Manulife Financial: Company Firing On All Cylinders, But Valuation Too Rich (Rating Downgrade)

seekingalpha04-20

Manulife Financial is a conservatively managed financial services company with a solid core North American business and good growth prospects in Asia.The company reported strong performance in terms ...

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MFC is a beneficiary of higher for longer interest rates, which should continue to boost margins as its invested assets turn over. The 5% dividend is well covered, with a payout ratio of around 50%. Since my last article in November 2023, when I rated MFC a buy, the share price has increased by 18.5%. MFC is a buy for long-term dividend growth investors, but in my opinion, now trades at Fair Value, so I am downgrading my rating to hold for now. In this article, I update the full-year performance and outlook, and review the valuation. As the company's main listing is on the TSX, all figures will be CAD unless otherwise stated. Company Description MFC is a Canada-based financial services company, and something of an institution in Canada, tracing its roots back to 1887. The company operates in four main business segments: Asia Asia has been the main growth driver for Manulife in recent years through a very solid franchise based in Hong Kong, Japan, and Singapore. Significant demand in Hong Kong has come from cross-border asset flows from China, as wealthy Chinese nationals seek to secure access to global asset markets for their savings, but net income is well distributed between Hong Kong and the rest of Asia. Canada Canada, as the home market, is currently the largest of the business units in terms of bottom-line contribution. The business is showing good rates. It operates in the areas of Group Life Insurance, Individual Insurance, and Annuities. MFC also owns a Canadian Bank - Manulife Bank, which consolidates its earnings under the Canadian business. US MFC operates in the US mainly in the areas of Annuities and Life Insurance. The US business has been under some pressure, with reducing new business sales, and earnings. New business sales have been impacted especially in the accumulation policies as higher interest rates created competition from cash deposits as an alternative, and in force earnings by increases in policy lapses and claims. Wealth and Asset Management (WAM) Manulife operates as an asset manager, with operations targeting retirement solutions, retail, and institutional clients. The WAM business is a fee-based business, which nicely balances out the potentially higher volatility from the risk-based life insurance business. Performance In the FY 2023 results, MFC finished off the year well, making progress on the solid Q3 results analysed in my November article. As a Canadian Insurance company, MFC reports under IFRS 17 accounting standards. As discussed previously, the period includes the transition from IFRS 4, the old accounting standard, to IFRS 17, which has significant changes for Life Insurers. MFC provides 'transitional' figures, which even out this one-off impact. Net Income increased by 47% year-on-year, adjusted for the change in reporting standards to IFRS 17. MFC Annual Report Management discussed three main performance indicators: Growth, profitability, and balance sheet strength. Growth Premiums reached $6.4bn, up 12% This is based on the annual premium equivalent (APE). APE is a non-GAAP metric which estimates the annual premium generated during a fiscal year. APE is explained well by Investopedia. Investopedia New business expected profit (CSM) of $2.2bn, up 12%. Expected profit is reported using the GAAP metric of Contractual Services Margin. KPMG provides a simple summary. I explored the IFRS accounting standard in this article. The new accounting standard IFRS 17, which becomes effective for annual periods beginning on or after 1 January 2023, requires that such day 1 profits are offset with a liability - the CSM. The CSM is gradually released over the term of the contract, so that the profit from the contract is realized by the insurer over multiple future accounting periods as it provides services under the contract. As such, the CSM represents the unearned profits that an insurer is required to defer on the issuance of insurance contracts and to recognize these profits as the services are provided in the future. WAM Assets under management inflows of $4.5bn - up $1.3bn on 2022. Profitability  Core Earnings per share up 17%, core ROE up 1.9% to 15.9%  MFC reports on core business as an adjustment for discontinued lines of business. EPS up 47%, ROE to 15.9% These figures are the all-in accounted numbers, including the discontinued business performance. This is an important milestone for MFC, as the core ROE now exceeds the 15% long-term target for the business. Balance Sheet Book Value per share $22.36, up 4% At the current share price of $31.50 at the time of writing, this has MFC trading at 1.4x book. Adjusted book value per share $32.19 Adjusted to reflect the ongoing core business, MFC now trades at around book value. Financial Leverage Ratio 24.3%, down 0.8% This meets another of MFC long-term targets, with a target leverage ratio below 25%. LICAT ratio 137% The LICAT ratio is the capital adequacy ratio used by OFSI, the Canadian insurance regulator, to assess the solvency of life insurers. Milestones in 2023 Largest ever Long-Term Care Reinsurance deal Long-term care (LTC) has been a very challenging business for life insurers, as claims costs far exceeded the assumptions used to price the business. With this transaction, completed with Reinsurance Group of America (RGA) MFC has been able to transfer 14% of its LTC liabilities to RGA. The deal was priced at a multiple of 1x book value, or 9.5x estimated earnings. $130m of future expected earnings are also transferred, but $1.2bn of capital can be released. $4.3bn of capital returned to shareholders NCIB share repurchase mandate for up to 2.8% of common shares This will allow the freed-up LTC capital to be returned to shareholders as well as more general capital returns. Successful transition to IFRS 17 This improves the transparency of reporting significantly and allows investors a much better insight into the long-term embedded value in the business. A return to growth in Asia MFC has a strong position in Asia, where the historical business growth rate has been high. The recovery from Covid took longer than in Canada and the US. For 2023 Asia generated 27% growth in CSM and 11% growth in new APE. Outlook Overall, the business outlook has continued to improve from the Q3 disclosures. Management has reiterated its medium-term targets of 15% new business CSM growth, 8-10% CSM balance growth, generating a core EPS growth of 10-12%. The milestones discussed above, and the fact that some targets have been exceeded in 2023, give good confidence in the outlook. On the earnings call, there was a lot of discussion of technical items, without too much on the outlook overall. A couple of noteworthy points:  Tax rate to increase from current 14% by 2-3% over time due to the implementation of global minimum tax standards. MFC runs their actuarial risk margins to a 90-95% confidence level, ahead of Canadian peers. This is a conservative position which gives a higher confidence level in CSM profit recognition. MFC has $22bn of capital above their solvency needs and $10bn above their target adequacy levels. Much of this $10bn can be returned to shareholders or support bolt-on M&A.  I covered the macro environment in my previous article, with interest rates and mortality trends providing tailwinds to MFC. Share price MFC experienced a significant drop in price around Covid, underperforming the TSX due to pandemic mortality and low interest rates. This underperformance was maintained for much of the post-Covid recovery. Since the last quarter of 2023, MFC has caught up with the TXS benchmark. Data by YCharts Due to the significant dividend, on a total return basis, MFC has consistently outperformed the TSX, with a 10-year total return 50% above the market. Data by YCharts Analyst ratings The market loves MFC right now, with Buy ratings from SA Analysts and Wall Street, and a Strong Buy from SA's Quant. Seeking Alpha SA Quant factor grades are strong, with a slight reduction in the valuation metric. Seeking Alpha Dividend grades are also strong, with a drop in the growth rating. Seeking Alpha Wall Street Analysts' findings are interesting, with nine out of 15 rating MFC a Buy, but five have it as a Hold, and one has it as a Sell. Seeking Alpha The price targets (USD prices) sit on average around the current market price. Seeking Alpha Morningstar has a Fair Value for MFC at CAD 29. No change from Q3. I conducted my own DCF valuation incorporating the Q4 results, a slightly higher tax rate, and the low end of management's guidance. I used a discount rate of 12.5%. This resulted in a fair value of $30 per share (CAD). Competitors Comparing the PE ratio to peers, Sun Life (SLF) and Great-West (GWO.TO), MFC looks pretty close but appears to be a slightly better value. Data by YCharts On a forward basis, analysts seem to credit MFC with more earnings growth potential than peers, so the valuation gap widens. Data by YCharts Looking at the comparison back in November, it is clear that MFC has closed the valuation gap significantly over the last three months. Author on SA Risks  I did a deep dive into risks previously. Key areas to watch:  Interest rates - higher for longer is good for MFC. Mortality and other actuarial assumptions. Counterparty credit risk of reinsurers. China with a large part of the Asia business via HK emanating from China. Asset risk.  My verdict and action plan  MFC is a company which I rate highly and is a core part of my portfolio. I have confidence in the ability of management to deliver on its targets. I see a long-term upside in the stock price; however, it currently trades at a slight premium to fair value. Some global peers offer better value. I am re-rating MFC to a hold. 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