Nationwide Financial Services, Inc. Q2 2008 Earnings Call Transcript

Nationwide Financial Services, Inc. (NFS)

Q2 FY08 Earnings Call

August 7, 2008, 10:00 AM ET

Executives

Mark Barnett - VP of IR

Mark R. Thresher - President and COO

Timothy G. Frommeyer - Sr. VP and CFO

Analysts

Colin Devine - Citigroup

Darin Arita - Deutsche Bank

Jeffrey Schuman - KBW

Suneet Kamath - Sanford Bernstein

Presentation

Operator

Good morning and welcome to the Nationwide Financial Services' Second Quarter Earnings Conference Call. My name is Andrew. And I will be your conference facilitator. All lines have been placed on mute to prevent background noise. A question-and-answer session will follow the speakers' remarks. [Operator Instructions]. This conference is being recorded.

At this time, I would like to introduce your host, Mr. Mark Barnett, Vice President, Investor Relations. Mr. Barnett?

Mark Barnett - Vice President of Investor Relations

Thank you, Andrew. Good morning and thank you for joining us this morning. Joining me on the call today is Mark Thresher, our President and Chief Operating Officer, who will provide his perspective on the transaction that we announced yesterday as well as our performance during the second quarter. Following his remarks, Tim Frommeyer, our Chief Financial Officer, will review the financial highlights and discuss our 2008 outlook. Then we'll open the call for questions.

At first, I'd like to remind everyone that we are committed to transparency, including an open and candid dialogue about our current operations and future prospects. Comments made during this conference call may incorporate certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. This may include statements concerning such topics as sales and earnings growth goals, operational plans and other opportunities we foresee. Underpinning these forward-looking statements are certain risks and the uncertainties. We refer our listeners to the Safe Harbor disclosures contained in the second quarter earnings release and our latest SEC filings to appreciate those factors that may cause actual results to differ from those contemplated in such forward-looking statements.

In addition, comments during this call will include certain non-GAAP financial measures governed by SEC Regulation G. For reconciliation of these measures, please refer to exhibit three of our second quarter earnings press release.

And with that, I'll turn the call over the Mark Thresher.

Mark R. Thresher - President and Chief Operating Officer

Thanks Mark. Good morning, and thanks for joining us little earlier today than normal. I get to our second quarter results in a few minutes, but first I want touch on our other news from yesterday.

As you know, last night, we announced the Nationwide Mutual Insurance Company and Nationwide Financial Services have entered into a definitive arrangement approved by both company's Boards of Directors. The Nationwide Financial Management team and I support this transition. The strategic rationale is compelling, the terms of the transactions for the public shares are fair, and the simplified governance and operating structure will better enable NF to be successful over the longer term.

Under the terms of the agreement, Nationwide Mutual will acquire all of the outstanding publicly held Class A shares of common stock of NFS for $52.25 per share. This represents a 38% premium over our unaffected share price on March 7th, the last trading day prior to disclosure of the original proposal for Nationwide Mutual. The transaction, which is subject to customary closing conditions as well as shareholder and regulatory approvals, is expected to close late in the fourth quarter or early 2009.

Before I go any further, I want to acknowledge the hard work of the special committee of the Nationwide Financial Board of Directors. The special committee undertook a deliberate and rigorous process to evaluate the proposed merger. As a result of that rigor, despite a very turbulent equity market, the special committee negotiated significant premiums to the original proposed price of $47.20.

It should be noted that NF management appropriately so was not actively involved in the special committee's deliberations or negotiations. Accordingly, I am not privy to watch that place and I am not in a position to answer questions today regarding the factors that the committee relied upon in their deliberation regarding value. However, what I can say is that they have the utmost confidence in special committee members. And I believe the process was fair and independent.

I believe that the special committee, in consultation with their independent financial and legal advisors, came to a reasonable conclusion that would be fully supported by the fairness opinion. Beyond that, there is not much more that I can add on valuation. The specific details about the process and the fairness opinion provided by Lazard will be made available in the proxy statement when it is filed.

Looking forward, I believe that simplifying our ownership structures is good for our customers, business partners and associates. While our current structure has served us well over the past decade, our ability to grow and meet the needs of our customers over the next decade and beyond will benefit from the simpler and more customer centric business model.

As you are aware, we are on a highly competitive industry and winning over the longer term require successful differentiation in the marketplace as well as scale. As we view landscape, there are many factors that are changing how financial services products are distributed. In particular, client firms are becoming more selective in seeking manufacturing partners that can help them achieve broader firm objectives rather than more product centric goals.

As I've stated on our previous calls, it is important that we take a more unified approach to how we think about and manage our mix to better position NF to accelerate top-line growth and realize cross business synergies.

As we began 2008, I've told you that one of my primary areas of focus was better alignment of our business model and organization to more effectively identify and serve customer needs. And to that end, we have been working diligently to shift away from a siloed product centric organization to one that truly understands consumers, client firms and investment professionals.

While Nationwide Financial did not solicit the proposal from Nationwide Mutual, combining our two organizations is entirely consistent with and complementary to our existing strategy. Simplifying our structural health NF, better leverage our ability to bring a combination of investment, protection and retirement plan solutions and services to our clients through a more unified approach.

One Nationwide, one strategy and a more effective organization will allow us be more closely focused on our combined customer needs and deliver even more compelling financial solutions.

Following the closing of this transaction, I believe that Nationwide will be a stronger company, better able to develop and deliver even more compelling solutions for our customers, all supported by common executional goals, priorities and performance metrics across the entire enterprise.

At the end of the day, this combination will allow us to more effectively function as the strategic partner with client firms by providing what they really need an easier way to meet the complete needs of the end customer.

On a more personal note, my management team and I will continue to lead our financial services businesses. I believe that we have one of the strongest management teams in the industry. To their leadership and the hard work of NF associates, significant progress has been made over the last several years to improve NF performance and outlook. And aspect recognized by the Mutual in his decision to pursue 100% ownership of NFS.

For all the reasons that I have outlined this morning, this transaction represents a unique and compelling opportunity and I'm excited to be part of it.

Let me turn to our second quarter financial results. Despite a difficult operating environment, our core business performance remained fundamentally sound through the first half of the year. While market turbulence and the weak economy are pressuring sales and revenue growth in some of our businesses, we have generally maintained operating margins and delivered reasonably solid core operating earnings through our focus on quality execution and discipline expense management.

Additionally, and very importantly, our balance sheet remains strong as our risk management capabilities are proving effective and our diversified investment portfolio is performing as expected given the market environment.

So turning to the numbers. The second quarter net operating earnings were $0.92 per diluted share compared to $1.39 per diluted share of the second quarter of last year. As both periods contained significant unusual items, comparisons are some what difficult. Excluding the significant items from both periods, net operating earnings for the quarter were $1.11 per diluted share compared to $1.13 per diluted share in the prior year.

Our reported return on equity for the quarter was 9.4% after adjusting for an unusual items we consider 11.2% to be the more normalized return equity for the quarter.

I'm very pleased with the dramatic improvement we are seeing in our life business, validating the actions we have taken to strengthen this business and enhanced its competitive position.

Second quarter sales are traditional and fixed life products increased 70% over last year due to the introduction of innovative product solutions, extended distribution reach, improved sales processes and enhancements of a Nationwide Financial network, that all have been initiated over the last twelve months.

Notably, recent market data indicates the Nationwide Financial's overall life insurance market share ratings improved significantly over the last twelve months. NF jumped ten spots in the overall life insurance market share rankings and universal life share rankings.

In our variable annuity business, second quarter of VA sales were down 8% sequentially and 20% versus last year. There is little question that market volatility and the softening economy continue to way on both, investment professionals and consumers, resulting in an increased sense of financial insecurity and indecision with respect to managing financial matters.

Many are sitting on the sidelines. As a consequence, demand for equity-based products such as variable annuities appears to be weakening across the industry.

In retirement plans, public sector sales were up 3% versus the prior year quarter, driven primarily by increased contributions from several large plants.

Private sector sales were down slightly over the second quarter of last year. The weakness in private sector sales is primarily caused by the continued volatility in the capital markets and a weakening economy which has reduced the number of small plan 401(k) plan in transition as plans sponsors have been reluctant to make changes in this environment. We also saw lower contributions in fewer deferral increases by participants in light of slowing economy.

Despite a tough sales environment, we are avoiding the temptation to take actions that might appear to drive an improvement in short-term results at the expense of longer term objectives. We are not interested in what we view as overly aggressive or irrational tactics designed to achieve short-term sales objectives.

While, I would not go so far as to say that we are currently seeing irrational competitive behavior, we are seeing increasing evidence of pricing pressure and aggressive feature wars in some product categories.

While aggressive competition is healthy, we believe it is important that we maintain an appropriate balance between the underlying value of what our products provides to the customer and adequate returns for NF.

That's said we are not sitting on the sidelines either. We are actively looking at ways and enhance our existing product portfolio. In the coming months, we'll be launching an array of new or enhanced products, designed to bring additional value to consumers while further strengthening our competitive position.

In conclusion, despite a very challenging environment, our core business performance remained fundamentally sound to the first half of the year. As we move forward, I believe it's signifying our owning structure by combing with Nationwide Mutual, is a great opportunity that will benefit our customer, our business partners and our associates. And is being done on terms that are fair to our public shareholders.

With that, I'll turn the call over to Tim.

Timothy G. Frommeyer - Senior Vice President and Chief Financial Officer

Thanks Mark and good morning. I'll begin my discussion with the few comments on the components of net income before getting into some detail on the quarter's operating performance.

During the quarter, we had $42 million of net realized losses. Impairments were $62 million, a level similar to the first quarter, half of which were related to securities backed by sub-prime or Alt-A collateral. And another 25% driven by other structured investments.

Looking at the asset classes that has driven the maturity of our impairments, we have invested primarily in assets with high credit quality and good subordination. We remain comfortable with this exposure, which only represents 15% of our total general account portfolio.

The other significant impact to net income was driven by the accounting for living benefit liabilities and associated hedges. This quarter, there was a $21 million net gain, driven primarily by a reduction in the liabilities versus last quarter.

As Mark noted, operating expenses were negatively impacted by several significant unusual items. In total, the unusual item negatively impacted results by about $0.19 per share and were driven by DAC unlocking, tax true-ups and other items within the corporate and other segment.

DAC unlocking this quarter negatively impacted consolidated results by $0.03. By segment, there was a $0.06 negative impact in individual investments. A one set negative impact in retirement plans, partially offset by a $0.04 favorable impact in individual protection.

Tax related items also negatively impacted earnings by another $0.11, primarily related to a true-up of estimated deductions to actual as we finalized our 2007 return.

Finally in our corporate segment, earnings were negatively impacted by $0.05 including a $0.03 negative impact as an operating gain on structured products was more than offset by operating loss on our trading portfolio. In true sense the above normal expenses related to the write-down of our corporate facility that's in the process of being sold. Excluding these items to more normalized net operating earnings for the quarter were around $1.11 per share.

Now turning to the core drivers, beginning with revenues. Equity markets began and ended the quarter below the first quarter's daily average. But the second quarter's daily average was modestly ahead of the first, benefiting the quarter on a sequential basis. On the year-over-year comparison, the daily market average was down roughly 8%, resulting in a corresponding decline in asset fees.

Volatility of returns on alternative investments reported in the corporate and other segment impacted both prior year and sequential comparisons for net interest spreads.

Additionally, at the consolidated level, prepayment premiums were $9 million below prior year and $5 million below last quarter. Excluding these volatile items, overall net spread margins have remained stable with core spread income flat versus last quarter and down versus prior year, driven by the decline in fixed annuity account values.

Finally, continued strong sales of fixed life insurance product contributed to the revenue growth in individual protection this quarter. With respect to expenses, we are continuing to exercise discipline which tops just to maintain our operating margin despite pressure on equity markets and spread related revenues.

Net of unusual items discussed in the current and prior periods, operating expenses were lower compared to both comparison periods. Finally, our guidance has been updated to reflect the challenging operating environment. The changes are primarily related to lower sales expectations in those businesses most impacted by the current economic environment.

Our core segment operating margin guidance is unchanged. The details are provided on our press release.

That completes my prepared remarks. Operator, please open the call for Q&A.

Question And Answer

Operator

[Operator Instructions]. The first question comes from Collin Devine of Citigroup. Please go ahead, sir

Colin Devine - Citigroup

Good morning, Mark.

Mark R. Thresher - President and Chief Operating Officer

Good morning, Colin.

Colin Devine - Citigroup

A couple of questions. As we've got first, can you confirm there wasn't outside actual appraisal done on in that fashion what that might have revealed as a potential evaluation figure? Second, I was curious as there were any outside offers for the company?

Mark R. Thresher - President and Chief Operating Officer

There was an actual real appraisal done. And what I have been told those sets that was not part of negotiations that to the extend if that was used by Lazard and the special community in their deliberations, that information will be disclosed in the proxy. The... as far as outside... any party solicitations for us, the answer is no. Nationwide Mutual made it pretty clear that they were interested in their first offer and we've been told that they were not contracted by anybody during the period.

Colin Devine - Citigroup

Okay. And then my follow-up, unless I've mistaken the CEO of Nationwide Mutual is also the CEO Jerry Jurgenson, I wonder if Jerry is available this morning to talk about that, since I presume given the deal happy ways that he would be aware of what the actual appraisal reveled.

Mark R. Thresher - President and Chief Operating Officer

Actually, I mean Jerry sat on the other side of the transactions in a similar position that I did, Collin. He actually did not have direct involvement in the negotiations. I'm not sure, so I would... don't believe he is aware of the details of that either because he really wasn't involved in negotiations on either side.

Colin Devine - Citigroup

Now that it's done. I'm curious why he is not. Is he available this morning? And if not, where is he?

Mark R. Thresher - President and Chief Operating Officer

I am not sure...

Colin Devine - Citigroup

So, the bottom line is he is not available for his own conference call.

Mark R. Thresher - President and Chief Operating Officer

Well, Collin in these conference call, as you know, historically I handle the calls. Since he was not involved specifically in the negotiations, the conclusion was he wouldn't add to the discussion.

Colin Devine - Citigroup

Okay. And then maybe the finally piece, in terms of what managements getting comped out of this, that would cover yourself and Jerry and such how is this going to be handled, there was a little problem for me to try to understand it from the annual proxy statement?

Mark R. Thresher - President and Chief Operating Officer

Colin I missed that. How... we are going to get paid is that the question?

Colin Devine - Citigroup

Yes. In terms of what vest and all that?

Mark R. Thresher - President and Chief Operating Officer

I mean... obviously any stock we you would understand from the proxy, we are going to get paid the same $52.25 where everybody else is. Okay. And as far as options, Jerry and I will be treated the same way as all other option holders, which all options will vest at the closing and any options that have a strike price lower than $52.25, we will get paid the difference and any options that at a strike price higher than that will just be cancelled.

Colin Devine - Citigroup

Okay. And I assume this is probably our last conference call. Mark, so on personal note, it's been quite a time. But thanks very much.

Mark R. Thresher - President and Chief Operating Officer

Well,thank you Colin.

Operator

The next question comes from Darin Arita of Deutsche Bank. Please go ahead.

Darin Arita - Deutsche Bank

Hi. Good morning.

Mark R. Thresher - President and Chief Operating Officer

Good morning.

Darin Arita - Deutsche Bank

Congratulations on getting the deal done. And also getting a higher price there. The question on... in terms of your Nationwide Financial post this deal, how does this change and what are your doing strategically, will you be able to do certain things you couldn't before; can you talk a little bit about that?

Mark R. Thresher - President and Chief Operating Officer

Yes. Obviously, a lot of work to go here. But, I mean we have been working in the past year on really a strategy around consumers back to channels, back to products and thinking more much more outside in. The rest of the enterprises is doing the same things. So, we have been targeting common consumer. So, I think we will be able to reach different consumers more effectively with all of our products this way. That's one of the primary things that we expect to be able to do.

The core businesses of Nationwide Financials are annuity business, are life insurance, are retirement plans business, the bank, mutual funds are all very important to the future strategies of Nationwide. Its really, if we can believe, we can bring them more effectively to common consumers with a more simplified ownership structure.

Darin Arita - Deutsche Bank

Do you think your ability to do larger M&A deals has increased?

Mark R. Thresher - President and Chief Operating Officer

Not necessarily because I mean in this situation I mean... now we would do all M&A deals I guess with cash. So that doesn't really change that.

Darin Arita - Deutsche Bank

Okay. I was just thinking you would be a part of a larger capitalized company. So --

Mark R. Thresher - President and Chief Operating Officer

But... we now have the combined capital. Obviously, the entire enterprise both our access capital as well as their capital position. We'll have to evaluate that post the transaction

Timothy G. Frommeyer - Senior Vice President and Chief Financial Officer

And Dan, this is Tim. I would just add that we will get some benefits from the persecution of risk at the top of the house which we don't get right now.

Darin Arita - Deutsche Bank

Okay, great. Thanks very much.

Operator

The next question comes from Carrie Petra [ph] of SourceMedia. Please go ahead.

Unidentified Analyst

Hello. I am representing Retirement Income Reporter magazine. And I have a two quick questions. The first is how do you think the re-mutualization will affect your variable annuity business and your retirement business?

Mark R. Thresher - President and Chief Operating Officer

Well, again, well technically not re-mutualizing. I mean we are... just to clarify that I mean we are being acquired by a mutual company and we own 65% of this today. So, I think in both of those businesses, they will continue to be strong for us. I don't think the transaction in any way takes away from our ability to execute if anything, it enhances our ability to execute across those businesses. So, I feel this is a positive as I said a business ability to focus on common consumers, common business partners across the enterprise for both of those things.

Unidentified Analyst

Okay. And then second part, you mentioned earlier that the simplified owner structural allowed you to be more customer centric. Do you believe that in your experience or generally that a non-public company, insurance company and financial services company can be more responsible... more responsive to its customers than a publicly hold company?

Mark R. Thresher - President and Chief Operating Officer

I wouldn't say that. What I really... what I meant was, since we have customers across the enterprise whether you look at the our auto insurance customers or our homeowners customers our life insurance customers, because of the ownership structure we have tended to look at serve build products for those customers in our individual legal entity siloeds. And I think that by eliminating those and actually looking at customers on more common way, we can bring all of those products together. So, it's not so much public versus private as much as one company versus two separate companies.

Unidentified Analyst

Okay. Thank you.

Operator

The next question comes from Jeff Schuman of KBW. Please go ahead.

Jeffrey Schuman - KBW

Hi Mark. It doesn't sound like there are lot of contingencies. Can you just us walk through kind what are the basic steps it has to happen to get this closed and when you might anticipate the proxy being filed please?

Mark R. Thresher - President and Chief Operating Officer

Yes. We will get start working on the proxy and get it's filed as soon as possible. And we'll... and really the probably the biggest variable that we have is the SEC and their review or lack of review of that proxy statement and what comments they may have. We've got certain other insurance apartment of regulatory approvals. But I think those are not significant. They are small. So, it's really the timing question is mainly around the SEC review of the proxy.

Jeffrey Schuman - KBW

Okay, great. Thank you.

Operator

The next question comes from Suneet Kamath of Sanford Bernstein. Please go ahead.

Suneet Kamath - Sanford Bernstein

Good morning. Just two questions. First, I think we all sort of observed that some of the changes that GAAP accounting has really created some volatility in some of the products that life insurance companies are offering as well some of the volatility related to mark-to-market and the investment portfolio. Given that you are probably not going to be confined by the constructs of GAAP accounting going forward and reset my assumption, maybe just a follow-up to Darin's question, are there areas that either have invariable annuity business revenue investment portfolio where you think you might be able to be a little bit more aggressive given you' are no longer subject to the volatility and GAAP?

And the second question I guess for Mark. I think in your prepared remarks you talked about some competition in the variable annuity business and perhaps some feature wars and I think you had said that you're not quite seeing a rational pricing, but you had some comments around pricing. Can you just provide a little bit more detail there? Thanks.

Mark R. Thresher - President and Chief Operating Officer

First to your first question, we will still be a SEC filing and we do have to follow GAAP, I mean as a sponsor of the various registry products as well as public debt or our medium-term note program and so on. So we will still have GAAP accounting to follow and we'll be filing with the SEC.

So, having said that, I think we will continue to take a look at both, our investment portfolio and make sure that we continue as we always have is to manage both the investment portfolio as well as our products on an economic basis and not necessarily worry about accounting volatility if we are comfortable with what's going on an economic basis.

I think it... my comments generally whether it was really all products more than let's focus just on VAs, I mean I think we're continuing NSV some price pressures in the following case space. But I think there are companies coming kind of in and out of the market and fixed universal life products tend to be a little bit more aggressive. I think we see that there are some additional competition now in... we are calling portfolio income insurance, providing some of the guarantees around managed account and that seems to be pretty competitive to start with. So, and just a general comment across the board, it's not one specific product. But I think the... in many cases people are being a little more competitive in the though market

Suneet Kamath - Sanford Bernstein

Okay. Thanks and best of luck.

Mark R. Thresher - President and Chief Operating Officer

Thank you.

Operator

There are no other questions at this time. I would like to turn the conference over to Mr. Mark Barnett for any closing comments.

Mark Barnett - Vice President of Investor Relations

Alright. Thank you, Andrew. Again, we would like to thank everyone for taking the time to join us. And as always, if you have any additional questions, feel free to call myself or any one on the Investor Relations team. Thank you and have a great day.

Operator

This concludes the Nationwide Financial Services second quarter earnings conference call. You may now disconnect your lines.

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