Good morning and welcome to the Principal Financial Group second quarter 2008 conference call. There will be a question-and-answer period after the speakers have completed their remarks. (Operator instructions) I would now like to turn the conference over to Mr. Tom Graf, Senior Vice President of Investor Relations.
Thank you. Good morning and welcome to the Principal Financial Group’s quarterly conference call. If you don’t already have a copy, the earnings release, financial supplement and additional information on the company’s investment portfolio, can be found on our website at www.principal.com/investor.
Following our reading of the Safe Harbor Provision, Chief Executive Officer, Larry Zimpleman and Chief Financial Officer, Mike Gersie will deliver some prepared remarks. Then we’ll open up for questions. Others available for the Q-and-A are Chief Investment Officer, Julia Lawler and our three Division Presidents, John Aschenbrenner, responsible for the Life and Health Insurance segment; Dan Houston, responsible for the U.S. Asset Accumulation segment; and Jim McCaughan, responsible for Global Asset Management.
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. Risks 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; Larry.
Thanks, Tom, and welcome to everyone on the call. This morning I’ll focus my comments on execution of our growth strategy including performance and progress of our three key growth engines
US asset accumulation, Principal Global Investors and Principal International. Mike Gersie will follow my remarks with a brief overview of financial results and a discussion of our investment portfolio in capital position.
Before I begin though I wanted to express my sincere thanks to Mike who as you now is retiring after 38 year with the company; his leadership, dedication and hard work have helped position this organization to capitalize on its opportunities and face the challenge ahead. As you also know Mike’s successor has been named; Terry Lillis brings 26 years of experience in key financial and leadership roles at the Principal. His most recent role CFO of the U.S. Asset Accumulation segment since 2000 makes him uniquely qualified for this critical position. Terry will join us at the third quarter earnings call.
Let me also welcome Dan Houston to his first earnings call. Dan’s promotion to President of the U.S. Asset Accumulation segment was announced in the first quarter as part of our planned succession process. Dan is also a seasoned veteran with nearly 25 years with the Principle; all dedicated to our retirement businesses.
Let me start with a couple of comments on the current operating environment. Equity markets continue to decline in the second quarter including a 3% drop in the S&P 500 driving that index down 16% since September 30 2007. In light of the environment I’d characterize our results for the quarter and through mid year as very solid reflecting strong underlying growth, the benefits of earnings diversification, ongoing strategic investment and discipline around expenses.
Highlights for second quarter include nearly $3 billion of net cash flows for U.S. Asset Accumulation and $6 billion through mid year, substantially offsetting the impact of poor equity market performance. A 32% increase in Principle Global Investors third-part assets under management; 19% growth in assets under management for Principle International driving it’s second best earnings quarter on record and double digit earnings growth in the Life and Health segment driven by record results for the specialty benefits division.
Once again we’re very pleased with a number of key growth indicators; measures we believe demonstrate our competitive advantages in asset management and accumulation and strong day-to-day execution of our growth strategy.
Starting with the U.S. Asset Accumulation segment, Full Service accumulation delivered sales of $1.4 billion in the second quarter bringing six month sales to $4.9 billion, an increase of 34% compared to the same period a year ago. Two key factors are driving our continued sales success, the advantage that we have in the market place with total retirement suite and strong momentum with distribution alliances.
For mid year total retirement suite made up 57% of sales based on assets and alliance sales are up more than $750 million or 40%. Looking forward, the pipeline remains strong and we continue to expect to meet or exceed our 10% to 12% sales growth target for the year. As a reminder down markets pressure sales in a couple of different ways; the plans we sell have lower assets and you do tend to see more aggressive pricing from some competitors.
Strong sales coupled with strong plan level retention drove Full Service Accumulation, net cash flows to more than $4 billion for the six months; an improvement of 160%. For the trailing 12 months Full Service Accumulation net cash flows are more than $7 billion. This translates into 7.3% of beginning of period account values significantly ahead of our long-term target of 4% to 6%.
As you know we also continue to work in cooperation with advisors to retain participant assets at risk due to retirement or job change. For the six months we’ve retained more than $1 billion of participant assets into our mutual fund, individual annuity and bank products, demonstrating both the strength of our asset retention capabilities and the depth and breath of our retail rollover solutions.
With record earnings, sales and net cash flows, this was a truly outstanding quarter for the individual annuities business. On a year-to-date basis sales are up 118% reflecting increased penetration across multiple distribution channels and continued success with the fixed deferred annuity product we launched in mid 2007. Withdrawals have remained stable in absolute terms, but have declined as a percent of beginning of year account values to 5.2% for the six months of 2008 from 6.4% from the same period a year ago.
Moving to Principal Funds, sales and net cash flows improved $240 million and $100 million respectively from the year ago quarter. We view this as a very solid result in light of market conditions. Reflecting continued solid progress in the wire house and independent broker dealer channels. Our sales are up 36% from second quarter 2007 and 27% year-to-date. As some additional context, industry flowed down nearly $300 billion or 97% comparing second quarter 2008 to first quarter of 2008. By comparison, our flows were up $40 million or 50% over the same period albeit on a relatively small base.
For Global Asset Management, the second quarter was a period of continued strong investment performance. 64%, 71% and 75% of the retirement plans separate accounts managed by Principal Global Investors ranked in the top two Morningstar quartiles for the one, three and five-year periods respectively at quarter end. Reflecting that strong performance, Principal Global Investors has been awarded more than $13 billion of unaffiliated assets through mid-year.
First half net cash flows were $4 billion contributing to more than $10 billion of unaffiliated net cash flows over the trailing 12 months, which translates into 16% of beginning of period assets. Investment choices managed by PGI continue to be attractive both to sponsors and participants within Full Service accumulation, accounting for 60% of both assets and flows. This and the non-affiliate flows contributed to total net cash flows for PGI of $7.3 billion in the first half up from $6.5 billion in the first half of 2007.
Principal Global Investors fee mandate business continued to perform well with 27% growth in unaffiliated management fees offsetting the impact on revenues of equity market declines and it slowdown in the real estate markets.
As an update on the spread and securitization business our first quarter efforts to reduce loan inventory in the CMBS joint venture were highly effective and the business broke even in the second quarter. We continue to minimize the risk of additional mark-to-market losses reducing loan inventory from $540 million at the end of April to less than $200 million at the end of July. Recent sales validated our valuation of the loan inventory at March 31, and throughout the quarter. As such we continue to believe the spread and securitization business will come in at or near breakeven in the second half of the year.
Demonstrating again a value of earnings diversification, Principal International delivered its second best earnings quarter improving 19% from a year ago and the Life and Health segment delivered 11% earnings growth. Principal International’s earnings growth reflects significant growth in assets under management, which are up $4.7 billion or 19% form a year ago. More than half of the increase in assets under management is from net cash flows which had $2.5 billion over the trailing 12 months or 10% of beginning of period assets.
I would also like to comment on two exciting recent global developments. Starting in October we’ll begin participating in a new employer sponsored 401(k) like market that is opening in July, and as we announced mid July we are going to be launching an asset management joint venture with CIMB group, a recognized pioneer in Shariah-compliant finance, a market with tremendous growth potential.
Moving to Life and Health, the second quarter was a period of solid earnings and return on equity improvement. As I mentioned specialty benefits delivered record earnings in the second quarter. On a year-to-date basis premium and fees are up 5% as a division continues to maintain pricing discipline in a highly competitive market. Expense management remained sound as well and we are working on a number of initiatives to continue driving sustainable profitable growth for the division.
Individual life division continues to build sales momentum across a broad spectrum of products, including 13% growth year-to-date for our non-qualified offering, one of the four pillars of total retirement suite. Total first year and single premiums and deposits are up 37% year-to-date reflecting increasing momentum with new independent distribution relationships and solid performance from the career channel.
Importantly due to effective capital management a division has been able to generate strong sales growth while keeping capital usage flat. After a strong first quarter the Health division posted solid second quarter earnings inline with expectations. Based on our expected pattern of earnings from high deductible health plans we continue to expect the division to earn between $45 million and $55 million for the year on a reported basis.
Our strategy for growing covered members remains highly focused on network discounts including principal specific provider contracts and on claims and expense management to improve our overall price competitiveness. While I return the membership growth is a multi-year process, I’d again reiterate the longer term opportunities for the division, in consumer driven healthcare, health savings accounts and wellness and our belief that we have the expertise to capitalize on these trends, Mike.
Thanks, Larry. This morning I’ll spend a few minutes providing financial detail for the company and each of our operating segments. Including items impacting comparability between periods, I will also cover our investment portfolio in capital position. Let me start with total company results. At $0.97 operating earnings per share was down $0.08 from the year ago quarter as communicated in last years release second quarter 2007 earnings included $21 million or $0.08 per share in benefiting items.
Second quarter 2007 was also a period of functioning commercial mortgage-backed securitization markets, and we earned $0.03 per share that quarter in the spread and securitization business. Adjusting for these items earnings per share is up about 3%.
While this is below our long-term growth target, we view it as a very solid result and market performance over the past three quarters have being consistent with our 2% per quarter assumption between U.S. accumulation businesses and principal global investors on affiliated assets. We would have finished the quarter with an additional $25 billion plus of assets under management.
Using current business and product mix, this would conservatively translate into an additional $0.07 to $0.08 of earnings per share for the quarter.
Moving to U.S. asset accumulation, segment account values increased $2.8 billion or 2% from a year ago to a $177 billion at quarter-end while segment earnings decreased to $12 million or 7%. Excluding higher prepayment fee income in the prior year quarter of approximately $5 million after tax, primarily in the investment only and Full Service Payout businesses segment earnings were down about $7 million.
I’ll focus my remaining comments relating to segment earnings on full service accumulation, which was down $6.5 million from year ago. The decline primarily reflects three items with lower income tax benefits and the negative impact of market conditions being partially offset by lower operating expenses.
I’ll start with the lower income tax benefits of $7 million. As you know we’ve receive a tax benefit for domestic dividends in our separate accounts and selected fifty mutual funds. Due to a number of factors we are receiving lower dividends from domestic equities within these accounts and as a result have a lower tax benefit. These factors include lower gains, change in product mix and investors moving out of equities.
Moving to market conditions, several factors are temporarily impacting revenue and earnings driving about $5 million of the after-tax decline in earnings from the second quarter 2007. This includes lower interest rate environment, which has resulted in lower yields in the general account and lower market value cash outs. Regarding operating expenses, the corporate wide reduction efforts initiated first quarter to offset the revenue impact of share market declines are working.
Compared to a year ago we’ve reduced full service accumulation operating expenses by about 3% while adding more than $7 billion of net cash flows over that period. While our expense efforts don’t totally eliminate near term pressure and earnings that are clearly making a difference. Importantly we believe they reflect the right balance between aligning expenses with revenues and the need to make ongoing investments to support our long-term growth targets.
Let me separately covered deferred acquisition cost, which represented a substantial portion of the decline in operating expenses. With acquisition expense capitalization and amortization down $5 million and $11 million respectively from second quarter 2007 the experience resulted in a net after-tax earnings benefit of about $4 million. As expected the drop in equity markets during the quarter did result in an increase in amortization expense, but the increase was more than offset by experience adjustments with higher deposit growth and the extension of the amortization period in the third quarter 2007 reducing normal amortization expense.
Adjusting for income tax benefits, market conditions and deferred acquisition cost full service accumulation earnings improved about 2.5% and a 3% increase in average account values.
Moving to global asset management, second quarter earnings of $24 million compared to $32 million a year ago. Consistent with the expectations we communicated last quarter the spread and securitization business came in at breakeven in the second quarter 2008, compared to earnings of $8 million in the year ago quarter.
The fee mandate business delivered very strong underlying growth although earnings were essentially flat on a reported basis. Third quarter earnings were damping by about $3 million after-tax due to the impact on fees of a slow down in the real estate markets and second quarter 2007 earnings benefited by about $3 million after-tax from a mandate that pays performance incentive fees every three years. Excluding these items fee mandate earnings improved more than 30% driven by very strong growth in non-affiliated management fees as Larry mentioned.
Moving to international asset management accumulation, second quarter earnings were up 19% from a year ago to $32 million. The improvement primarily reflects continued strong asset under management growth and operational efficiencies. It also reflects the benefit from higher yields on invested assets in July due to higher inflation.
A couple of income statement line items merit a brief explanation. As you know when accounting for equity method subsidiaries all items that make up after-tax net income are collapsed together in a single line, net investment income. In the second quarter Brazil increased its effective tax rate to 40%. The impact of this change reduced net investment income and those pre-tax operating earnings by $15 million. Offsetting this impact was a $15 million benefit reflected in the income tax line, as we are allowed to foreign tax credit.
Based on normalized earnings Principal Internationals return on equity is just over 10% for the trialing 12 months. The segment remains on track to achieve sustainable return on equity of 11% by 2010. At $67 million second quarter earnings for the Life and Health segment were up $7 million or 11% from year ago. Trailing 12 months return on equity improved 70 basis points from year ago to 12.6%.
The increase in segment earnings is primarily due to an $8 million increase and earnings for the Specialty Benefits division reflecting favorable clients experience particularly in the individual visibility line and growth in business. A $24 million Individual Life earnings were solid improving slightly from the year ago quarter. Well, that from a year ago health division earnings of $12 million were solid as well, and thinking about the reminder of the year for the health division keep in mind that the accounting treatment of high deductible health plans typically results in the highest level of earnings in the first quarter, moderate earnings in the second and third quarters and losses in the fourth quarter.
Let me also comment briefly on net realized, unrealized capital losses. In the second quarter 2008, we’ve recognized $85 million of capital losses through the income statement, which includes $23 million of losses related to impairments of fixed maturity securities, $7 million of impairment on equity securities and unrealized capital losses of $56 million primarily from mark-to-market of interest rate swaps.
Given interest rate movements and the volatility in the credit markets predominately driven by technicals, we believe our level of credit losses was reasonable, inline with peers that have already reported results and consistent with the range of expected losses that we priced for over the credit cycle.
Further reflecting interest rate and market volatility during the quarter, improved credit spreads drove a decrease in net unrealized losses of approximately $1 billion substantially offsetting an increase in net unrealized losses due to interest rates of approximately $1.5 billion.
The largest credit improvement was in industrials or the gain from improved credit spreads exceeded $250 million, but importantly we also saw more than $200 million of improvements in financials, more than a $150 million of improvement from commercial mortgage-backed securities, and more than $100 million of improvement from our corporate credit collateralized debt obligations. I would also point out that since we match asset and liability durations on an economic basis, any decline associated with raising interest rates is mirrored by a decline in the value of our liabilities.
We’re obviously pleased with second quarter’s improvement in credit spreads, but continue to believe that fundamentals are not being fully reflected. Values remained depressed because markets are not operating efficiently given think trading dominated by four sellers. I would again emphasize that we continue to have the intent and ability to hold. Given ongoing investor interest and exposure to certain investments, we posted on our website some additional detail and commercial mortgages and commercial mortgage-backed securities, our comments specifically on these holdings.
Regarding commercial mortgages with 90% occupancy, 58% loan-to-value and 1.9 times interest coverage we remain extremely comfortable with our portfolio. Even in the slowing economy we have tremendous amount of cushion. Regarding our CBMS holdings delinquencies in the underlying mortgages were seven tents of a percent through mid-year. We’ve remained very comfortable with a high quality of the underlying mortgages in the strong subordination cushioning of our CMBS holdings.
To ramp up my comments, let me cove our capital position. First I would like to state clearly that we do not anticipate any need to raise equity capital going forward. At quarter end we had approximately $300 million of access capital between the life and holding companies over and above the capital ratios appropriate to our current credit ratings. Cash flow remained strong and we continue to generate capital in excess of what we need to support organic growth.
There also a number of normal capital management levers that would be available to us, should the environment become even more challenging, including debt issuance, expense controls and pulling back on acquisitions. As such we remained confident in the adequacy of our capital position and our ability to navigate through this credit cycle. This concludes our prepared remarks. I would now ask the conference call operator to open the call to questions.
(Operator instructions) Your first question is from Jimmy Bhullar with J.P. Morgan.
Jimmy Bhullar – J.P. Morgan Securities
Hi and thank you. I have a couple questions, both on the pension business. First, if you can talk about your pipeline in the FSA business given how weak the market has been. It doesn’t seem like your deposits or the lapses have been impacted, but if you could just talk about what do you see in the second half? Secondly on margins in the FSA business, how much of a decline due you expect in your margins over the next few years given that the mix is shifting slightly towards the larger cases and also you’ve got more Esoft business on the book? That’s all I have.
Hi, Jimmy thanks. Good morning. We’ll give those to our rookie here this morning. I’ll have Dan Houston to cover both of those for you.
Thanks, Larry, I appreciate it. We start with the pipeline first on full service accumulation, we are actually seeing that the pipeline for assets is actually up about 4% and the case pipeline is down slightly. If we move then onto the mix of business, we gave some revised guidance last earnings call to talk about ROAs in that 30 to 32 basis points which is again consistent with what were we think we can be long-term. We have talked about the mix of assets changing in the last few years, introducing more ESOP opportunities to PFG, but I would also attribute that in large part to our competitiveness in the large case of market, it’s not unusual to have our larger prospects have a disproportionate percentage of their assets go either to ESOP, employer stock and or excess fund. So, again we’re comfortable that 30 to 32 basis points on the FSA line.
Your next question is from Jeff Schuman with KBW.
Jeff Schuman – KBW
Good morning. First a comments that a question. I want sort of appreciate the depreciated the decomposition of the unrealized investment loss into the interest component and the credit fees I think that’s constructive. I am also wondering if you will be able to sort of expand that going forward and give us kind of a picture of kind of the accumulated impact, as of my understand you don’t have that right now, but its extending to develop that concept further, I think that’s pretty helpful for all of us.
The question I want to ask was about commercial mortgages, I am wondering if you give us a little bit more color in terms of what you’re seeing in terms of your commercial mortgage loan experience, delinquency trends and then in particular I was wondering given your I think somewhat overweight in retail and some of the bankruptcies and deterioration we’ve seeing that recently, whether you’re starting to see any signals or warning financing that sector.
Okay thanks Jeff, this is Larry let me just add my own comment to yours around the unrealized losses. I think it is that we would agree with you. I think it is absolutely critical that everyone understands the makeup of those and particularly since we are running and have run for years very immunized portfolio here, as we said in our earlier comments any increase in unrealized loss attached to interest rates is simply nearing a comparable movement on the liabilities side, but that just not reflected in accounting. So, it is we think absolutely critical to understand the component that’s making up the unrealized loss and we appreciate your feedback on that. I have Julia talked a little bit about your CMBS questions Jeff.
Jeff Schuman – KBW
Just rephrase asking more about the direct commercial mortgage loans in the CMBS actually.
Yes I can cover that. We’ve had the trend in delinquencies has been very positive and then it’s zero and it has been zero in our portfolio for sometime. So the trend is good because zero is good and it’s pretty amazing considering the size of our portfolio and as you mention that this time it certainly has been slowing down.
As it relates to our retail portfolio I am not sure is its overweight to retail, but I will say that we’ve had a very little expenditure to the name that you’ve been reading about in the paper. We had no exposure to moving than our commercial loan portfolio. We have one loan exposure to learning and things and interestingly enough they are doing pretty well in our particular loan and we think they’re going to affirm that lead. So we track that very, very closely and so far so good on all the names that we’ve seen.
Jeff Schuman – KBW
That's helpful, thank you
Your next question is from Colin Devine with Citigroup.
Colin Devine – Citigroup
Two questions one if you could just digging into net asset falls again, what you’re very strong, but I still recall in the past Larry, you’ve cautioned that when market rise they kind of get a little bit weaker, when markets are downing they get a bit stronger just because the way the math works. How much, if we look at you’re very strong in that fallen numbers this quarter really it is a reflection of the market just reducing the actual withdrawals and then Mike if you could just go back to the capital numbers again and just give us what is your excess to capital, again I lost that figures as you were going by, how much excess debt capacity you figure you have right now and is there any thought of getting back into buybacks between now and the end of the year?
Okay Colin, thanks. I’ll go ahead and comment on your first one. We’ve always given a range in terms of the full service accumulation of net cash flow that has been in that range of 4% or beginning account value to 6% and what we tried to do with that is in giving that range kind of a ballpark of what that will be overtime given sort of normal equity markets.
Now as we’ve commented we’ve seen a 16% decline in equity markets since September 30 and I don’t know what normal is anymore. I think we’re redefining it day-by-day, but clearly that’s been an extreme decline and as a result of that I think to your point, you would expect us to begin to move towards or maybe go outside the high side of our 4% to 6% range.
However, I don’t want to diminish the fact that at 7.3% it is strong, but I also absolutely agree with your point that in the reverse situation, which we saw a year and a half, two years ago when the flows were more in the 4%, 4.5% range, we were the ones commenting at that point, that it was the higher equity markets that we’re putting pressure on the net cash flows and obviously that’s the condition that could repeat itself sometime in the future.
I’ll have Mike to comment on your other questions around capital and debt capacity and buyback.
Colin Devine – Citigroup
Just a second Mike. Larry you said the real number here on some sort of long-term basis closer maybe to 6.5 which is still excellent, but the 7 plus is partially a reflection of the market, is that fair?
Yes, it is fair Colin.
Colin Devine – Citigroup
Okay, thanks sir.
The number we used in the recorded part of the message was $300 million, so we’ve got $300 million of excess capital and that would be – but somehow we get three pockets. One first pocket would be cash at the holding company, second pocket would be – I think of it as excess capital or accretion of the life company, third pocket would be debt capacity. The bulk of the $300 million is in the life company, so it’ll be in that middle pocket.
In terms of looking at buybacks for the rest of the year, again with market conditions being what they are, we believe it’s prudent to go slow. So, I think we could say without getting in further aboard, without really being able to speculate on what future conditions would be, I think we’re in a go-slow period in terms of share repurchase.
Colin Devine – Citigroup
Finally at the rating agencies and to reiterate your point earlier, there is absolutely no reason to think that you would need to raise external capital?
There would be no reason that we know of to raise external capital.
Colin Devine – Citigroup
Thanks and good luck Mike.
Okay, thank you.
Your next question is from Dan Johnson with Citadel Investments.
Dan Johnson – Citadel Investments
Great, thanks very much and just a little bit of a follow-on to Colin’s question and as you mentioned when the markets were up last year, you identified how it hurt withdraw and this quarter we talked about how markets down hurt sales. Can you look at sort of net here together and as you said we’re down 16% versus sort of a year ago where we were actually kind of nearly up around the same amount. Do up or down market have a significant impact on your total flows?
Okay, Dan good morning. This is Larry. I’ll make a few general comments. Dan may want to clean that up a little bit. If you look at our total deposits, I guess you really have to sort of think about and again we provide you detail in the financial supplement around how much of those are deposits from existing client versus how much of those are deposits that come up or if you will new sales and I think you again see that the majority, but by no means the vast majority, but the majority of those deposits are coming off of the deposits on existing business.
So that’s very solid, that’s very stable, that’s very predictable and then so the delta component really Dan then relates to the other element that’s shown there in the financial supplement which is the deposits that come up in new sales as well as transfer assets that come up in new sales and again about 70% of our new sales involve transfer assets. So, that’s a high-level talk and maybe Dan Houston here can make a few comments on that.
Thanks Larry. Maybe just drilling down one additional level as it relates to how clean it is. If you look at hardship withdrawals that’s been coming up, actual hardship withdrawals are up about 10% in terms of the number of requests. If we look at loans, surprisingly loans are actually down by 2%, although the actual dollar here is up 3%. If you combine those two together, they are still a relatively small dollar figure, so again as it relates to whether or not the net cash flow is a clean number, I’d say it’s a clean and even when you adjust it for withdrawals related to either hardship or loans?
Dan Johnson – Citadel Investments
Perfect and just the other final question was on the backend in the quarter. You had mentioned that the lower part of it was related to the third quarter adjustment and my memory doesn’t go back that far; can you remind me, do we have an annual third quarter sort of backed to a process?
Again, this is Larry. I’ll just take that one quickly. The comment related to third quarter was as it relates to full service accumulation and we went in and did what was more of a one off study in third quarter last year Dan around essentially refining the expected life time for those contracts and what we’re finding is frankly the experience that’s demonstrating that the persistency of those contracts was longer than with our back amortization had been at that point.
So, you saw the normal amortization for full service accumulation we extended out in order to be more appropriate with the higher persistency that we’re seeing in that business, but that was in the third quarter last year and it was more of a one off, so it’s not something that would necessarily repeat itself, but it does explain the lower amortization that has been in effect since third quarter ’07.
Dan Johnson – Citadel Investments
Got it and the market impact over the last years so versus what order has been assumed in the back calculation, how does that get reconciled given sort of deviation from sort of the 2% scenario?
Right, that is reconciled each quarter as we go along Dan.
Dan Johnson – Citadel Investments
Great, thank you very much.
Your next question is from Suneet Kamath with Sanford Bernstein.
Suneet Kamath – Sanford Bernstein
Yes, thanks. Just a question about your CDO portfolios; obviously we’ve been seeing in the press that some of these investment banks are liquidating; structured product CDOs at pretty low sense on the dollar. I’m just wondering as you think about third quarter and marking-to-market you’ve mentioned a couple of times that there’s not a lot of liquidity in some of these asset classes. Can you just talk about how those trades may effect how you mark those positions as we think about third quarter results?
Sure, this is Larry. Let me just give a general comment and I’ll have Julia, provide you with the detail. I think much as happened sometime around unrealized losses Suneet. I think it’s absolutely critical that everyone understands what’s inside CDO. CDO is just a generic term and there can be whole variety of different asset classes that sit with inside the CDO and so to talk about someone else who sells the CDO at a certain price per dollar is not in and of itself controlling or helpful unless you understand what’s inside that CDO as compared to what is in our holdings and so again I won’t speak for Merrill Lynch, but I suspect the more likely scenario there was they were sitting on sub-prime residential, which is not essentially where most of our CDO exposure is but then I’ll have Julia provide the detail.
Thanks, Larry. Good morning, Suneet. If you are able to look on our slides that we put out on our web site, slide number six does break out our CDOs. You can see very clearly the bread down credit CDOs versus CMBS CDOs versus what you’re hearing about, which is the sub-prime CDOs and we do it by credit quality as well and we give you the amortize costs and we give you the carry amount.
So, you can see pretty clearly that what’s really been in the news of people selling or the markdowns is related to the sub-prime CDOs and you can see that we have been marking these down to those lower $0.20 levels either on a market value basis for some reasons and some cases we’re permanently impairing rather than temporarily impairing some of these sub-prime CDOs. You can also see that our level very, very small; is that helpful Suneet?
Suneet Kamath – Sanford Bernstein
Yes that’s helpful. If I could just follow-up I’m assuming that you’re in pretty constant contact with the rating agencies in terms of asset quality. Have you noticed any move on their part to focus a little bit more and the gross unrealized losses and maybe factor that into their thinking? I know in the past they’ve not really looked at book value inclusive of AOCI, but any sense that perhaps they are moving in that direction. Thanks.
Yes we are in constant communication with the rating agencies and I would say that our discussion around asset quality has intensified. I think there are questions around what’s behind some of these numbers, (inaudible) talk about what driving some of these marks, certainly we had all of those conversation, but for the most part I would tell you, the rating agencies understand what’s going on in this portfolio, they understand what’s going on in the market and what’s creating the dislocation in the market and they’ve gotten very comfortable so far with our portfolio.
Suneet Kamath – Sanford Bernstein
Thank you very much.
Your next question is from Tom Gallagher with Credit Suisse.
Tom Gallagher- Credit Suisse
Good morning, a couple of questions, but first just a follow-up on Suneet’s question. So, is your anticipation that the way at least in terms of how you’re looking at excess capital and how the rating agencies are evaluating capital adequacy, that unrealized loss positions are not going to factor into the equation; it’s going to continue to be recognized losses that show up on a statutory accounting basis; is that fair to say?
This is Larry. I mean I would say based on, everything we know at this point in time, I mean I think that’s a fair comment. I would just go back to what Julia said; I mean the real important thing here is that the rating agencies do understand what’s going on. I mean they’re not looking at just kind of high level numbers, broad metrics like just total unrealized losses. I mean they are digging in and I think it’s important to dig in and really understand what’s in that portfolio? Where are the delinquencies really happening versus where all there is technical pressures in the market? So again I think the point to be made here is simply that the rating agencies do understand what’s going on, they do have that detail and we are in constant communication with them.
Tom Gallagher – Credit Suisse
Okay and then just a follow-up I guess on the CDO side for Julia. When you look at some of the bonds that are trading let’s say between $0.50 or $0.60 on the dollar, for you to kind of roll forward over the next several quarters is there going to be some possibility that some of these get written down even if you believe they are ultimately money good or maybe you could just talk a little bit about at what point the severity of the price decline might outweigh the recoverability of the cash flows and how you kind of view that balancing act? Thanks.
Tom, I think your question there really is as it relates more to what is if you will policy related to periods of time when market prices may remain depressed or particularly for technical reasons and the extent to which that might drive some consideration around whether you would ultimately have to impair those, which is really more of an accounting judgment, more than it is truly an investment or portfolio management decision. So, maybe I’ll ask Mike to see if he has any comments that he wants to offer into that.
We always every quarter have very through discussions with our accounts. They’re very comfortable with our process, they understand the rigor around the process we have, both in making I’ll say asset valuation decisions and also impairment decisions. So, we do not anticipate any significant change in policy or process in the foreseeable future.
Tom Gallagher – Credit Suisse
And then just lastly, any change in statutory required capital coming for you all as it relates to how you’re looking at excess capital. I think there are some changes coming, as it relates to structured assets and risk-based capital charges?
To our knowledge, I don’t think that will have any significant impact on our risk-based capital.
Tom Gallagher – Credit Suisse
Your next question is from Steven Schwartz with Raymond James.
Steven Schwartz – Raymond James
Hey good morning, everybody and before I forget, Mike, best of luck to you.
Steven Schwartz – Raymond James
Let’s look at a couple of happier things maybe; the CIMB deal, Larry this is your first movement into Shariah-Compliant asset management?
Jim McCaughan may want to comment. We’ve actually done a little bit of work in the Shariah-Compliant area. However, it’s been sort of under the wing of Principal Global Investors. They certainly have been pursuing that market opportunities. This is actually a little bit more focused opportunity using our joint venture partner in Malaysia, CIMB commerce group who is a recognized leader in Shariah-Compliant banking products and they have a desire to extend that leadership over into the asset management space as well and obviously recognizing the strength of our global asset management capability. They feel like we’ll be an excellent partner. Maybe Jim would want to comment a little bit about our Shariah-Compliant capability.
In terms of Shariah-compliant capability I think there is two important features here; one is the so called cyclic fund market where our bonds are structured as so that those are rent loan ownership rather than a payment of interest and we have a strong capabilities in the quantitative analysis and the structure analysis of bonds which are really quite well placed for helping those people to comply with those trends.
Also in equities the strengths in investing in particular sectors, that our portfolio engineering skills allow us to implement restrictions that clients choose to have and we’re finding that in a number of parts of the world there are more religious and ethical constrains being used and we’re delighted to work with CIMB here, to respond to some of the concerns that they’re clients files, in particular their Milton clients filed about investing in particular sectors or particular stocks.
Our approach allows us to engineer portfolios, which are well diversified but nevertheless comply with their constraints. It’s really very exciting to able to address a broader client range using these techniques.
Steven Schwartz – Raymond James
Okay and then on another topic; Larry I think the American Academy of Actuaries came our earlier this week suggesting that the Social Security terminates should be raised. I would think that that would be good for you. You being Principal as oppose to you personally.
Well, I think the Academy Steven that particular recommendation was as it related to Social security and we won’t go into a monologue here on Social securities, but obviously there are a number of issues there that I think we believed would be in the interest of our country to deal with that issue and one of the realities around the way that you’d deal with a financial shortfall on Social security is I think any reasonable person who would look at this would conclude that rising the normal retirement age would be one of the primary steps that we would use for closing that financial short fall.
I don’t know Steven the extent to which that necessarily – it has an indirect implication as it relates to the retirement ages generally or normal retirement ages and if you will employ a sponsor plan, but I’m just noting that those two are really somewhat separate. I don’t know that necessarily changes the whole view around normal retirement age being 65, but it certainly helps the financial conditions of social security.
Steven Schwartz – Raymond James
Okay, all right. Thanks guys.
You bet. Thanks.
(Operator instructions) Your next question is from Eric Berg with Lehman Brothers.
Eric Berg – Lehman Brothers
Thanks very much and good morning to everyone and good morning. I was hoping to return to the capital issue and Mike or Larry, I suddenly listened attentively to all the discussion about the $300 million in excess capital in the debt capacity and the capital being generated, but it sure feels like that’s not a particularly big cushion to deal with future turbulence. In other words my ultimate question is why is this not the right take.
It sort of feels like we are flying along here very smoothly with a little bit of a capital cushion but we got this $5.5 billion CMBS portfolio that is very stable right now, but if we were to have to take large losses on it – not saying we’re going to but if that were to happen, that $300 million doesn’t feel given the magnitude of the size of the company, the size of the investment portfolio to be a big number.
So, my question is why isn’t that the right take to say that principal is stable from a capital positions right now, but if there were a sudden change in the market, it would have to raise capital. Why isn’t that the right perspective to have?
Okay, Eric. Good morning, this is Larry. Well, again I think we tried in our prepared comments to point out that first of all we do believe that we have a very high quality portfolio and we remain very comfortable with the make-up of the portfolio and again we do a lot of our own internal testing to evaluate what might emerge in terms of actual losses or impairments on a quarter-by-quarter basis and as we do that scenario testing and I’m not talking about single point scenario testing, I’m talking about multiple scenarios, we see that our current capital base plus the items that Mike mentioned in his comments are more than sufficient to cover any level of expected losses with even ability to have more moderate economic scenarios.
In addition to that as I think we said in our comments there are a variety of a set of real time capital management levers that we could pull; in other words for example today we still envision some level of M&A as an ongoing element of our business strategy and so the opportunity for capital management is there. There certainly is again an ability to continually evaluate the level of expense. Now I want to be a little careful there, because we believe that much of the expense – we’re not an organization that runs with a high level of excess expense, but like any organization there are certain levels of investment and they are fairly significant that we believe have appropriate payback for us over a long-term period of time.
For example, we talk a lot about our work secure and retire secured capability as just one example and we believe those are appropriate long-term investments; we’re going to continue to do that, but these are all capital management levers that we could go to and so we would regard Eric, our current level of capital as appropriate, as prudent, given our AA rating and we don’t see anything realistically that changes that conclusion, but I’ll have Mike adding further comments that he’d like.
I think the only comment I’d add Larry and I think it sort of wraps up what you’ve said, is this organization generates a lot of free cash, a lot of free capital. Obviously a bit constrained is because of our stock market and our earnings right now, but it gets back to a more normal period or even in an abnormal period, there is still a lot of additional resources that this organization generates as it moves through time and that gives us a bit of additional cushion.
Eric Berg – Lehman Brothers
Mike, I hope you have an incredibly happy and healthy retirement. Thank you.
We have reached the end of our Q&A. Mr. Zimpleman, your closing comments please.
Let me thank you again for joining us this morning. We appreciate your interest and support. As we said we’re very pleased with our results for the quarter, particularly in light of what remains a difficult operating environment, but our businesses continue to show strong momentum and we believe that’s going to continue and we continue to stand by the quality of our investment portfolio and importantly the very, very disciplined process we have behind it; a process driven by strong risk management, very broad diversification and tight asset liability matching.
I’d again note the improvements since first quarter and credit spreads especially related to our commercial mortgage-backed securitizations and our credit CDO holdings, our portfolio is relatively less exposed to date to sub-prime residential mortgage and below investment grade securities.
While there are some headwinds due to market conditions we believe we face them as a company with very strong fundamentals and a long track record we’re effectively navigating in highly challenging environments and we look forward to meeting with all of you over the next several months and having the opportunity to discuss our competitive advantages that we think make Principal very compelling long-term investment.
Thanks and I hope everybody has a great day.
Thank you for participating in today’s conference call. This call will be available for replay beginning at approximately 1:00 pm Eastern Time until the end of the day August 13, 2008. The access code for the replay is 53322914. The number to dial for the replay is 800-642-1687 for U.S. and Canadian callers or 706-645-9291 for International callers. Thank you again for participating in today’s conference call. You may now disconnect.
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