2023-10-28 04:03:17 ET
Summary
- Principal Financial Group's stock has performed poorly, losing about 17% of its value in the past year.
- The company reported solid third-quarter earnings, beating expectations with adjusted EPS of $1.72. The Retirement and Income Solutions unit saw revenue rise 15% and sales increase by 30%, driven by.
- Mediocre performance at the asset management unit should be monitored for signs of further fund outflows.
- With an 8% capital return yield and RBC just above 400%, shares are fairly valued in my view.
Shares of Principal Financial Group ( PFG ) have been a poor performer over the past year, losing about 17% of their value as its asset management arm has struggled with fund flows and profitability has been challenged by higher mortality. Overall, though, the company reported a solid third quarter. The stock appears to be about fairly valued, and I would view shares as a hold. PFG pays a nice dividend, which it just increased, but shares are unlikely to recover this year’s losses in my view
In the company’s third quarter , Principal earned $1.72 in adjusted EPS, beating estimates by $0.10. This was up about 8% from last year. This result is broadly in-line with the financial market sensitivities that the company has published. As you can see below, every 10% move in the S&P 500 shifts earnings by 5-8%. The company is broadly neutral to interest rates, given its focus on life and retirement policies (more below) and unlike property & casualty insurers who are benefitting from higher rates. With the S&P rising about 14% on average in Q2, we’d expect PFG to earn 7-10% more, all else equal. That is essentially what it delivered
Principal’s most critical unit is Retirement and Income solutions, which saw revenue rise 15% to $710 million, aided by higher markets and rates. The company registered $7.6 billion in sales, which was up 30%. Higher rates and volatile stocks have increased consumers’ demand for annuities and other retirement products, boosting these sales. Thanks to the top-line growth, normalized operating income rose 13% to $ 260 million.
Principal also has an assortment of smaller insurance operations. Specialty benefits revenue rose 8% to $771 million operating income rose 32% to $132 million thanks to lower claims. Life premiums fell 1% to $242 million and operating earnings fell 27% to $30 million. Higher mortality has been weighing on this group’s profitability. Last year, amidst unsatisfactory underwriting results, it also did a reinsurance contract, which lowered its capital base and earnings power but should reduce earnings volatility. As such, earnings should be stabilizing at this lower levels.
One encouraging aspect of this quarter was that PFG completed its annual actuarial assumption and needed to take just $6 million in reserves, which is essentially a rounding error for a company of PFG’s size. When insurers, particularly in the life and retirement space, sell a policy, they cannot be sure of how profitable it is. If you sell life insurance to someone who is 40, you may assume they live to 80 and model annual profits off of that, but he may die at 78 or 82, making the policy somewhat more or less profitable than anticipated.
Every year, as the insurer is gathering more data on how its policies are actually performing relative to modelled expectations, they adjust the reserves, essentially revising past reported profits. It was encouraging to see just minor revisions were needed here, which means that policies are performing within management’s modelled expectations by and large.
Aside from insurance, Principal is a large asset manager. Principal Global Investors revenue rose 6% to $394 million, aided by performance fees in real estate. Operating earnings rose 7% to $152 million. AUM of $469 billion is up 4% from last year. It also has a large international presence with International revenue up 10% to $239 million thanks to $1 billion of flows in Brazil. $168 billion AUM, up 16%. Operating earnings rose just 3% to $76 million, though indicating some lost operating leverage
PGI’s AUM growth was really due to the strength in the equity market, and this is one unit that has been struggling. As you can see below, the firm had $2.6 billion of net outflows during the quarter. Over the past year, it has seen $8.3 billion of outflows.
While PGI has generated solid long-term returns, its more recent performance has been mixed. Only 45% of its assets are beating the median fund in their universe. Equities have also been performing worse than fixed income over the past five years; fees for equities tend to be higher, so even if PGI kept flows flat but saw outflows from equities and into fixed, that would likely be negative for earnings.
Now, these results are not bad enough to cause a mass exodus from PGI’s funds. Its performance has not been bad, just very mediocre. That is likely good enough to keep most existing clients but not good enough to win many new clients, which is why net flows have been negative. This is an area that investors need to stay focused on, as investment management provides earnings without being particularly capital intensive. For fund flows to improve through in a sustained way, I suspect we will need to see performance pick up.
Aside from managing funds for others, PFG as an insurer also has a significant investment portfolio of its own. It has a $76 billion investment portfolio, $64 billion of which is in fixed income. This is a high-quality portfolio; 90% of fixed maturities are classified NAIC 1 or 2 (investment grade) with 70% rated A- or higher. In general, PFG is not taking significant credit risk in its portfolio, investing in higher quality securities, including a $26 billion portfolio of corporate debt.
I would flag there is $3.75 billion of commercial mortgages on the balance sheet. Some commercial real estate, in particular office, faces significant secular pressure. However, the average mortgage has a loan to value of 47%, so properties would have to lose half of their value for PFG to face losses. This could happen to select properties, of course, but in aggregate, I would expect losses from this exposure to be quite small.
Given the magnitude of its fixed income portfolio, it may seem surprising that toward the beginning of this analysis I shared the PFG saw little P&L exposure to interest rates. Looking at its results, though, its net investment income rose just 0.1% to 4.8% year over year. This is because as a life insurer, PFG tends to own long-dated (10+ years) bonds. It takes a long time for the portfolio to mature to increase yields materially. Moreover, the life and retirement policies it writes are based on prevailing rates. When rates were 3%, it prices annuities accordingly and bought bonds at 3%. With rates at 5%, it prices annuities at a higher return, and it buys bonds at 5%.
The liability it owes policyholders maintains the same interest rate duration as the bonds it buys, so the balance sheet is naturally hedged (assuming of course that it has modelled its policies properly), which is why rates do not provide much tailwind or headwind. Now, from an accounting perspective, it does not mark to market its liabilities like it does its bonds, which flow into accumulated other comprehensive income, where it has a $7.1 billion loss. But the present value of its liabilities should also be $7.1 billion less than their book value. This is why when looking at book value per share, I recommend looking ex-AOCI. PFG’s book value ex-AOCI is $53.21 up nearly 5% this year.
Alongside the quarter, PFG raised its quarterly dividend by $0.02 to $0.67. So far this year, it has returned about $900 million to shareholders, and for the year its capital return (dividends and share buybacks) yield will be about 8%. PFG has a solid but not spectacular capital position. It has a risk-based capital ratio of 404%, a bit above the 400% that is the line for a life insurer you want to stay above. Firms like Lincoln Financial ( LNC ) have seen their shares and credit rating suffer when facing shortfalls to this line.
Now, PFG has $904 million of holdco liquidity, which it can use to make capital returns. To be clear, the insurer opco has $360 million of excess capital. PFG has room to maneuver, but this close to the 400% level, I believe it is prudent for PFG to only dividend earnings from the opco, not this excess capital buffer. Over time, PFG believes its business’s free cash flow conversion to be 75-85% with the remaining earnings needing to stay in the insurance entity to support growth and new policies.
Having earned $4.73 so far this year, PFG is positioned to earn about $6.50 over calendar 2023. If equity markets stay around this level and insurance results continue as they have, PFG should be able to earn about $7-$7.20 in 2024. At an 80% conversion rate, it would have about $5.70 to return to shareholders in dividends and buybacks.
That provides ample dividend coverage. At $68, shares would have a 8% capital return yield, similar to Prudential ( PRU ). I view this as fair value for insurers with limited excess capital, particularly as I am concerned about fund flows at PGI. Moreover, if the stock market falls, PFG’s earnings power will fall in sympathy.
Now, if you are bullish on stocks, PFG could see its earnings rise, and shares may be more attractive. Similarly, if you are bearish, you should likely avoid PFG. All else equal, I personally believe rates are more likely to stay high than stocks are, so I prefer insurers, like Chubb ( CB ) who win from higher rates to those like PFG who win from higher equities. At $68 with an 8% yield, PFG is neither a compelling buy nor so expensive to be an urgent sell, and I would expect shares to perform broadly in-line with the market, making it a hold.
For further details see:
Principal Financial: Fairly Valued Given Its Capital Position