Prudential's Rock-Solid Appeal
We view Prudential Financial (PRU; recent price, $75) as a major global player in the insurance and investment segments. We believe its size and scale provide for unique opportunities for growth at attractive margins. International growth, both internally and through acquisitions, should help improve top-line expansion, and we see attractive demographics that should lead to strong growth in Pru's retirement business.
Additionally, we expect future share repurchases to support earnings per share (EPS) growth. With a current yield of 1.0%, Pru shares offer the potential for a compelling total return. The stock carries Standard & Poor's highest investment recommendation of 5-STARS, or Strong Buy.
Prudential is one of the largest U.S. financial-services companies, with $532 billion in assets under management and more than $2 trillion of life insurance in force as of yearend 2005. It serves customers in roughly 30 countries.
Financial services operates through insurance (36% of 2005 operating revenues, 38% in 2004), investments (27%, 25%), international insurance and investments (35%, 34%), as well as a corporate and other segment (2.4%, 2.6%). The insurance segment consists of the individual life and annuities unit (49% of the division's 2005 operating revenues) and the group insurance unit (51%), which distributes group life, disability, and related insurance products through employee and member benefit plans.
The asset management segment (27% of the division's 2005 operating revenues), the financial advisory segment (7.3%), and the retirement services segment (65%) comprise the investment division. International insurance and investments consists of insurance (94% of the division's 2005 operating revenues) and investments (6.0%).
As one of the largest financial-services firms in the U.S., Prudential has the breadth and depth that, we believe, affords it significant competitive advantages. Operating in an extremely competitive industry, Prudential has been able to find ways to increase profitability and improve financial strength. We believe the company is focused on two prime areas of growth: international businesses and domestic retirement and savings.
A significant source of profitability and potential growth comes from Pru's international insurance and investments division. Prudential currently operates in 10 foreign countries: Japan, Korea, Taiwan, Mexico, China, Argentina, Brazil, Germany, Italy, and Poland. We do not anticipate Pru entering any new markets in the near future, but expect the company to focus on improving profitability and distribution at the current operations.
We expect Japan and Korea to be the driving force of profitability for this division, but also forecast improving results from Mexico and China. The international insurance unit has a current return on equity (ROE) of 23%, while the international investments business has an ROE of 10%. Pru believes it can sustain a 20% ROE for the entire division over the next five years.
We see large opportunities for Prudential to benefit from aging baby boomers. Through acquisitions, the company has positioned itself to be a major player in the retirement services business. The 2004 acquisition of CIGNA's (CI) retirement business doubled the company's defined contribution business and added considerable scale to Pru's retirement operations. Additionally, as part of the June, 2006, acquisition of Allstate's (ALL) variable-annuity business, Pru was granted the exclusive distribution rights to sell variable-annuity products through Allstate's proprietary distribution force of independent contractors and financial professionals.
The forces shaping the life insurance industry today stem from a number of demographic changes, as well as from structural shifts within the financial-services marketplace. According to the U.S. Census Bureau, the segment of the general population of retirement age (65 or older) is expected to increase from 12.4% in 2000 to 13.0% in 2010, 16.3% in 2020, and 19.6% in 2030. Conversely, while the segment of working-age people (ages 20 to 64) in the general population is expected to increase from 59.0% in 2000 to 60.0% in 2010, this percentage is then projected to decrease sharply—to 57.2% in 2020 and then to 54.2% in 2030.
As a trend, the overall aging of the population is helping to turn insurers' attention gradually away from income-protection financial products and toward retirement-oriented financial products. In addition, increasing longevity is also having an influence on insurers, as longer lives bolster the need for greater retirement wealth. For more traditional life insurance products, increasing longevity has helped reduce mortality rates, which can aid insurer profitability in these product lines.
The realization by baby boomers that they may not have the financial safety net of Social Security has led to a heightened awareness of the need to save for retirement. (Baby boomers are the approximate 77 million Americans born between 1946 and 1964.) Moreover, a shift in pension trends—from defined benefit plans to defined contribution plans, such as 401(k) plans—has given many Americans a greater sense of financial empowerment.
Since Pru's demutualization (i.e., conversion from a mutual to stock insurance company) on Dec. 18, 2001, it has improved its return on equity by more than 700 basis points to 12.4% as of Dec. 31, 2005. We forecast an improvement in operating ROE to approximately 14% in 2006 and expect ROE to approach 15% by yearend 2007. Over the past three years, pretax adjusted operating earnings increased $1.6 billion, or 80%; assets under management rose $118 billion, or 29%; and total revenues increased from $27.7 billion to $31.7 billion, or 14.6%. Since its initial public offering, Pru's annual common stock dividend has risen 92.5%. In 2005, the company repurchased 32.4 million common shares for about $2.09 billion.
We believe Pru has several sources of potential growth in 2006, including the recent acquisition of Allstate's variable-annuity business; its 38% joint-venture interest in Wachovia Securities; the completion of the integration of the CIGNA retirement division; and the potential to increase overall debt leverage, which should also help ROE improve, in our view. Furthermore, we believe new annuity products should support continued earnings growth at the U.S. insurance division in 2006.
At any time before July 1, 2008, Pru may, subject to limitations, require Wachovia (WB) to purchase its interest in Wachovia Securities. Prior to July, 2008, the purchase price generally would equal $1 billion plus Pru's share of the joint venture's transition costs, adjusted for additional investments. After July, 2008, the purchase price generally would equal Pru's share of the appraised public equity value of the venture plus a control premium.
On Aug. 28, 2006, Pru announced a $600 million settlement with various regulatory agencies in connection with market-timing activities at its formerly wholly owned unit Prudential Securities.
We expect pretax adjusted operating income in the insurance division to remain relatively flat in 2006, with unfavorable mortality experience offset by increased cost control measures driven by reduced head count. We project that sales in this division will benefit from new annuity products and an expanded distribution network. We forecast strong growth in pretax adjusted operating income for the investment division, helped by our expectation for more than $110 million in expense savings from the CIGNA retirement division acquisition and the Wachovia joint venture. We expect demand for total retirement services and earnings from stable value products to help drive growth.
We estimate that pretax adjusted operating income will see mid-single-digit growth in 2006 for the international insurance and investments division, on improving retention rates, expanded distribution, and strategic acquisitions, and should be partially offset by higher expenses related to recruiting and client servicing.
TARGET PRICE: $87.
We first look at historical valuations for Pru. Since its demutualization on Dec. 18, 2001, its price-to-book ratio (excluding realized investment gains and losses under accounting standard FAS 115) has risen steadily from about 1.0 times at the end of 2001 to 1.8 times in 2005. The expansion of the price-to-book multiple has coincided with growth in adjusted operating return on equity. Pru's adjusted operating ROE (excluding FAS 115) has risen from 4.2% in 2001 to 12.4% in 2005.
Our 12-month target price of $87 is based on a multiple of approximately 1.9 times our 2007 book-value estimate of $46 per share. We think a slight multiple expansion is likely in the year ahead, which should be helped by expansion overseas and improving ROE. Our target price also reflects a p-e multiple of 13.3 times our 2007 operating EPS estimate of $6.53, which is toward the low end of Pru's historical average.
Relative to peers, Pru historically has traded at a premium on a multiple to earnings basis. Again, we feel this is warranted due to the higher-than-average ROE and its varied product offerings and geographic diversification. Currently, the stock is trading at approximately 13 times our 2006 operating EPS estimate of $5.75, or about in line with the peer group average.
The company's publicly traded common stock reflects the performance of the financial-services businesses, while its private Class B stock reflects the performance of the closed block businesses. The closed block businesses represent a number of insurance products no longer offered, including certain participating insurance and annuity policies. As of Dec. 31, 2005, Pru had reinsurance agreements covering approximately 90% of the closed block policies.
We believe Pru's corporate governance policies are sound. A supermajority of board members (greater than 90%) are independent outsiders. Directors receive all or a portion of their compensation in the form of equity. We are also encouraged that both the nominating and compensation committees are comprised completely of independent, outside directors.
The primary negative factor, in our view, is that Art Ryan serves as both CEO and chairman of the board. In general, we prefer that a non-executive director serve as chairman, to better serve the interest of shareholders. Additionally, Pru has several takeover defense mechanisms in place, which we view negatively, such as a poison pill and the ability of the board to amend the bylaws without shareholder approval.
Risks to our investment recommendation and target price include currency risk; lower-than-expected investment income in a continued low interest rate environment; reserving risks for new guaranteed minimum benefits; the pricing and availability of reinsurance for some products; integration risks from acquisitions; regulatory risks; and litigation resulting from market-timing issues related to the joint venture with Wachovia.