Conclusion: HOLD – 12-Month Target Maintained at $19.00
Manulife Financial (MFC) reported a net profit of $0.53 per share in Q1/11 versus net profit of $0.64 per share in the same period last year. This quarter saw a net positive impact of $111 million from the increase in equity markets and lower interest rates. Excluding a number of the Items of Note below, including the aforementioned gains and the $151 million ($0.08 per share) net impact of P&C reinsurance claims related to the earthquake in Japan, core EPS was closer to $0.42. Simply put, the quarter was better than we expected by about $0.05 per share and considerably higher than consensus. We continue to believe core quarterly earnings to be about $0.40 to $0.45 per share. ROE in the quarter was reported at 16.5% annualized. MFC’s capital adequacy ratio (MCCSR ratio) decreased to 243 bps from 249 bps as at the end of the prior quarter.
MFC further lowered its equity and interest rate sensitivity in the quarter. As at quarter-end, MFC had hedged 63% of Gross Guaranteed Value, up from 55% as at the end of last year. Although MFC is now more protected from the potential downside of earnings due to market fluctuations, investors must note that the potential of any windfall profits on the upside has also been reduced (see discussion of “Equity Market & Interest Rate Sensitivity” below). The quarter reflected weaker than expected earnings from the Canadian sector offset by stronger earnings out of Asia. The transition of the U.S. operations to better pricing, including on long-term care products, seems to be progressing, although it will require more time.
Mid-term EPS outlook for MFC continues to be more constrained as we expect MFC will experience slower earnings growth due to (i) product re-pricing which will likely generate slower volumes in the segregated fund and variable annuity businesses (ii) sustained costs related to hedging future business, and (iii) higher cash components of equity combined with generally higher capital ratios. Furthermore, investors should be cautioned that MFC’s relative high sensitivity to both equity markets and interest rates will continue to make earnings extremely noisy and volatile (albeit somewhat less than prior quarters).
Our 2011 forecast has been maintained at $1.70 as business growth potentially slows due to product repricing, lower volumes and further hedging costs (estimated at $400 million for fiscal 2011). Our forecast assumes a marginal increase in long-term U.S. Treasury yields and a further, albeit modest, improvement in the outlook for equities. At our forecast level of 2011 earnings, the dividend payout ratio approximates 31%. Our 2012 EPS forecast has been maintained at $1.85.
MFC has very strong fundamentals when compared to most life insurance companies, however, there is little question that MFC still remains sensitive to the outlook for equity markets and long-term interest rates over the next 24 months. Capital is very strong and the aforementioned market exposure that MFC carries will make earnings very volatile. We maintain our HOLD recommendation, however, if investors take the position that equity markets will move higher over the next year or so and interest rates, in particular long-term rates, will increase significantly in the same time-frame, then MFC could be accumulated. However, we continue to caution that investing in MFC is not for the “weak-of-heart”.
Valuation
We have maintained our 12-month share price target at $19.00. Our target price reflects the uncertainty in the earnings outlook and implies a P/E multiple of 10.3x based on our 2012 EPS outlook. This valuation assumes a discount of 5% to the average of the life insurance group.
Equity Market & Interest Rate Sensitivity – More Protection = Less Upside Potential
MFC further lowered its equity and interest rate sensitivity. Although MFC has now protected the potential downside for earnings, investors must note that the potential of windfall profits on the upside has also been reduced.
As at quarter-end, MFC had hedged 63% of Gross Guaranteed Value, up from 55% as at the end of last year. Management indicated that it has reached its 2012 target for hedging. All new Variable Annuity business sold is dynamically hedged.
The Current Sensitivities Are Estimated as Follows
- Net EPS sensitivity to equity markets was lowered in the quarter whereby a 10% decrease in public equity markets would impact EPS by about $0.33 per share annually, down from approximately $0.45 last quarter. A 10% increase in public equity markets would impact EPS by about $0.20 per share annually, down from approximately $0.25 last quarter.
- Net EPS interest rate sensitivity decreased in the quarter such that the impact of a 100 bps parallel increase in interest rates over 12 months would increase annual EPS by about $0.65 per share ($0.85 per share last quarter). A parallel decrease in interest rates by 100 bps would lower annual EPS by about $0.80 per share ($0.95 per share last quarter).
Notable Items Impacting Quarter – Positive $292 million or $0.16 Per share
1. Positive $111 million impact from the changes in equity markets and interest rates. This reflects a $117 million net benefit from interest rates partly offset by a $6 million net loss on equity markets.
2. Positive $254 million impact from policy liabilities related to activities to reduce interest rate exposures.
3. Positive $170 million market gains on non-fixed income assets, strong credit results & trading gains. About half of the gains were related to fair value gains on real estate and oil & gas assets.
4. Positive $8 million relating to refinements in assumptions and models used to value policy liabilities.
5. Negative $100 million based on expected macro hedging losses based on long-term valuation assumptions.
6. Negative $151 million estimated net impact from P&C reinsurance claims related to the earthquake in Japan.
Other Quarterly Operating Highlights
- MFC reported a Q1/11 net profit of $1.0 billion or $0.53 per share versus a net profit of $1.8 billion or $1.00 per share last quarter and an adjusted net profit of $1.2 billion or $0.68 per share in the same period last year. Normalized EPS for the quarter appears to be more in the order of $0.42.
- Total U.S. Insurance reported a solid Q1/11 net profit of US$409 million versus US$203 million in the same quarter last year. Overall, insurance sales declined 19% Y/Y as MFC continues to reposition its product mix to a lower risk profile. Sales of targeted products for growth increased 44% Y/Y while sales of universal life with no-lapse guarantees and non-par whole life products were down 48% Y/Y as MFC repositions its products to improve returns and rebalance the risk profile. Long-Term Care sales declined 52% Y/Y driven by previously announced product price increases. These price increases are expected to improve profitability of new business moving forward but at a cost of slower sales for the balance of 2011.
- U.S. Wealth Management reported Q1/11 net income of US$317 million, down 10% Y/Y. Funds Under Management (FUM) increased 10% Y/Y, generating higher management fee revenue. Mutual fund sales increased 26% Y/Y as this segment continues to be the focus of growth (higher margin business). Retirement Plan Services experienced lower sales, down 16 Y/Y. The latter is expected to improve as proposals have returned to more normal levels after slowing last quarter. Variable annuity sales decreased 25% Y/Y as management continues to reduce its equity exposure. MFC is focusing sales on higher margin products such that overall sales growth is expected to continue to slow.
- Canadian Division reported net income in the quarter of $505 million versus $282 million last year. Excluding market and investment impact, net income was about $211 million, down marginally from $217 million last year. Individual insurance sales were up 15% Y/Y while Group sales decreased 14% Y/Y. Individual Wealth Management reported strong mutual fund sales. FUM increased to $117 billion, up 12% Y/Y. Manulife Bank reported improved growth with loan volumes up 20% Y/Y.
- Asia reported net income of US$357 million, up 2% Y/Y. Excluding net experience gains of $100 million, as a result of equity, interest rate and credit issues, net income increased 13% Y/Y. Japan insurance sales increased 50% Y/Y with growth across all sectors. Mutual fund sales, overall, were generally strong aided by the acquisition of the 49% stake in TEDA Fund Management. FUM increased to US$69 billion, up 19% Y/Y.
- Reinsurance reported a net loss of $93 million versus net income of $43 million in the same period last year. As noted earlier, these results reflected a provision for the Japan earthquake of $151 million.
- Total FUM at quarter end was $478 billion, up 7% Y/Y. Excluding FX, FUM increased by 9% Y/Y. Segregated funds were up 4% Y/Y. Mutual fund AUM increased by 36% Y/Y and included the $3.8 billion of the AIC funds and $1.8 billion associated with the acquisition of the 49% interest in ABN AMRO TEDA Fund Management.
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