PRU - Should You Buy Prudential Financial For Its 4.85% Yield?

2024-01-13 09:48:16 ET

Summary

• Prudential Financial's shares are not undervalued due to weak growth prospects, justifying its current valuation.
• The company offers a diversified set of products and services, with a strong presence in over 50 countries.
• Prudential Financial has a strong financial profile, with a solid dividend yield that is attractive to income investors.

Prudential Financial ( PRU ) offers an interesting dividend yield, but its shares aren’t undervalued right now, as the company’s relatively weak growth prospects justify its current valuation.

Business Overview

Prudential Financial is an insurance company providing a diversified set of products and services, including life insurance, annuities, retirement products, mutual funds and investment management services.

It’s present in over 50 countries across the globe and has about 50 million customers, while it’s also one of the world’s largest asset managers, with some $1.4 trillion of asset under management (AuM) at the end of last September. Its current market value is about $37 billion, and its shares trade on the New York Stock Exchange.

The company is one of the largest life insurance companies in the U.S., offering several insurance and investment management products through several sales channels, including independent brokers, agencies, and its own sales force.

I’ve covered the company back in 2017 , and its business profile has not changed much until today, which is somewhat disappointing given that its business had relatively low growth prospects. Indeed, its business continues to be well-balanced between international and U.S. operations, while its investment management business (PGIM) maintains a relatively low weight on the company’s total earnings, as shown in the next graph.

In the domestic market, most of its earnings come from the spread business (46% of the business unit earnings), including life insurance and annuities products, while fees have a weight of 35% and underwriting generates about 19%.

One of the company’s goals is to reduce market sensitivity across its operations, for which it has completed a reinsurance operation with Somerset Re some months ago, to reinsure some $12.5 billion of reserves backing Prudential’s guaranteed universal life policies. These policies were written prior to 2015, and represented about one-third of the company’s total reserves in the guaranteed life policies business.

Another important move was the recent establishment of Prismic Life Reinsurace, a collaboration between Prudential Financial and Warburg Pincus. This is a Bermuda-based life and annuity reinsurance company, which will be owned by Prudential, Warburg and a group of investors, and Prudential is expected to reinsure to Prismic a block of structured settlement annuity contracts, with reserves of about $10 billion.

This is another step in its efforts to reduce market sensitivity across its domestic operations, and in the future Prismic is expected to become a long-term reinsurance partner for Prudential. Furthermore, Prudential Investment Management and Warburg will provide investment management services to Prismic, increasing even further the relationship between all parties involved.

In international markets, Prudential Financial has a large exposure to Japan, which is a profitable market but has modest growth prospects, plus it also has exposure to growth markets where it has increased its presence both through acquisitions and organic initiatives.

In Asset Management, it has a diversified AuM mix, with fixed income representing some 41% of total fees generated in the business unit, followed by real estate and equities. This is a positive profile given that the asset management industry is facing increased pressure from passive investing, especially in the equities space.

By being diversified across asset classes, Prudential Financial may be less exposed to this structural issue, while asset managers with higher exposure to U.S. equities, such as T. Rowe Price Group ( TROW ) which I’ve covered recently , have a less appealing profile over the long term because are more likely to suffer from the structural shift of investing funds toward passive and index investing.

Additionally, Prudential Financial funds have good historical investment performance, with most of them beating benchmarks in the last five and ten years, which should theoretically be a strong support for net flows. However, due to weak capital markets in 2022, its third-party net flows have been negative over the past few quarters, a trend that has not reversed in 2023 despite capital markets being in a more positive tone.

Given that earnings are highly related to AuMs, this does not bode well for earnings growth in the asset management business in the near future in this segment. On other business lines, given that Prudential Financial is mainly exposed to mature markets in the U.S. and Japan, its growth prospects can be considered relatively muted over the long term.

Financial Overview

Regarding its financial performance, Prudential Financial has reported a mixed performance in recent years, given that its top-line was more or less stable between $60-66 billion, but its earnings were somewhat volatile.

In 2022 , its revenues amounted to $60 billion, a decline of 15.7% YoY, while its reported bottom line was negative by some $1.4 billion due to losses on investments due to higher interest rates. Adjusted for this effect, its pre-tax adjusted operating income was $4.5 billion and its adjusted operating return on equity ((ROE)) ratio, a key measure of profitability within the insurance sector, was 9.1%.

During the first nine months of 2023 , the company has reported an improved operating momentum, reporting a pre-tax adjusted operating income of nearly $4.3 billion, almost reaching the same profitability during this period that it was able to report in the previous year. Its adjusted operating ROE improved to 12.7% and its GAAP earnings per share amounted to $3.15, compared to a negative figure in the previous year.

For the full year, Prudential Financial EPS is expected to be about $5.7, but according to analyst’s estimates, it should increase to a more ‘normal level’ next year to about $13 per share, showing that its reported earnings were quite affected by rising rates and its negative effect on derivatives and fixed income investments, while on an adjusted basis its business performance has been much more stable.

As interest rates are expected to decline in the near future as the market is expecting the Federal Reserve to cut rates in the coming months, this should be an important factor for the company’s reported and adjusted figures to be more similar.

Regarding its balance sheet and liquidity position, this one of company’s strongest factors of its investment case, as the company had liquid assets of about $4.3 billion at holding level at the end of last September and its $251 billion investment portfolio has a conservative allocation, as shown in the next graph.

Moreover, its capital position is also quite good, given that its RBC capital ratio is above 375%, thus Prudential Financial has a strong balance sheet and does not need to retain much earnings, enabling it to distribute a good part of its earnings through dividends and share buybacks.

Indeed, the company has a good dividend history since 2008, delivering a growing dividend over the past 14 years, at a compounding annual growth rate of 16% during this period.

However, more recently, its dividend growth has been more modest given that its last annual growth was only 4.3% to $4.80 per share. Its current quarterly dividend is $1.25 per share, or $5 annually, which means related to 2023 earnings the company increased its dividend by 4.2% YoY. At its current share price, this leads to a dividend yield of about 4.85%, which is quite interesting to income investors.

Furthermore, the company also has made share repurchases over the past few years, further enhancing its capital returns to shareholders. This shareholder remuneration policy is not expected to change much in the near future, as the company is likely to maintain a growing dividend path in the coming years and continue to make share repurchases to distribute excess capital to shareholders.

Conclusion

Prudential Financial is a solid company and has a strong financial profile, enabling it to offers a compelling shareholder remuneration policy. However, despite its recent efforts to improve its business profile and reduce market sensitivity, its growth prospects aren’t impressive, and I don’t expect the company to enter into transformative M&A, thus its business profile is not expected to change dramatically in the medium to long term.

This means its low valuation is justified by relatively weak growth prospects, thus despite Prudential Financial being currently trading at only 10x earnings, I don’t see its share as being undervalued. Therefore, I think its investment case is highly geared to income, due to its attractive dividend yield that seems to be sustainable over the long term.

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