MET MetLife Inc

We are maintaining our Neutral recommendation on the shares of Prudential Financial Inc. (PRU), following its fourth quarter earnings release. The company reported substantially ahead of the Zacks Consensus Estimate due to a three-fold increase in International earnings, led by Japan acquisitions during early 2011.

However, we reiterate our Neutral recommendation on the back of a volatile equity market and low interest rate environment, both of which do not bode well for the life insurer.

Prudential is the second-biggest U.S. life insurer and has a sizable business in the U.S. life insurance sector, with strong positions in high-margin businesses and a diversified portfolio. Though there was a drag on revenues in the recent past (last couple of years) due to the volatile economic environment, the company has consistently increased its revenues over the past several quarters.

Prudential has a strong international presence that provides it with better organic growth opportunities than its peers. Revenue from its international business (mainly spread across Japan and Korea) accounted for approximately 40% of its 2010 net income.

Prudential has a strong footprint in Japan, with operations in the region for over thirty years. The recent acquisition of Japan-based Star Edison has expanded the company’s distribution profile, increased its scale of operation, and expanded the client base by roughly 50%. Management believes that the acquisition will pull the group’s return on equity (“ROE”) to above 12% in 2012 and above 15% in 2015.

Prudential has also announced a 50 - 50 joint venture with China-based Fosun Group in a $78 million deal. The company is eyeing the fast-growing Chinese life insurance market that has expanded at an average of 30% a year over the past three decades.

Prudential has been focusing closely on three areas – Asset Management, Annuities and International – and axed other allied businesses such as Health Care, Property and Casualty, Retail Brokerage, Investment Banking and Commodities. Management expects to generate ROE of 13% -14% by 2013 by disposing less profitable businesses that have diminished overall returns.

Our Neutral recommendation is based on our cautious near-term outlook on Prudential’s U.S. insurance business, given the weak economy and high competition. We expect the overall production from the business to be modest over the next few quarters.

The Individual Life business, within the U.S. insurance business, is expected to see weak sales, primarily due to price increases implemented over the last year. A weak economy will also keep sales under pressure. In the Group Insurance business, we expect near-term results to be affected by high unemployment, limited wage inflation and intense competition. Although the current environment is challenging, we expect Prudential to generate mid to high-single-digit growth in its Group Insurance business over time.

Moreover, Prudential’s investment portfolio remains a source of threat because of its high exposure to commercial real estate, through Commercial Mortgage Loans and Commercial Mortgage Backed Securities, hedge funds and partnerships. Also, the ongoing low interest rates are likely to pressurize net investment income, thus making it difficult for the insurer to keep pace with the obligation that they have accumulated on high sales of annuities and life policies over the past few years.

We are positive about Prudential’s effective capital management. Prudential initiated a $1.5 billion share repurchase program in June 2011 for the first time since 2007; it will last through mid-2012. With an excess capital of $2.2-$2.7 billion in hand, we foresee an active capital management program through share repurchases, even if management targets to maintain $1 billion of liquidity at the parent company.

With so much of free cash available, Prudential has the capacity to execute an accretive acquisition, leading to inorganic growth. We also believe the company is in a position to participate in the consolidation of the global life insurance and retirement market.

A right mix of business and strong fundamentals has helped Prudential garner market share from weak competitors. Moreover, Prudential is poised to improve its earnings faster than its peers – Metlife Inc. (MET), and American International Group Inc. (AIG) – in the coming years.

 
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