Prudential: The Rock Slides

Shares of the insurance giant were knocked lower Thursday after it missed its earnings target and lowered its 2008 profit guidance

Investors got a bit of a shock from the Rock. Just two months ago, Prudential (PRU) had reaffirmed its 2007 profit forecast and issued guidance for 2008. But when the insurance giant released its financials after the close of trading on February 6, it announced shortfalls for both. Startled investors sold the company’s stock the following day. The shares fell by as much as 10% on Feb. 7 before closing at $71.39, down nearly 8%.

Prudential announced 2007 aftertax operating income of $3.4 billion, or $7.31 per share, compared to $2.9 billion, or $6.06 per share, in 2006, a 21% increase. However, the number was well below the company's guidance of $7.45-$7.60 per share. The Newark, N.J.-based company reduced its 2008 operating income guidance from $8.20-$8.40 to $7.70-$8.40.

However, the earnings may not be as bad as they appear on first glance. During the company’s conference call Feb.7, CEO John Strangfeld explained that the unusual items, including hits from externally managed European investments and in U.S mortgage operations, resulted in a loss of 20 cents per share. Pru lowered its 2008 guidance not because of business shortfalls, but because of a shift in market conditions. In December, the company assumed a close of 1480 for the S&P 500 in 2007 and 2% growth per quarter in 2008. Now, it has reduced performance assumptions, to the actual S&P close of 1387, with no growth in 2008.

Many analysts appear to agree with the company assessment, calling the selloff an investor overreaction to the earnings miss. "Right now we're in an investment environment where perception is dominating reality," UBS analyst Andrew Kligerman said. "Prudential's a rock. It’s in great shape." (UBS has provided non-investment banking securities-related services to Prudential in the past 12 months.)

Variable annuity sales grew by 15%; international insurance sales, although still uninspired, seem to be improving; asset management had strong inflows as well. "Underlying business fundamentals remain healthy," JP Morgan analyst Jimmy Bhullar concurred. (JPMorgan has an investment banking relationship with Prudential.)

Unsurprisingly, investors may also be worried about mortgage exposure. Commercial mortgage securitization has been a drag, resulting in an 8-cent loss in the 2007 fourth quarter, but "Prudential has the ability to [shut the business down] if they want to," Morgan Stanley analyst Nigel Dally said. Tighter borrowing conditions and rising credit spreads may make it more profitable to underwrite commercial mortgages for the company’s own accounts. (Morgan Stanley has received compensation for investment banking services from Prudential within the last 12 months.)

Subprime, too, is less of worry. Prudential recalculated their risk levels to take into account the failure of bond insurers and a 40% fall in housing prices, and estimate a possible hit of only $150 million over 5 years. "It's hard to get worked up about it," Kligerman said.

Some analysts believe the selloff has created a buying opportunity in Prudential’s stock, which currently trades at 1.5 times book and at a price/earnings ratio of 9. "You never see it at nine," Morgan Stanley’s Dally said. "I'd be a buyer." But nervous investors, faced with news of any headwinds for financial firms, appear to prefer a different approach.

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