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How Potent Is Prudential’s Comeback?

April 15, 2014 | About:
Patricio Kehoe

Patricio Kehoe

7 followers

The year 2014 seems to be full of change for many companies, with new acquisitions, mergers, and management renewals on several fronts. And after Prudential Financial Inc. (PRU)’s debacle in 2009, where the firm’s aggressive stance on spread-based benefit products caused it to raise equity capital, results have been wobbly. However, with Rob Axel taking over as senior vice president and controller this October, the winds of change are bound to take off soon and the company is keen on regaining its pre-crisis profitability. Although the company has been taking active steps to catapult results in the upcoming years, some investment gurus like Ray Dalio (Trades, Portfolio) and Paul Tudor Jones (Trades, Portfolio) have sold out their shares in the firm. But was this the right decision? And will Prudential manage to regain its original profitability?

Clouds Are Disappearing, but It’s Not Sunny Yet

With over $1 trillion in assets under management from operations in the United States, Asia, Europe, and Latin America, Prudential is one of the leading financial service enterprises, offering life insurance, retirement services, and investment management. However, it’s past risk-taking behaviour has put a strong halt on financial results in the past years, showing declines in several key metrics. While fourth quarter 2013 reported a net loss of $427 million (compared to 2012’s net loss of $185 million), due to investment losses on hedging programs related to foreign currency exchange rates and a weakening yen, operating earnings increased 36% year over year, closing at $1.5 billion. As the company is set on reversing its negative balance sheet trend, the long term strategy will focus on expanding its fee-based income model and driving returns through underwriting profitable policies.

Furthermore, with its subsidiary in Japan, Gibraltar Life, bringing in over 90% of international premium revenue, strengthening its position in this market will be Prudential’s main growth driver looking forward. In order to improve profitability and offset high expenses, the company invested in purchasing Star Life and Edison Life from American International Group Inc. (AIG) in Japan, in addition to 2013’s acquisition of a life insurance unit from Hartford Financial Services Group Inc. (HIG). However, while the firm’s large agency distribution network adds value to its sales by providing product expertise to its clients, maintaining this costly structure is bound to put pressure on margins, diminishing Prudential’s cost advantage. Furthermore, while the company is currently reviewing the pricing of its products, so as to adjust its benefit ratio and generate profitability, it remains unclear when it will be able to turn its results around completely.

What to Expect Looking Forward

Fourth quarter results for this insurer were somewhat profitable in comparison to previous years, especially in the U.S. retirement and asset management divisions, where sales increased by 11%, resulting in a 40% year-over-year boost in operating earnings. Higher operational efficiency and favorable mortality rates also contributed to margin expansion, and net profit margins are expected to average 6% for the upcoming years, up from 2013’s -1.61%. However, the Japanese market showed sluggish results, with sales of single premium life products falling substantially during the fourth quarter.

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Moreover, the current 3.7% revenue growth will increase slightly over time, due to the company’s international expansion and acquisition strategy, but the CAGR won’t overstep the 4% mark until 2018. Thus, I feel somewhat bearish about Prudential’s medium-term growth and think investors would benefit from waiting for the next few quarterly results before investing in this company. Also, the 1.86% decline in returns on equity, in addition to the sharp drop in free cash flow (down by more than half since 2012), will take time to repair.

Disclosure: Patricio Kehoe holds no position in any stocks mentioned.

About the author:

Patricio Kehoe
A fundamental analyst at Lone Tree Analytics

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