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Low Interest Rates a Headwind for Prudential, but Market Appreciation Boosting PGIMLow Interest Rates a Headwind for Prudential, but Market Appreciation Boosting PGIM Rajiv Bhatia Equity Analyst Business Strategy and Outlook | by Rajiv Bhatia Updated Feb 22, 2021 Prudential Financial, like other life insurers, is operationally leveraged to capital markets. Low interest rates have been an ongoing headwind in recent years. It’s unlikely that interest rates return to pre-financial-crisis levels and thus we expect Prudential to continue to face this headwind for the foreseeable future. Prudential generates over half of its operating income from outside the United States,but the bulk of this is from Japan, which faces even steeper headwinds than the U.S. in terms of interest rates and market growth. To this end, management is focused on growing its international book from growing markets such as Latin America. Given the headwinds facing life insurance companies, managing expenses is unsurprisingly a big focus for life insurers and Prudential is no exception. During its 2019 Investor Day, management outlined a $500 million in run-rate cost savings by 2022 through a combination of process, talent, and technology changes. In addition, Prudential has made technology investments, most notably acquiring AssuranceIQ in October 2019. AssuranceIQ is a technology platform that sells a variety of insurance products directly to the consumer. We think the deal has strategic merit as it expands Prudential’s direct-to-consumer reach to less affluent customers and AssuranceIQ’s fee-based revenue has limited exposure to capital markets. At an upfront cost of $2.3 billion (with a $1.15 billion earnout), AssuranceIQ was not cheap but we expect modest earnings accretion in 2021 and beyond. One bright spot for Prudential has been its investment-management business that has benefited from market appreciation. Returns on equity and operating margins in this segment are higher than the firm overall. In addition, performance on Prudential’s funds have been good, as measured by the number of funds outperforming their benchmarks. That said, PGIM only accounts for just over 10% of its operating profit and thus the life insurance business dominates Prudential’s overall results. Economic Moat | by Rajiv Bhatia Updated Feb 22, 2021 In general, life insurers do not benefit from favorable competitive positions. Industry competition is fierce, and in many cases the products are commoditized. Furthermore, insurers do not know their cost of goods sold for a number of years, allowing them to underprice policies without knowing it. Managers at firms may have an incentive to chase growth without regard for profitability, a cycle in which competitors are forced to match low prices or risk losing business. We believe it’s especially difficult to develop a moat in life insurance as underwriting risks are easily understood and contract structures are largely homogenous. As an example of how life insurance is commoditized, there are plenty of websites that allow prospective buyers to compare rates for life insurance policies with similar terms. We acknowledge that certain adjacent businesses such as asset management and retirements services (for example, defined contribution record-keeping) can have narrow moats, but on a consolidated basis, these businesses are rarely large enough for us to have confidence that it will result in consist returns on equity exceeding cost of equity for the whole company. Prudential’s GAAP return on equity has averaged approximately 9% since 2006. This average return is short of our estimate of the cost of equity, supporting our no-moat rating. Prudential’s international operations primarily consist of Japan. In addition to Japan, Prudential has operations and/or joint ventures in Korea, Taiwan, Brazil, Argentina, Mexico, Chile, China, and Malaysia. Prudential sells a variety of insurance products, including whole life insurance, retirement income products, annuities, and AD&D insurance (accidental death and dismemberment). Prudential markets and distributes its products through propriety agents (life planners and life consultants) and third-party channels (banks and independent agencies). Prudential competes with Nippon, Japan Post, Dai-ichi, MetLife, and other firms in Japan. Due to a declining population and low interest rates, the market conditions have been challenging for Japanese life insurers, and we expect this to continue for the foreseeable future. Prudential’s U.S. Individual Solutions division consists primarily of individual annuities (approximately 90% of pretax division income) and individual life insurance. Prudential’s annuity business is primarily variable annuities, and as of Dec. 31, 2019, Prudential had $165 billion in variable annuity account value. The individual life insurance is primarily term life insurance though it includes guaranteed universal life, variable life, and other universal life. Prudential’s market share is approximately 8%, second to MetLife though we note Prudential faces several competitors that have market shares in the 3%-5% range such as New York Life, MassMutual, AIG, Lincoln National, and Principal Financial among others. Given that costs are primarily variable in the insurance business, we don’t believe Prudential has a competitive advantage from scale. Prudential’s U.S. Workplace solutions include both retirement solutions and group insurance solutions. Prudential’s retirement solutions service defined contribution (DC) and defined benefit (DB) plans with investments, record-keeping, and other services. Prudential also offers institutional investment products such as annuities and pension risk transfer products. Prudential’s Group Insurance offers group life and group disability insurance. When a plan sponsor is considering de-risking a pension, a request for proposal (RFP) is typically conducted with five or more insurers with pricing being the primary driver. Given the relatively low fixed costs of an insurer’s income statement, we believe insurers rarely develop a cost advantage and hence this business lacks a moat source. In the defined contribution (DC) record-keeping business, we estimate Prudential has about 3% market share by assets, well behind market leader Fidelity. Given recent ERISA litigation, we believe plan sponsors are increasingly discerning on fees and able and willing to switch to another provider for favorable pricing. Prudential’s Global Investment Management (PGIM) business serves as an asset manager to both institutional and retail investors and boasts over $1.5 trillion in assets, with 80%-plus of this invested in fixed income assets. About half of Prudential’s assets under management are held in the general account or by affiliates. Consistent with moat ratings for other asset managers, we believe this segment has a narrow moat driven by switching costs. Although switching costs are not explicitly large, inertia and the uncertainty of achieving better results elsewhere tends to keep investors invested with the same fund for a period of time. Operating margins in this division, which were 28% in 2019, are much higher than the firm overall. Despite significant scale, Prudential’s total assets under management trail that of BlackRock, Vanguard, Fidelity, Vanguard, and other firms. Prudential’s asset management segment also contributes less than 10% of the company’s overall revenue, so isn’t large enough to affect the company’s overall moat rating. Fair Value and Profit Drivers | by Rajiv Bhatia Updated Feb 22, 2021 After tweaking our model following the release of fourth-quarter financial results, we are increasing our fair value estimate to $82 from $78, primarily due to time value of money. This equates to 0.9 times book value excluding accumulated other comprehensive income, or AOCI and about 11 times our 2021 adjusted earnings per share estimate. We note that market appreciation (particularly for available-for-sale fixed income securities), can increase AOCI. We forecast flat to low-single-digit premium growth given the majority of Prudential’s insurance book is in the mature markets of Japan and the United States. We expect the firm’s asset management business to grow as market appreciation and inflows can exceed the drag on fee pressure. This leads to a GAAP return of equity in the mid-single-digit percentages, a bit below the high-single-digits seen in recent years. We use a cost of equity of 11% to reflect the company's balance sheet leverage and exposure to capital market movements. Risk and Uncertainty | by Rajiv Bhatia Updated Feb 22, 2021 As of Dec. 31, 2020, Prudential had approximately $554 billion of invested assets on its balance sheet. The vast majority of Prudential’s corporate debt is investment-grade and is well diversified across various industries such as financial, consumer non-cyclical, and utilities. Prudential also faces risk from claims in excess of the amount reserved. In 2018, Prudential did raise reserves for legacy long-term care products it sold. Prudential investment yields are affected by interest rates. In addition, Prudential’s equity securities on its books and its asset management business are affected by equity market movement. Given that Prudential’s financial results are dependent on a variety of factors outside the firm’s control, our fair value uncertainty rating for Prudential is high. Stewardship | by Rajiv Bhatia Updated Feb 22, 2021 Overall, we believe Prudential merits a Standard stewardship rating. This assessment was conducted using our prior stewardship methodology. We will be transitioning our assessment mechanism for Prudential, and the balance of our stock coverage, to a capital allocation methodology by the end of September 2021. John Strangfeld spent 11 years as CEO of Prudential before retiring in 2018. Prudential’s current CEO is Charles Lowrey, who took over in December 2018. Prior to the CEO role, Lowrey ran the firm’s international business. On the positive side, while Prudential, like most life insurers, struggled during the financial crisis and was forced to raise capital, the damage was limited and the company's balance sheet recovered relatively quickly. We also like that Prudential has actively divested noncore businesses and been selective when it comes to acquisitions, though we acknowledge the jury is still out on AssuranceIQ. We are generally pleased with the firm’s capital return policy. In 2019, Prudential returned over $4 billion to shareholders in the form of share repurchases and dividends. Share repurchases slowed in 2020, but we expect them to resume in 2021. We also believe the firm’s focus on expense management is prudent given the relatively commoditized nature of the life insurance business. On the negative side, Prudential has faced hiccups in the past. In 2018, Prudential boosted reserves in the long-term care business. We view being appropriately conservative when it comes to reserves as a key element of stewardship for insurance companies. That said, Prudential is not the only company to take a charge related to this line recently, and it hasn't written any new policies in quite some time. |
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