CNO Financial Group's CEO Discusses Comprehensive Recapitalization Overview Conference Call (Transcript)

Sep. 5.12 | About: CNO Financial (CNO)

CNO Financial Group, Inc. (NYSE:CNO)

Comprehensive Recapitalization Overview Conference Call

September 05, 2012 11:00 am ET

Executives

Erik Helding – Senior Vice President, Treasury & Investor Relations

Edward J. Bonach – Chief Executive Officer

Frederick J. Crawford – Executive Vice President and Chief Financial Officer

Analysts

Randy Binner – FBR Capital Markets

Christopher A. Giovanni – Goldman Sachs & Co.

Paul Sarran – Evercore Partners

Sean Robert Dargan – Macquarie Capital

Operator

Good morning, my name is Ashley, and I will be your conference operator today. At this time I would like to welcome everyone to the Comprehensive Recapitalization Overview Conference Call. All lines have been placed on mute to prevent any background noise. After speakers remarks there will be a question-and-answer session. (Operator Instructions). Thank you, Mr. Erik Helding you may begin.

Erik Helding

Thank you. Good morning and thank you for joining us on CNO Financial Group’s Recapitalization Overview Conference Call. Today’s presentation will include remarks from Ed Bonach, Chief Executive Officer and Fred Crawford, Chief Financial Officer. Following the presentation we will have a question-and-answer period.

During this conference call, we’ll be referring to information contained in yesterday’s press release, you can obtain the release by visiting the media section of our website at www.cnoinc.com. This morning’s presentation is also available on the investor section of our website and was filed in a Form 8-K this morning. Let me remind you that any forward-looking statements we make today are subject to a number of factors, which may cause actual results to be materially different than those contemplated by the forward-looking statements.

Today’s presentation contains a number of non-GAAP measures, which should not be considered as substitutes for the most directly comparable GAAP measures. You will find a reconciliation of the non-GAAP measures, to the corresponding GAAP measures in the appendix. Then now I would like to turn the call over to our CEO, Ed Bonach. Ed?

Edward J. Bonach

Thanks Erik. Good morning everyone and thank you for joining us today. We are pleased to discuss the significant steps we are taking to further improve our capital structure and shareholder value. Our strong operational and financial performance have positioned us favorably to execute on a recapitalization plan, which we anticipate will lower our cost of capital and improve financial flexibility. This recapitalization plan is propelled by the strength of CNO’s business strategy and performance.

Before I dive deeper into the rationale, it’s worth quickly reflecting on our business performance and current capital position noted on slide four. We are dedicated to the underserved and rapidly growing senior middle-income market, which defined and differentiate us in the industry. We have been investing in the expansion of our distribution to this market, while emphasizing profitable growth. This is continuing to yield solid sales and earnings results.

In the first half of 2012, sales grew 9% over the first half of 2011, and operating earnings were up 8% over the same period. We continue to generate and deploy significant amounts of excess capital, with strength in both statutory earnings and cash flow sent to the holding company. Our strong financial position and our continued generation of cash and excess capital allowed us to continue to buyback stock in an accelerated rate.

As previously announced during the second quarter, our Board of Directors approved an additional $100 million for share repurchases as well as approved an initiation of a dividend program. These were significant milestones for CNO, marking the tremendous progress the company has made, through some of the most challenging economic conditions in our history, and also demonstrating confidence in our currents in future cash flow and financial strength. It is even with the increased capital deployment in the second quarter, our key metrics of risk-based capital and debt to total capital further improve during the quarter, and liquidity at the holding company increased to nearly $200 million. These accomplishments have recently been recognized by the rating agencies with S&P revising the outlook and our ratings to positive in early August, and both A.M. Best and Moody's providing upgrades to our ratings within the last week.

Turning to slide five, with the momentum we have in our strong operating performance credit profile and ratings progress combining with favorable market conditions, we have the opportunity to further improve our capital structure and lower our cost of capital. As detailed in the press release we issued last night, the transaction is expected to be accretive to both EPS and ROE, with our diluted share counts decreasing 12% as of June 30, 2012. In addition to significant improvements in EPS and ROE, the transaction will further improve financial flexibility, push out near-term debt maturities and rebalance our fixed and floating rate structure.

Lastly, it is important to note that as a result of a privately negotiated agreement with Paulson & Co. to repurchase their convertible debentures, at a discount to estimated market value, the transaction will significantly reduce the convertible overhang, which naturally leads to uncertainty over conversion timing or debt maturity in concentrated ownership.

Now I would like to hand it over to Fred, to discuss the transactions and the impacts in further detail. Fred?

Frederick J. Crawford

Thanks Ed. Before jumping into the recapitalization plan, it’s worth reflecting on our underlying capital strategy. The building blocks of the strategy include a capital base capable of absorbing market stress, maintaining ratios consistent with investment grade ratings at the holding company and lowering our overall cost of capital through proactive financing strategies and effectively deploying free cash flow. This strategy has yielded more specific capital targets including leverage in the 20% range. RBC in excess of 350%, interest coverage of five times, and liquidity sufficient to service our required holding company cash outflows in excess of a year. Our announced recapitalization plan is guided by these strategic targets. For some time now we have discussed recapitalization as a potential stair-step in terms of critical shareholder value metrics.

Slide seven, essentially pulls from our press release, which provide useful metrics and the impact of the recapitalization plan as if the transaction had taken place, December 31, 2010. Our plan is expected to lower our weighted average cost of debt by approximately 160 basis points. We are re-leveraging the balance sheet in part to redeem the majority of our convertible securities reducing our diluted share count by 12% and springing forward our EPS and ROE.

Our valuable tax asset and free cash flow are not impacted by the transaction. In other words, the economic value of both our tax asset and on going free cash flow appreciate when considered on a per share basis. Of note, on a pro forma and diluted share basis, both ROE and book value per share benefit from our plan. We are very pleased with what has been accomplished in a short timeframe on the ratings front, capped off with A.M. Best upgrade announcement last night. We have briefed all four agencies on the details of our recapitalization plan, we expect the agencies to issue releases in reaction to our announcement, and we are comfortable our plan is consistent with current ratings and outlooks and supports further positive actions.

Slide nine, provide the useful summary to understand more specifically the individual transactions involved in the recapitalization. There are really three things that had to come together to make for an attractive opportunity; ratings, market conditions, and negotiations with Paulson Funds, the majority owner of our convertible debentures. Armed with Ba3 from Moody's, and B+ positive outlook from S&P, we are tapping a sector of the credit markets, where spreads have come in considerably. Our plan is to raise $900 million in the floating rate institutional loan markets and the longer term bond market with staggered maturities.

We have also obtained commitments for a $50 million three year revolving credit facility for contingent capital and liquidity. With the proceeds, we are refinancing all of our senior secured debt at lower rates, redeeming the 9% bonds requires a premium, but locks in an attractive long-term rate, extends maturities, and reestablishes baskets that govern over future capital deployments after completion of what is effectively the repurchase of 36 million shares. A critical component of the recapitalization plan is the repurchase of Paulson funds investments in our 7% convertible notes. We believe this represents a good outcome with CNO obtaining a discount to estimated market value by providing liquidity to a concentrated and sizable ownership position.

Slide 10, simply lays out the pro forma capital structure, while we expect leverage to be up around 21% at closing, we anticipate there will be amortization and cash flow sweeps similar to our current credit agreements that will result in modest de-leveraging overtime. We show here the traditional calculation of leverage and our 16.6% ratio as of the second quarter. We anticipate our leverage covenant will be substantially similar to the formula applied in our current agreements; the difference is about 1 percentage point as shown in the schedules to our press release.

Turning to our debt profile, this was an important component of dialog with the rating agencies. Our goals include lowering our weighted average cost of debt, such that any additional leverage would have little impact to run rate free cash flow and coverage ratios. We also addressed financial flexibility, extending maturities and restructuring cash flow sweeps allowing us to better balance leverage and cost of capital. It’s reasonable to expect an additional stair-step in our future as we progress towards investment grade.

Having a dominant part of our capital structure floating not only acts as a natural Low-For-Long interest rate hedge, but provides greater flexibility should we elect a pre-pay or refinance in the future. I noted earlier that free cash flow is essentially uninterrupted by this plan. The core cash flow story remains the same. We spend much of 2011, building RBC and holding company liquidity with both now and excess of our capital targets. We view our current excess liquidity position over $100 million and RBC ratio above 350% as an insurance policy when considering the potential cash flows sent up to the holding company. As a result, we are maintaining our previous guidance on dividends to the holding company, of $200 million to $275 million and share buybacks of $150 million to $170 million in 2012.

Now, I’ll hand it back to Ed.

Edward J. Bonach

Thanks Fred. Slide 13, demonstrates our strong record of execution. Towards the left portion of the timeline, you see a series of transactions that reduced risks and improved capitalization through reinsurance transaction and a spin-off of our former Closed Block LTC business. Concurrently, we began to improve our cost structure with actions taken to align our distribution and operations to better serve our target markets. As we progress at the center of the timeline, we were then able to focus on improving financial flexibility, while lowering our cost of capital.

Moving all the way to the right hand portion of the timeline, as we began generating significant amounts of excess capital, we developed a balance capital deployment strategy, returning value to our shareholders in the form of buybacks and dividends, while also aggressively paying down debts and continuing to grow our core businesses. These actions have been noted as Fred mentioned by rating agencies with steady improvements in our ratings over the last few years.

Turning to slide 14, I would like to reiterate that CNO represents a compelling value proposition. We have been growing and have above average growth potential as we are defined and differentiated by our market focused on the senior middle-income market, which is both underserved and rapidly expanding with the baby boomers now turning age 65.

We continue to invest in expanding distributions, reducing solid sales growth and we have now a track record of stability and growth in earnings. We expect no interruption to our financial performance, capital generation or ratings momentum with this transaction. This recapitalization plan is an extension of all of our accomplishments in the last several years as we continue to seek ways to provide value to our shareholders. The plan is an opportunity for us to lower our weighted average cost to capital, improve financial flexibility, and maturity profile, as well as reduce the overhang from the convertible debt of being accretive to EPS and providing a meaningful stair-step to ROE.

Now we’ll open it up for questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Randy Binner with FBR.

Randy Binner – FBR Capital Markets

Hi, great, thank you very much. So I guess the question from my perspective is on the remaining $93 million of the convert and kind of just curious on why, that was not kind of broaden as part of this deal and if there is kind of a potential to see a tender there, kind of any movement on the remainder of the convert?

Frederick J. Crawford

Yes, Randy, it’s Fred. I mean there is really a couple of reasons, so why focusing on the Paulson ownership interest and the convert, there is really a few reasons; one is, we could obviously negotiate a private transaction, which allowed for both the discounts as you see in the transaction, but also a certainty of execution. So the problem of course naturally with the tender is uncertainty over what you will get, what you won’t get, and certainly uncertainty over the premium that you are likely to pay to attract the bonds and, so this gave us a chance to both execute on a discount and execute on with a certainty.

The other component that it addresses more specifically is those of you familiar with the 382 tax dynamics would note that this also serves to avoid the natural conversion of those shares, and the change or shift in ownership interest that would go against the possible threshold levels associated with 382. While we have ample cushion in that threshold anything we can do to further descend or reduce the risk profile is always a good economic outcome when considering the importance of the tax benefits to the company.

When it comes to the remaining stub of the convert, just a couple of comments and that is we would view the potential repurchase of further converts as no different than we always do in terms of what’s the highest and best use of our capital. So we’re simply going to, continue to generate free cash flow and we’ll make decisions as to what best to do with that capital treating the convert stub period no different than any another option we may have in front of us.

Randy Binner – FBR Capital Markets

Okay. And then just a couple of follow ups, and first I guess the discount, on the headline basis obviously there was a May call, so it was, I kind of a high level basis, it seems like there was a premium to take out Paulson, the discount part was just to the fair value, and what was that percentage of the discount?

Frederick J. Crawford

Yes, so the way to think about it is, those of you familiar with convert pricing would know that there is three fundamental components to the pricing, one is so called parity or the value of the shares once converted into the structure and the share price as a result of that, the second is the economic benefit on the coupon payments that would be foregone, if you were to retire the convert. So in other words, owners of the convertible security logically are doing another year’s worth of coupon payments and so there is a simple present value calculation to those economics. The third component of the pricing, is the option value, and candidly that option value is very small. It’s small for the simple fact that we are trading so far out of the money, that as the stock price rises that option value falls.

So what you’re really more fundamentally left with is the parity value of the convert, and the present value of the cash flows due to a holder of the convert over the next year. It’s essentially from that dynamic that we apply the discount. So the way to think about it is eventually there will be a market transparent if you will, pricing of the convert at which a discount will be applied to, that gives us confidence that the discount will fall through.

Edward J. Bonach

And the discount Randy is 2.8% to that calculated market value.

Randy Binner – FBR Capital Markets

All right. Got you and then just one more if I could, if you decided to do the 93 in the tender would that – would you be able to stick, do you think with the capital return guidance you laid out before and still be able to call the 93.

Edward J. Bonach

I mean it’s sort of difficult for us to over speculate on that point, but I would just make a couple of comments, one of the unique natures of buying back a convert is the fact that it is treated in our ratios as debt, yet acts as a implied stock buyback particularly when you are trading so far out of the money, up north of $9 a share, as we speak, and so buying back the convert is somewhat more neutral if you will, to your core capital ratios, but I’d be mindful of those ratios, we talked today about what are the guiding principles that we try to managed to make sure we maintained ratings progression, which is critical to not only our business but also the notion of an additional stair-step in our future, and so we’re always going to balance the accretive nature of buying back something like the converts, with the balance sheet issues, and so Randy we’ll just take all that into account.

Randy Binner – FBR Capital Markets

All right. That’s helpful, thanks.

Operator

Your next question comes from the line of Chris Giovanni with Goldman Sachs.

Christopher A. Giovanni – Goldman Sachs & Co.

Good morning, thanks so much. You have both mentioned the ROE stair-step this provides as well as the additional opportunity for another stair-step, when you hit investment grades, so curious if the 8% ROE target that you guys have by the end of 2013, 9% by 2014, does that assume another stair-step from ratings upgrades, or does that purely off no business growth, pricing actions and then capital management?

Edward J. Bonach

Yeah, Chris this is Ed. It does anticipate contributions from all four of the levers that we’ve been consistently talking about, so profitable new business being layered on to managing our in-force business and maintaining of growth in margins there along with expense efficiencies and effective deployment of capital. So we see those all continuing to contribute to a few more steps to get us to that 8% and then 9% ROE as you noted by 2014.

Frederick J. Crawford

One other thing, I would add is in your early set up comment Chris, this notion of, I would rather the market place is not view as a threshold point of further activity i.e. lowering our cost of debt and our cost of capital as the achievement of investment grade in of itself that’s the goal, it’s logical that as we progress towards that goal there will be opportunities to address the capital structure again, but we’re going to do what we did, what we announced here last night.

I’d read a few reports suggesting hey, this seem to a little earlier than I thought, but if you think about it, when you are a company that’s facing very strong market conditions, in the capital markets with not only low interest rates, but a particularly strong bid on this sector of the corporate bond market, and a particularly strong bid on CNO’s name, you have to really contemplate strongly whether it make sense to lock in that longer cost of capital now when you have the opportunity, particularly when you look out at macro conditions, which may move against you overtime, you don’t want to be coupe a half. And so as we go forward, we’re going to look for the plain simple economic opportunities to advance shareholder value and we’ll pull the trigger on, if it doesn’t make sense, but we’re going to do it in a way that balances continue progression on the rating side.

Christopher A. Giovanni – Goldman Sachs & Co.

Okay, I appreciate those additional comments. And then this doesn’t have any impact the commentary you guys provided last quarter around sort of lower for longer interest rate environment, obviously this provides some hedging if rates continue to stay lower from a refinancing, but this doesn’t alter any of those sensitivities you provided?

Frederick J. Crawford

No, it doesn’t.

Christopher A. Giovanni – Goldman Sachs & Co.

Okay, and then lastly, Ed, you’d mentioned sort of the onset of sort of the execution strategy began when you started with transactions on the Closed Blocks, so can you provide some commentary on how you’re thinking about additional opportunities for your existing or the remaining run off book?

Edward J. Bonach

Yeah, Chris that’s primarily hosed in our OCB, or Other CNO Business segments, and there I think quite similarly in one way to our former LTC Closed Block that we believe as we put in different price increases through changes in non-guaranteed elements that improve the economics and stability of that business that it will give us more flexibility and option to pursue other transactions, be that reinsurance or sales of parts of that business, and that still is part of our tool box in addressing OCB as well as adding value overall to CNO’s EPS and ROE.

Christopher A. Giovanni – Goldman Sachs & Co.

Thanks so much.

Operator

(Operator Instructions) Your next question comes from the line of Paul Sarran with Evercore Partners.

Paul Sarran – Evercore Partners

Hi, good morning.

Edward J. Bonach

Good morning.

Paul Sarran – Evercore Partners

I wanted to ask a couple of questions about what kind of terms you expect on the term loan and the senior secured notes, specifically in terms of what you expect any kind of sweep requirements to look like also any prepay penalties or may call provisions you expect to say, and whether or not there will be any sort of caps on restricted payments or kind of bucket for restricted payments. And whether any of these features are going to be different than what you were looking at before?

Edward J. Bonach

Sure, let me do this with you Paul and folks on the phone is first, and all of those all very relevant questions, there is an extended marketing period of selling, distributing the bonds and finalizing the term sheets and we’re just now starting to ramp upping that, those of you who maybe less familiar with the below investment grade market should take note of the fact that there is a period of time, that ramps up to the eventual closing of the securities including even some road show type dynamics, so as we go through that process, you will see the formation of the terms and conditions solidify, but we certainly come out at it with the notion of what to expect, and so let me give you, some broad brush strokes on what to expect.

First, in terms of sweeps, we would expect and are certainly looking to construct a situation where we are required to pay less down on debt for a given buyback of stock or dividends. They would in fact be sweeps and those sweeps would are anticipated to be tied to the deployment of capital towards share repurchase and dividends similar to what our structure is today. But more constructed along the lines of our leverage similar to today and importantly though falling away at a higher leverage amount than what we currently have. So as you recall these sweeps fall away for us under our current agreement at 12.5% leverage, we would expect that to be a higher leverage threshold, something that’s more comfortable in the sense of managing cost of capital, but safely within investment grade guidelines as an insurance company, so we would expect that dynamic on sweeps.

The second would be in terms of prepayment provisions. As I mentioned in my opening comments, we skewed the funding towards floating rate dynamics to really address that very point and that is to lighten the load of prepayment penalty type provisions, but what we would expect, certainly on the bond deal, we would expect customer in may call and redemption features, substantially similar to the once we currently have in our current high yield bond offering. When it comes to the floating rate institutional loan market place, you typically have what’s called a one-on-one soft call, which means basically there is a modest prepayment penalty in the first year of those securities, if you were to refinance at a lower rate. So it’s meant to be sort of an ability for holders, who get potentially refinanced very quickly after having bought into the securities to be helped out a bit through a small or modest prepayment penalty that quickly falls off as you get into the facility and so our expectation is as we go forward it will be similar to today, where we could retire those securities without penalty.

In terms of the notion of a basket, I alluded to that in my comments in terms of what we are retiring, we would expect there to be a so called restricted payments basket, which is sort of a basket that builds by virtue of cumulative income or cash flow overtime and sets caps or creates an environment for a limitations around cumulative buybacks and dividends overtime. Once again, while it’s early days in terms of what we would construct there, we would look forward to be done in a way that allows us to manage our capital structure in a very, efficient manner relative to a leverage and use of deployable cash. I can’t go into more specifics than that because we are really into the process of building out the securities, but we would take the same sort of philosophical approach to that type of a basket as we are taking to the sweeps, to try to have that aligned.

The last comment I would make, which you didn’t ask, but I’ll volunteer and that is covenants, we would expect the covenant package to be substantially similar to what we currently have today, with substantially similar room that we are currently enjoying in those covenants. And obviously, what we have as a company is the added benefit of stress testing, which has become obviously quite sophisticated in the industry and in CNO, to where we can really monitor those covenants in a way that allows us to feel very comfortable under stressed conditions that we have the flexibility to move forward and continue to build the company. Okay

Paul Sarran – Evercore Partners

All right. Thanks.

Operator

Your next question comes from the line of Sean Dargan with Macquarie.

Sean Robert Dargan – Macquarie Capital

Thank you. And good morning, I was wondering if this changes your thinking of using non-Life NOLs, or if you have any update on that topic.

Frederick J. Crawford

This transaction in of itself, does not have implications for the current economic dynamics between our life and non-life tax position and really for the simple reason that it has not really adjusted to a great degree our pro forma interest expense. So I mentioned in my comments that there hasn’t been any material adjustments in cash flows related to the new debt because of the lower coupon, you can imply from that that there is not a material change in interest expense, so it doesn’t tend to alter the holding company dynamics. I would say if there is a dynamic to address as it relates to tax it would be what I mentioned in an earlier response to a question and that is there are, you have build up for the defenses, if you will from a 382 perspective by addressing the Paulson ownership interest and avoiding the potential shift in ownership that could result if those converts were to be converted in the ownership position spike up.

Sean Robert Dargan – Macquarie Capital

Thank you.

Operator

At this time there are no further questions.

Edward J. Bonach

Thank you operator and thanks to all of you on the call for your interest and support to CNO.

Operator

This concludes today’s conference call. You may now disconnect.

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