We are maintaining our Neutral recommendation on the shares of Prudential Financial Inc. (PRU).
Prudential is the second-biggest U.S. life insurer and has one of the best collections of businesses in the U.S. life insurance sector, with strong positions in high margin businesses and a significant diversification. Though there was a drag on revenues recently (for the past couple of years) due to the volatile economic environment, the company has consistently increased its revenues over the past several quarters.
Prudential has a strong international presence that provides it with better organic growth opportunities than its peers. Revenue from its international business accounted for approximately 40% of 2010 net income.
Prudential has a strong footprint in Japan, with operations in the region for over thirty years. Japan is a market that continues to present attractive opportunities for Prudential to build on success in protection products and increasingly address retirement needs. The recent acquisition of Japan-based Star Edison has broadened the company’s distribution, increased its operation scale, and expanded the client base by roughly 50%.
Management anticipates this acquisition to be accretive to return on equity and earning per share based on the value of the in-force acquired and the expense synergies likely to be achieved after integration. Management also believes that the acquisition will pull the group’s ROE to above 12% in 2012 and above 15% in 2015. With this acquisition, Prudential would be the largest foreign life insurance company in Japan based on in-force life insurance.
Prudential has also announced a 50: 50 joint venture with China-based Fosun Group in a $78 million deal. The company is eyeing the fast growing Chinese life insurance market that has expanded at an average of 30% a year over the past three decades. Since the insurance penetration is still far below the average levels in the Chinese market, it looks promising to Prudential. It is being projected that the Chinese insurance market will grow at an annual growth rate of 10–15% for the next five years.
Prudential has been focusing closely on three areas – Asset Management, Annuities and International –, and as such has axed other allied businesses such as health care, property and casualty, retail brokerage, investment banking and commodities. Management expects to generate ROE of 13% to 14% by 2013 by disposing less profitable businesses that have been dragging the overall return. ROE in first half of 2011 was 11%.
However, we hold a cautious near-term outlook on Prudential’s U.S. insurance business, given the weak economy and high competition. We expect the overall production from the business to be modest for the next few quarters.
The Individual Life business within the U.S. insurance business is expected to see weak sales, primarily due to price increases implemented over the last year. A weak economy will also keep sales under pressure.
In the Group Insurance business, we expect near-term results to be suppressed by high unemployment, limited wage inflation and intense competition. Although the current environment is challenging, we expect Prudential to generate mid to high-single digit growth in its group insurance business over time.
Moreover, Prudential’s investment portfolio remains a source of threat because of its high exposure to commercial real estate, through CML and CMBS, hedge funds, partnerships etc. Moreover, the ongoing low interest rates will pressure net investment income, thus making it difficult for the insurer to keep pace with the obligation that they have accumulated on high sales of annuities and life policies over the past few years.
Coming back, we are positive about Prudential’s effective capital management. Prudential initiated a $1.5 billion share repurchase program in June 2011 for the first time since 2007; it will last through mid 2012. With an excess capital of $2.2–$2.7 billion in hand, we foresee an active capital management through share repurchases, even if management targets to maintain $1 billion of liquidity at the parent company. With so much of free cash available, Prudential has the capacity to execute an accretive acquisition, leading to inorganic growth. We also believe the company is in a position to participate in the consolidation of the global life insurance and retirement market.
A right mix of business and strong fundamentals has helped Prudential garner market share from weakened competitors. Moreover, Prudential is poised to improve its earnings faster than its peers – Metlife Inc. (MET), and American International Group Inc. (AIG) – in the upcoming years.
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PRUDENTIAL FINL (PRU): Free Stock Analysis Report
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