Shares of Prudential (PRU) rallied over 6% on Wednesday as investors reacted to stronger-than-expected results. Still, shares are nearly 30% lower than a year ago and trade at lower levels than five years ago. Lower interest rates are a headwind for Prudential, and life insurers more generally, as the income they can earn on their fixed income portfolios declines over time. Still, the company is performing well and trades at such a substantial discount to book value that shares are attractive.

(Source: Seeking Alpha)

Q2 results were solid

In the company’s second quarter (financials available here), Prudential earned $1.85 on a non-GAAP basis, ahead of expectations by $0.13. On a GAAP basis, PRU lost $6.12, due to realized investment losses, which were generally non-cash items related to embedded derivatives in its products.

Also, once per year, Prudential, like all insurers, reviews its reserves and assumptions for revisions; the company does so in the second quarter. This quarter, PRU revised its long-term expectation for the 10-year treasury yield down to 3.25%, which impairs the future profitability of existing insurance policies. Essentially, the company is taking a hit to earnings and book value today rather than bleeding it over time. Of course, this yield is substantially higher than the 0.55% the 10-year treasury currently yields. This cost the firm about $330 million.

Operating Earnings were substantially lower than last year’s $3.03. $0.55 of the drop comes from after-tax impacts of the annual review. Even with these headwinds, the company generated an adjusted operating ROE of 8.4%.

In the quarter, PGIM, which accounts for 15% of the firm’s earnings power and is the company’s asset management arm, was the standout performer. Operating income was up $60 million to $324 million, which was a record high. The unit saw $3.7 billion of net inflows, a strong $9.4 billion of retail inflows against $5.7 billion of institutional outflows from one large client (these flows can be lumpy). Prudential now has $1.605 trillion of AUM, up 7% from a year ago, largely aided by markets. 85% of AUM is outperforming its benchmark over the past three years, and 96% over the past decade. This strong performance track record should engender continued positive flows.

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The US insurance business accounts for 42% of its business. Workplace Solutions, which contains Retirement and Group Insurance, saw income nearly halve to $286 million, largely relating to the annual review and some impact on underwriting from COVID-19. Account values are $498 billion, up 4%, which will support future earnings growth.

The individual business earned $185 million, including a $124 adjustment impact. This was down 4%, normalizing for the adjustment. Annuity values were down 4% to $159 billion as the company actively diminishes the size of this business. Individual life sales were up 2% to $184 million.

International (43%) earned $693 million from $790 million, due to lower investment spread and sales activity due to COVID. Prudential has a leading franchise in Japan, where it revised its yield forecast down 30bp to 1.00% on the 30-year.

Overall, the company was able to manage a change in its interest rate assumption while reporting an over 8% ROE. PGIM continues to perform well. Lower rates and sales activity weighed on the insurance arms, but they remained solidly profitable.

Prudential Should See Sequential Improvement

Prudential entered this crisis in sound financial health, and it remains sound. The parent company has over $4.5 billion of cash and liquid assets. PRU’s investment portfolio is also of very high quality.

PRU’s portfolio is 36% invested in government securities, which are very low risk. Only 3% in equities & alternatives, with the remainder largely in credit fixed income assets (i.e., corporate bonds and mortgages). Impressively, the firm only took $139 million in Q2 credit losses. That is a 0.03% loss rate, indicative of a well-run investment grade portfolio. Considering the same professionals manage Prudential’s own assets as PGIM, where results have been consistently ahead of benchmark, this is no surprise.

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Coming from a position of financial strength, Prudential is focused on improving operations. It is targeting $140 million of cost savings this year as part of a $500 million effort by 2022. $75 million has already been realized, putting the company well on track.

As noted above, operating earnings faced a $0.55 hit from the annual adjustment. The company’s baseline for Q3 2020 earnings is $2.63 as reserve adjustment impacts fade. COVID net costs were $50 million in Q2, and are expected to be $25 million in Q3. These two factors, combined with higher starting AUM and continued cost cuts, drive the $0.78 improvement the company is expecting over the next quarter.

Now, the big risk the company faces is low interest rates. As we saw this quarter, a 50bp drop in the 10-year treasury was the primary driver of a $334 million charge. It’s important to note this assumption of 3.25% is a long-term assumption. On the earnings call, management clarified it expects the 10-year treasury to average 1.25% over the next five years and 1.9% over 10 years, hitting 3.25% in 2030 and beyond.

This rate forecast could be attainable; it’s hard to predict 10 days out, let alone 10 years out. However, if rates undershoot this target, further annual revisions will be made as the earnings power of already-in-force policies declines. An extreme drop all the way down to 0.25% would lead to a pre-tax charge of $2 billion, based on this quarter’s numbers. The company has a 396 million share count and assuming a 21% tax rate, that translates to a $4/per share hit, or less than two quarters’ worth of earnings.

That is a manageable exposure, in large part because Prudential has been diversifying its business away from interest-rate sensitive life products. PGIM, 15% of the business, is rate-agnostic. Indeed, because rate rallies push up the market price of bonds, it actually can help boost AUM and revenue. Additionally, even in the US life business, 56% of earnings come from fees.

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Prudential should see better earnings in the second half of the year as assumption revisions and COVID fade. While low rates hurt profitability, it is actually manageable given the sufficiently large fee business.

Valuation is Attractive

Prudential has an adjusted book value of $92.07 from $97.15 last year. I would note headline book value is $165.53 vs. $150.04 last year. Prudential has about $77 of accumulated other comprehensive income. AOCI largely arises from when assets that are being held to maturity trade above par. Given these bonds will be held as they pull down towards par, AOCI will eventually decline, and adjusted book value provides a more accurate assessment of the true economic value of its net assets.

Even with a $4 haircut for rates at 0.25% as noted above, book value would be $88, or substantially above the $67 share price. This company has about $9.50-10.50 of earnings power, and shares are reflecting too much angst about low interest rates at less than 7x earnings and 73% of book value.

As its fee-based business continues to generate cash flow, I can see shares getting above $80 or 0.9x book value. Barring a rise in interest rates, the company is unlikely to get past book value given worries about future adjustments. On top of this 20% upside, investors also earn a 7% dividend yield, which the company covers more than 2x with net income. Investors should stay long PRU.

Disclosure: I am/we are long PRU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.