Wells Fargo Gets Prudential's Brokerage Share

Includes: MET, PRU, WFC
by: Tom Armistead

Prudential Financial (NYSE:PRU) recently announced that Wells Fargo (NYSE:WFC) will pay $4.5 billion in cash to purchase Prudential's noncontrolling interest in their retail brokerage joint venture, which includes Wells Fargo Advisors, LLC (collectively, Wells Fargo Advisors). Market reaction was ecstatic, sending shares up more than 5% to 51.97 in early trading. While this is good news, it is not unexpected, and does not constitute a reason to chase the gains.

Life Insurance Issues – as mentioned in my article on Metropolitan (NYSE:MET), life insurers have become somewhat suspect due to their exposure to MBS, CMBS, CRE, and exposures to the equity markets due to guarantees included in their variable annuity products. As the economic outlook has become clearer and somewhat more favorable, these companies have started to revert toward their normal valuation metrics. The question would be, how far will this process go?

Valuation – using a projected 5 year average EPS, working off 3&3/4 years actual and 1&1/4 projected I get 4.34 X 19.5 = 85 as a midpoint target based on historical ratios. I used S&P's estimate of 5.55 EPS for 2010: my own would have somewhat higher.

Working off book value is a little more difficult. Readers know that I am a fan of nonGAAP metrics for financials, basically taking the view that mark to market losses have been exaggerated and will tend to revert toward amortized cost over time. Like others in the industry, PRU provides a nonGAAP Book Value excluding Accumulated Other Comprehensive Income (Loss). BV ex AOCI stood at 47.46 per share at the end of the last quarter, to which I added 4.33, relying on the company's estimates of the value of the Wachovia lookback. The sale shows these estimates were accurate.

Using BV ex AOCI as adjusted, I get 52.09 X 1.16 = 60 as a midpoint target based on historical ratios.

From 60 to 85 is quite a difference between the two metrics. If earnings are high enough to suggest that PRU should be valued higher than 1.20 X BV ex AOCI, it is probably because they are chasing yield, saving money on hedging, or otherwise increasing the amount of risk assumed in order to increase earnings.

My guess is that PRU will head toward 85 as conditions improve and memory fades. However, it might be a good idea to start reducing exposure if and when it gets up over 60.

Facts and Figures – the company held an investor's day on 12/10/09, and the slide show was filed on an 8-K with the SEC. It's a long one, with a lot of factual information. My impression was favorable: I believe the issues PRU has in common with its competitors have been clarified and dealt with sufficient to make risk/reward attractive at today's prices.

Outlook – conditions going forward should be favorable for life insurers due to 1) the demographics of the baby boomers creating demand for retirement products and 2) the demand for insurance from new middle classes in emerging markets.

Strategy – PRU sports a beta of 2.6. Implied volatility stands at 39.7%, while historical volatility clocks in at 110.6%. The market's perception of the risk involved seems to be decreasing. Implied volatility is sufficient to make selling calls attractive, suggesting a covered call strategy. Suspecting that PRU would dive if the market tanks, the Jan11 40 calls make sense to me as a substitute for owning the shares. The thinking is, with a 52 week low of 10.63, it is very convenient to be able to limit downside risk.

Disclosure: Author holds long positions in PRU and MET, no position in WFC.