My previous article on Prudential Financial (NYSE:PRU) reviewed questions investors had about the 1Q20 quarter which can be viewed here. The company read my mind and answered the majority of my questions with an overwhelming amount of detail. In this article, I review my questions and answers.
Prudential announced earnings on 5/5/20 and the conference call was on 5/6/20. The financial performance was underwhelming and the stock was hammered with the stock price declining 8%.
Prudential continued to be reactive and shored up its balance sheet and improved liquidity. The company raised $1.5Bn of debt to enhance liquidity. Charles Lowrey, CEO states:
We successfully issued $1.5 billion of senior debt in early March while spreads were still attractive. This included a $500 million green bond issuance, the first of its kind for a US company in our sector. These actions pre-funded our opportunities through the end of 2021 and enhanced the liquidity of our businesses. As part of the playbook, we further enhanced the liquidity of our businesses and also paused share repurchases at the end of the first quarter to see how the economic environment develops.
Two items to highlight: 1. The company took steps to solidify liquidity by issuing debt and conserving cash. 2. Conserving cash partially consists of pausing shareholder repurchases. While that is a sound strategy, some investors may shy away from the stock since repurchases have been paused.
The capital position is outlined in the 1Q20 Earnings Presentation.
Yes, the company has solid liquidity and access to capital. The impact from COVID-19 is estimated >$400MM and it appears Prudential has adequate liquidity to weather the storm as the pandemic begins to ease.
Kenneth Tanji, CFO stated:
Our financial leverage ratio is at our target, and our regulatory capital levels at our insurance companies remain higher than the targets. In addition, we have substantial sources of funding. Our cash and liquid assets at the parent company were $5.3 billion at the end of the quarter. As previously highlighted, we expect to receive net proceeds of approximately $1.7 billion from the sale of Prudential of Korea business following the close of the transaction, which is expected in the second half of 2020. And another source of funding is free cash flow from our businesses, which represents approximately 65% of earnings over time.
Seasonality And Financial Performance
A gem in the rough could be the stability of Earned Premiums & Fees in 1Q20. However, there were significant misses in operating performance.
Many of the business units significantly underperformed compared to guidance. Below are some highlights.
- Although AUM increased 4% to $1.3 trillion from 1Q19, adjusted operating income dropped due to lower strategic investment earnings and higher expenses.
- Individual Annuities were negatively impacted by lower fee income and lower net investment spreads.
- Individual Life under-performance was a result of less favorable underwriting results and lower net investment spread results.
- Gibraltar was lower due to lower net investment spread results and lower earnings from joint venture investments due to market performance.
Overall, the impacts from COVID-19 hampered a business that is tied to the financial markets. The performance of the business units were negatively impacted by tighter spreads, less favorable underwriting and lower net fee income.
Seasonality impacts going forward
Source: 1Q20 Earnings Presentation
Interest Rate Sensitivity
The chart below outlines the earnings drivers for the company's three segments. Two items that stick out are lower fee and spread income, and lower underwriting that will be discussed later.
Actions taken to mitigate low interest rates are repricing products more quickly and pivoting to less interest rate sensitive products. This is coupled with the cost savings initiative to achieve $140MM for 2020, of which, ~$30MM of cost savings were realized in 1Q20.
Mr. Lowery continued to discuss:
First, we are repricing our products more quickly and pivoting towards lower risk and less capital-intensive products. Second, with respect to rotating our international earnings mix to higher growth markets, in April we reached an agreement to sell our Prudential of Korea business.
Clarification was requested in the conference call and Mr. Tanji responded with:
I'll take that. The products that we are shifting towards do have less interest rate sensitivity, things like variable life, things like we're looking to release a structured variable annuity. And so they will be less capital-intensive and less interest rate-sensitive. I don't think there's anything more to the dynamic than that.
The company has plans and is reactive. To me, some of these plans appear longer term, akin to turning a cargo ship. Also, I wonder about the income that can be generated from lower risk and less capital-intensive products. I think investors want to hear that the company can be nimble and pull some levers to reduce risk and improve liquidity in the near term.
Capital Deployment Strategy
To conserve cash, the share repurchase program has been paused with no clear return date stated. Nigel P. Dally, Analyst, Morgan Stanley asked a question to gain more color.
Mr. Tanji responded:
I think the primary thing we're looking at is the economic cycle, and we're seeing substantial impact given the situation that we're in. We like the quality of our investment portfolio and we think it's manageable, but we want to see how this credit cycle emerges. So I don't know if I can put a time frame on that. I think time will tell.
I guess that is a reasonable response, but not what investors wanted to hear. Investors were curious about the dividend. There was nothing specifically pointed to about the status of the dividend. But, during the prepared remarks, Charles Lowrey, CEO, stated:
We feel comfortable about our ability to manage equity market fluctuations and continued low interest rates over time. We're also highly confident about the quality of our investment portfolio, which Rob will cover in more detail shortly. The strength of our financial position means our dividends to shareholders remain well covered by our income and free cash flow.
Now, I do not know if that statement was included to ease our worries or it's just a fact that cash flow could support the dividend. I guess we will find out when the dividend is declared.
Price To Book Value
Adjusted book value is largely unchanged year-over-year. The improvement in adjusted BV/share is due to the decline in the number of diluted shares.
As we can see below, both the price and book value were negatively impacted by the financial performance.
I was curious about whether or not guidance would be provided given the circumstances. It is understandable that guidance was provided given the nature of the business and knowing the timing of premiums received (if received). Total impact from COVID-19 is expected to be $250MM or a greater than 20% impact on adjusted operating income! Ouch!
The 1Q20 Earnings Presentation laid out the impact of COVID-19 on its 2Q20 adjusted operating income in which the majority of the business units are anticipated to be impacted.
The potential impact from COVID-19 is estimated to be $200MM in FY20 for net mortality/morbidity and $230MM in costs associated with sales support, employee health protection, technology and other expenses.
Kenneth Tanji, CFO commented:
After considering the profile of our insured policyholders, we estimate the impact on earnings from net mortality may be approximately $200 million in 2020. Also, assuming the spread of COVID-19 is substantially contained in the second quarter, we estimate approximately $135 million of earnings impact may occur in the second quarter with possibly lower impact in the second half of the year.
Much of the projected impact is expected in 1H20 and may linger into 2H20 at a lower level. This could be a bright spot!
Well, like the majority of businesses operating in this environment, Prudential was negatively impacted by the pandemic. With financial markets crushed and credit markets frozen for a period in March 2020, poor operating performance can be expected. Management has taken steps to shore up its liquidity and balance sheet, but operating performance has some work to do. Managing these changes through Q1 and Q2 could be of utmost importance for how the year turns out. Investors will still have questions about the dividend and share repurchases. Hopefully, we will have those answers during the next earnings cycle.