Prudential Financial Looks Undervalued Now With A Stable Yield Of 6%

Summary

• Prudential Financial, a $30-billion market-cap player in the financial services sector, oversees a vast portfolio of assets totaling around $1.417 trillion as of Q1 FY23.
• Prudential's Q1 2023 financial results showed a mixed performance across segments, with underlying business growth, but challenges in asset management fees, fee income, and variable investment income.
• However, recovery tendencies are already visible. At the same time, the dividend yield of ~6% appears to be stable and the stock is undervalued at ~7x forwarding earnings.
• Prudential has a significant investment portfolio in CMBS that could be negatively impacted by a decline in value.
• Despite some risks, I assign PRU stock a Buy rating with a year-end price target of $95 per share.
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The Company

Prudential Financial (NYSE:PRU), a $30-billion market-cap player in the financial services sector, oversees a vast portfolio of assets totaling around $1.417 trillion as of March 31, 2023 [10-Q filing]. Its operations span across key regions including the United States of America, Asia, Europe, and Latin America. Through its various subsidiaries and affiliated companies, Prudential offers an extensive range of financial solutions, encompassing life insurance, annuities, retirement options, mutual funds, and investment management. These comprehensive offerings cater to both individual and institutional clients, facilitated by one of the most expansive distribution networks in the financial services industry.

The company's main operations can be categorized into several segments. These include PGIM, which is a global investment management business. Additionally, there are U.S. Businesses, comprising Retirement Strategies, Group Insurance, and Individual Life businesses. The International Businesses segment is also significant, bringing in over 66% of net consolidated adjusted operating income in Q1 FY23. Furthermore, there is the Closed Block division, treated as a divested business that is reported separately from the Divested and Run-off Businesses within the Corporate and Other operations.

PRU's 10-Q

As you can see, Prudential's Q1 2023 financial results showed a mixed performance across segments, with underlying business growth, but challenges in asset management fees, fee income, and variable investment income. The firm reported Q1 2023 pre-tax adjusted operating income of ~$1.3 billion or $2.66 per share on an after-tax basis. PRU experienced lower asset management fees in its PGIM segment, primarily due to decreased AUM caused by higher interest rates, equity market declines, and net outflows. Prudential's U.S. Businesses saw lower fee income and less favorable variable investment income, partially offset by higher rates on spread income and improved underwriting. The International Businesses segment faced a decrease in earnings, primarily resulting from lower spread income due to less favorable variable investment income.

Prudential's Q1 2023 IR presentation

Prudential's investment portfolio looks quite diversified, with ~30% in government securities, ~43% in investment-grade corporate securities, and nearly 40% in private placements. The company's focus on conservative underwriting is reflected in its mortgage loans, which represent 13% of the portfolio and have an average loan-to-value ratio of 57% and debt service coverage of 2.4 times.

Prudential's Q1 2023 IR presentation

Prudential's PGIM experienced third-party institutional and retail net outflows of $14 billion in the quarter, driven by client redemptions for liquidity needs and investor rebalancing in response to higher interest rates and inflation.

Prudential's Q1 2023 IR presentation [author's notes]

Despite these challenges, Prudential aims to expand access to investing, insurance, and retirement security by investing in growth businesses, delivering exceptional customer experiences, and developing innovative financial solutions.

As the most recent example of that, Prudential announced the acquisition of a majority stake in Deerpath Capital Management, a leading US private credit and direct lending manager. This acquisition should enhance PGIM's alternative capabilities, generate additional fee-based revenue, and complement its existing lending origination capabilities. Before the takeover, the PGIM segment had $237 billion in AUM across alternatives, and now it'll add another $5 billion, bringing more expertise in lower middle market direct lending.

During the latest earnings call, Prudential's CFO, Ken Tanji, mentioned that variable investment income in the first quarter was below expectations by $150 million, and underwriting experience was adjusted by $85 million to normalize for Q1 performance. Additionally, other items are expected to increase adjusted operating income by $25 million due to seasonally elevated expenses. These adjustments result in baseline EPS of $3.20 for the 2nd quarter, while excluding specific items would yield $3.29 per share, indicating an improvement in underlying earnings power driven by business growth and higher interest rates. Tanji emphasized the company's strong capital position, with cash and liquid assets at $4.6 billion, and their balanced approach to capital deployment, prioritizing financial strength, flexibility, investment in their businesses, and shareholder distributions.

Prudential's Q1 2023 IR presentation

In Q1, Prudential indeed returned $700 million to shareholders and increased the quarterly dividend by 4%, marking its 15th consecutive annual dividend increase. Prudential Financial stock holds a strong "A-" in Seeking Alpha's Dividend Consistency grade, beating the whole Financials sector by a margin:

Seeking Alpha, PRU

Over the past 5 years, Prudential has demonstrated a dividend growth rate of 8.23%, based on the data on hands. The projected annual dividend payout is $5.00 per share, which gives us a forwarding yield of ~6.02% amid a solid payout ratio of just 54.19%, according to Seeking Alpha. At the same time, PRU's average number of outstanding shares fell by >14% over the past 5 years, and the tangible book value per share began to gradually recover in Q1 FY23 after falling sharply since early 2022. The EPS recovery started even earlier, from the middle of last year.

Data by YCharts

From all this, I can conclude that Prudential Financial's business is relatively stable over the long term and has the potential for further dividend increases and buybacks, which is good for long-term shareholders seeking value.

Valuation

From financial theory, we know that a low P/E ratio likely indicates that investors are concerned about the financial health of the company, while a high P/E ratio suggests that the company is well-positioned for growth.

PRU's forwarding P/E multiple is by no means high - they're currently 20-24% below the 5- and 7-year medians, respectively:

Data by YCharts

Still, PRU cannot be said to have problems with EPS expectations. Wall Street analysts' consensus assumes roughly the same P/E ratio for the next 5 years, which seems unrealistic to me:

Seeking Alpha [author's notes]

On the other hand, if we look at the P/TBV ratio, we see a slightly contradictory picture: PRU shares currently look expensive in the context of their historical perspective, but at the same time they're the cheapest among their industry peers:

YCharts, author's notes

Argus Research analyst Kevin Heal wrote about the same things in his research paper [May 11, 2023 - proprietary source]. He wrote that PRU appears attractively valued relative to a group of comparable life insurers based on long-term ROE and dividend yield. Argus' revised price target of $95 implies a multiple of 8x projected EPS for FY2023, in line with the median of the peer group.

At the same time, Morningstar Premium gives PRU a generous fair value price of $105 per share:

Morningstar Premium, PRU [author's notes]

The Verdict

Of course, I'm puzzled by a number of risks mentioned by Seeking Alpha fellow analyst Real Investments, among others, in his recent article. First, Prudential Financial has a significant investment portfolio in CMBS that could be negatively impacted by a decline in value. A potential decline in CMBS values may reduce the company's overall profitability and net worth and affect its ability to originate new loans and investments. It may also lead to a credit downgrade, making it more expensive for the company to borrow money. Second, high claims and an increased mortality rate continue to weigh on Prudential Financial's profitability. Although management believes in a return to pre-pandemic mortality rates, current reports indicate that mortality rates remain high, which could impact the company's financial performance. Third, I'm concerned that the impending recession could severely hurt PRU for the foreseeable future.

But despite these risks, I like Prudential Financial's stock at current price levels if we take a 5-10 year investment perspective. The shareholder return is good when we have a dividend in the region of 6% and a $1 billion share repurchase program for 2023. There is also a chance that ROE will continue to recover from the recent sharp decline and that the credit risk to debt ratio will continue to decline, making PRU more attractive.

Data by YCharts

So I assign PRU stock a Buy rating with a year-end price target of $95 per share.

Thanks for reading!

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[Steve Fischer]

"undervalued " is a term thrown around often. PFU sells at book value while many other financial companies. JXN BHF CUBI sell for a fraction of the BV- they are different of course and Prudential may be a solid company but think of a different term.

[Dividend God]

long Pru

[CincinnatiRick]

$95 not a very ambitious price target. A simple return to normalcy in the markets would get you there easily.

[usiah]

Tempted to add more PRU.

Retired income investor

[Livejoyfully]

I own it, the author doesn’t. My actual experience with Pru is don’t buy at this level. Look at the beta, look at the 10yr return, lower rates, higher rates, whatever you pick.

Be patient, and buy low 70s

[crayfishx4]

@Livejoyfully agree

[femur]

enjoyed your article on PRU

[Dicktater143]

Well said , long PRU .

[ndardick]

Excellent article, Danil. It's serendipity. While you and I have never discussed PRU with each other, I recently acquired 3/4 of a full position in PRU at about its current price for the handsome dividend in excess of 6% and its reasonable amount of potential appreciation. I agree with your Buy rating and $95 year end price target. Morgan Stanley recently set a 12-month price target of $102.

[Maxuncle]

Thanks for the article Danil. Can you comment on the potential exposure/risk for PRU if the FED continues tightening and the ongoing (but quiet-for-the-moment) banking crises heats up again?

[Simpleton Investor]

Thanks for the well written update, long term holder here reinvesting those dividends and watching its slowly grow into a giant holding

[cons123]

It will be a slow recovery for PRU. The economy and their past mistakes will take time for to overcome. The upside is greater than the downside at this time. I am long PRU and expect another five cents per quarter at the usual annual raise.

[marc_charbo]

@cons123 I agree. It won’t be a rocketship back to $100.

[gastro4]

Thanks for analysis

[Danil Sereda]

@gastro4 you're welcome!