JHVE Photo
Prudential Financial (NYSE:PRU) has performed well over the past year, with its shares up by about a third and hovering near 52-week highs thanks to an improving capital position and increased profitability from rising interest rates. I last covered PRU in March, rating the stock a Hold at the time. With a 7% capital yield, I felt the dividend was solid, but the stock would struggle to rise above $110. However, I was overly cautious. The stock has risen 12%, slightly outperforming the S&P 500’s 9% gain. I expect better results than before, and this seems to be reflected in the stock price.
Find Alpha
Prudential has benefited from rising interest rates, allowing it to gradually widen investment spreads on its insurance and annuity products. As a result, the company’s first-quarter operating income was $3.12, up from $2.70 a year ago. The company’s bond portfolio yield in the first quarter was 4.12%, up from 3.93% last year. Given that most of the company’s assets are in maturities of five years or more, investment yields are expected to gradually increase further, even as the Federal Reserve is likely to begin cutting interest rates later this year as it rolls over bonds purchased pre-2020 at generally lower prevailing interest rates.
Now, before I move on to the insurance business, I want to point out that PGIM, the asset management division I was wary of, is showing significant improvement. PGIM profits increased to $169 million from $151 million last year. Keep in mind that the first quarter was a seasonally lower profit period due to incentive fee payments. PGIM’s asset management revenues increased 12%, while expenses increased 10%. This represents reasonable operating leverage for an investment management firm that does not need to add headcount as rapidly as its assets grow.
On the flip side, I want to note that PGIM’s asset management fees increased 8% to $774 million and performance fees increased 79% to $93 million. I focus on asset management fees because performance fees can be very volatile. It is encouraging to see them up 8% on a 6% increase in AUM. Given fee pressures across the industry, this was a very welcome reversal as fees tend to grow more slowly than AUM.
We’re also impressed with PGIM’s asset accumulation recovery. The firm’s investment track record has been solid, but not as strong recently. Over the past three years, 66% of the fund has beaten its benchmark, but this is below the 10-year performance of 92%. This, combined with a shift to passive products, has weighed on net inflows. As shown below, this has reversed sharply thanks to a new large fixed income operation. Overall, about 40% of assets under management are in fixed income, 22% in real estate, 21% in stocks, and the rest is diversified into alternative strategies.
Prudential
For now, I don’t expect inflows of this magnitude to become a new run rate, but they should support revenue growth in Q2. However, my concerns about continued outflows may have been overly cautious. Given the broader pressures, I am hesitant to make strong assumptions about continued inflows, but even stability is a positive and should support further revenue growth in Q2 and Q3, especially given that markets are reaching new highs.
This downside risk seems less significant than it was a few months ago, so it’s important to note that the insurance business is still receiving the tailwinds I expected. Fortunately, that is the case. U.S. profits increased about 10.5% to $839 million. Institutional profits increased 11% to $441 million due to broadening investment reach. The quarter was highlighted by $11 billion in institutional inflows from two large pension risk transfer (PRT) transactions. I view PRT transactions favorably. Life insurance companies benefit when policyholders die later than expected, while pension plans benefit when policyholders die sooner than expected. This business provides a natural hedge and helps limit overall mortality risk.
Individuals saw a more modest increase of 8% as higher spreads offset a slight decline in fee income, taking into account distribution costs. The rising interest rate environment has contributed to increased annuity sales as investors look to lock in current yields. PRU’s individual retirement annuity sales reached an 11-year high of $3.3 billion, driven by robust demand for fixed annuities. Importantly, these annuities are simpler than traditional variable annuities, reducing the market sensitivity of the overall business. Strong sales and market performance helped total retirement account value increase by $12 billion to $388 billion, with the “closed block” of $90 billion down from $101 billion last year. This change in composition is favorable, but it will take several years for the closed block to be fully unwound. With financial markets continuing to rise, we expect account values to rise further, generating some additional fee income.
Finally, I would like to point out that group insurance increased from $25 million to $45 million thanks to favorable underwriting conditions. Here, the picture is a bit more mixed. As you can see, benefit rates are down 120 basis points year-on-year. But they are steadily increasing. We expect group performance to stabilize in this area after perhaps unsustainably strong Q2 and Q3 2023. Overall, the division has not contributed much to profits.
Prudential
Finally, individual life suffered a loss of $121 million due to costs associated with the termination of a reinsurance transaction. As noted in our previous article on PRU, the company’s profits declined as it reinsured risks (as it now pays reinsurance premiums), but it freed up capital to support PRT and annuity sales, which should be higher margin products. I view this as a favorable business mix change. Additionally, international profits increased nearly 7% to $894 million. International sales increased about 5% to $520 million. The company has a significant presence in Japan and also has a large presence in Brazil. Still, 61% of sales are denominated in USD due to high domestic yields, which we view as favorable as it limits currency translation risk.
Now, I should also mention that Prudential’s investment portfolio is relatively conservative and diversified. Many of these bonds were purchased in a low interest rate environment, resulting in $7.7 billion in unrealized losses in AOCI. These bonds were sold against their insured contracts in the interest rate environment at the time, so the actual economic impact was limited. PRU expects to hold these bonds to maturity and reduce the AOCI losses over time.
Prudential
While I feel good about the company’s investment portfolio, I want to highlight its 14% mortgage holdings. If it sees losses, I see them more likely coming from commercial real estate, given rising interest rates driving down valuations and low office occupancy. PRU’s portfolio is fairly conservative. Average LTV is 58% and debt service ratio is 2.45x. Only 7% of loans are at LTVs above 80%. Less than 3% of loans have debt service ratios below 1.0x. These are the assets I’m most interested in, but they represent about 1% of the total investment portfolio. If PRU were to incur losses here, they would likely play out over several years and would be relatively small due to the low weighting of the portfolio.
Prudential
PRU also continues to be in the conversation about capital return. In the first quarter, it returned $726 million in capital, including $250 million in share repurchases. As a result, share count was down about 1.5% from last year. In June, it reaffirmed its expectation of about $1 billion in share repurchases, maintaining the first quarter’s pace. The holding company has $4.2 billion in highly liquid assets and a strong balance sheet, in line with its $3 billion to $5 billion target. In the first quarter, it raised its dividend by 4% to $1.30, for a yield of 4.4%. The $1 billion in share repurchases equates to about 2.3%, for a total capital return yield of about 6.7%.
Now, back in March, we were targeting $12 EPS in 2024. Given a typical 65% free cash flow conversion, this equates to about $8 in distributable earnings. Given the announced dividend and share repurchase plans, PRU could still generate about $8 in earnings, although I expect earnings to exceed $12. A somewhat seasonally weak first quarter with worsening winter mortality will result in about $50 million in additional PGIM expenses and $70 million in underwriting losses. To offset this, PGIM’s performance fees may not be able to remain as high.
Thus, I expect PRU to earn approximately $13.20-$13.40 this year. Approximately half of this expected increase is due to higher market levels, which mechanically supports increased fee income, and the remainder is due to improved PGIM flows and accelerated sales of new insurance products and PRTs. This positions the company to generate slightly higher capital returns next year, with capital return capacity at approximately $8.65.
This puts the future return on capital for PRU shares at 7.2%. Given the relatively slow growth of the insurance business, I continue to believe a return on capital of around 7% is appropriate. This implies a fair value of $123.5, about 3% above current levels. Combined with dividends and share reductions, the total return on the stock could be 8-9%.
So while PRU is performing better than I expected, its fundamental performance is reflected in the price and I view the roughly 8% return as market-in-line, so I remain a “hold.” PRU is a good fit for dividend-oriented investors with moderate capital appreciation potential, although I believe other insurers such as Jackson (JXN) have more upside potential.
