although our results in the third quarter reflected the highly unsettled market environment, underlying performance of our businesses continue to be quite favorable. Our International Insurance operations, which are largely insulated from changing financial markets, continued to produce a very solid growth in earnings and strong fundamentals. The Life Planner business achieved an 11% increase in earnings as they continue to successfully execute their time-tested business model.
Sales in the Life Planner businesses increased by 13% in comparison to the third quarter of last year based in constant dollars. In Gibraltar, adjusted operating income increased 82%, including the contributions of the former Star and Edison businesses we acquired earlier this year, as well as the gain on sale of a portion of our indirect investment in China Pacific. If we back these items out of this quarter's results to get a same-store type comparison, earnings would exceed those of last year's third quarter by 26%."
3Q11 EPS of $1.07 was well below expectations, but largely a result of one time events, like VA and DAC charges. Asset management performed particularly below expectations, despite y-o-y increases in net flows and AUM. On the positive side, Gibraltar side reached record levels, more than doubling above $500M, and Retirement account values grew by 10% annually. Going forward, however, I do not believe that the firm will reach its 2013 ROE target of around 13% - 14% due to capital constraints from an intrusive regulatory environment. I anticipated ROE declining by 300 basis points while organic growth hovers around 4%-5%.
Consensus estimates for the firm's EPS are that it will decline by 0.8% to $6.22 and then turnaround to grow by 12.5% and 16% in the following two years. Assuming a multiple of 8x - which is reasonable given macro headwinds - and a conservative 2012 EPS of $6.95, the rough intrinsic value of the stock is $55.60. This implies only 16.7% upside and, in my view, does not merit calling the investment a value play. If the multiple were to decline to MetLife's level and 2012 EPS turns out to be just 4.3% below the consensus at $6.70, the stock would fall by 15.7%. Accordingly, I believe the investment has greater risk than many investors are expecting at the given price.
MetLife, on the other hand, has indicated optimistic growth in its guidance. Management has guided for 2012 EPS of $4.80 - $5.20, not including share repurchases since the Fed has rejected its policy. I am actually anticipating buyback activity of around $1.5B, as the RBC ratio was around 8% recently. Put differently, MetLife has set the bar low. In addition, investors are not fully appreciating the $18B worth of notational interest rate floors that the insurer purchased to hedge against the low rate environment.
Consensus estimates for MetLife's EPS are that it will grow by 12.1% to $4.91 and then by 2.9% and 10.1% more in the following two years. Assuming a multiple of 8x and a conservative 2012 EPS of $4.94, the rough intrinsic value of the stock is $39.52, which implies 29.4% upside. Even if the multiple were to stay constant and 2012 EPS turns out to be 5% below the consensus at $4.80, the stock would only fall by 8.8%. Unlike my outlook on Prudential, I believe MetLife has favorable risk/reward.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in MET over the next 72 hours.