| 2006 | 2007 | ||||||
| Price: | 49.50 | EPS | |||||
| Shares Out. (in M): | 0 | P/E | |||||
| Market Cap (in $M): | 12,066 | P/FCF | |||||
| Net Debt (in $M): | 0 | EBIT | 0 | 0 | |||
| TEV (in $M): | 0 | TEV/EBIT | |||||
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This report will argue that AMP’s low valuation is due to several reasons.
1) AMP has confusing financial reporting in two segments including Asset Accumulation and Protection. The lack of detailed and logical disclosure makes AMP somewhat of a ‘black box’ for investors even after a year as a public company.
2) AMP’s adjusted ROE of 11% in Q2 2006 is low relative to peers with a similar business breakdown. By the end of 2008, AMP should easily be able to improve ROE to the high end of management’s target of 12%-15% on a forward basis.
3) AMP is considered to be a below-average fund manager by investors; very few appreciate the inherent ‘stickiness’ of its customer base, the lack of controversy and scandals at RiverSource, the improved results that most AMP mutual funds have shown recently, and the bright prospects that RiverSource has in the foreseeable future.
Although AMP has appreciated about 20% YTD, AMP offers investors an approximate return of 25% annually from current price levels with solid downside protection. AMP is owned by a diversified group of institutions highlighted by Berkshire Hathaway, Greenlight Capital, and Gotham Capital.
Obtuse Financial Reporting:
An investor looking at AMP would correctly assume that it is a hybrid between an asset management company and a diversified insurance company. AMP has financial products in mutual funds, certificates, wrap accounts, managed accounts, fixed and variable annuities, banking services, life insurance, auto, home, and health insurance.
The problem and therefore opportunity is the fact that AMP is still not well understood by investors. The two segments Asset Accumulation and Protection and the below revenue breakdowns are too vague to help many investors understand how AMP makes money.
FY2005 % Sales
Asset Accumulation and Income 73%
Protection 25%
Corporate 2%
Total 100%
Fixed and Variable Annuities 29%
Asset Management 20%
Brokerage and Banking 22%
Fixed and Variable Universal Life 10%
Life and Health 8%
P&C 7%
Certificates 4%
Total 100%
Management, Financial Advice 33%
and Service Fees
Distribution Fees 15%
Net Investment Income 30%
Premiums 15%
Other Revenues 7%
Total Revenues 100%
Most sell-side analysts consider AMP an insurance company; however, the management team emphasizes AMP as a broad-based financial-planning company and does not make comparisons to specific insurance industry peers. Bloomberg lists AMP as an investment management / advisory services company; the Company is included in the S&P 500 asset management group. The current ROE of 11% is too low for most asset management companies. The picture is clearly jumbled.
Asset Management versus Insurance Profits:
The lingering question is what percentage of normalized profits come from fee-heavy, asset-light investment management type revenues and what percentage of normalized profits come from capital-intensive, commodity-like insurance revenues and premiums? Management refuses to precisely break down this number and many investors and sell-side analysts are uncomfortable. For example, the Citigroup analyst who covers AMP stated that many institutions refuse to invest in AMP because of its poor disclosure.
After having several conversations with IR, comparing notes with industry contacts, and reviewing financial statements and segment disclosures from American Express and post-spin-off AMP, it remains difficult to calculate the precise number. Estimates range from a low of under 20% to as high as 40% of pretax profits resulting from asset management.
We know that 20% of the business is asset management revenues from the Company. We also know that most decently run asset management firms can generate robust pretax margins in the mid 20s to low 30s over a full cycle. The remaining 80% of the revenues are generated from a hodgepodge of insurance businesses listed above. Most decently run non-P&C, diversified life insurance focused companies generate much lower pretax margins than asset managers do. Over a full cycle, pretax margins for insurance businesses similar to AMP should be in the high single-digits to mid double-digits.
Consequently, the 20% of asset management revenues is likely to result in 25% to 33% of operating profits for AMP with the insurance businesses consisting of 67% to 75% of operating profits. During a conference call around the time of the spin-off, AMP IR did not believe this range was aggressive or inappropriate. This would assume that asset management pretax margins are approximately double that of the commodity insurance businesses.
ROE Is Too Low Relative to Industry Benchmarks
At the time of the spin-off, AMP management indicated that a 12% to 15% ROE would be attainable over the long run. AMP was earning a 10.5% ROE in Q2 2005 and was rated a hold or sell by 8 out of 10 sell-side analysts; the skepticism was largely due to management’s lack of a precise timeline or clear strategy to improve ROE. Since the time of the spin-off, the market has become more receptive to earnings growth and ROE improvement; AMP has exceeded earnings estimates several quarters in a row and issued more specific guidance.
After much speculation, management indicated earlier this year that by the end of 2008, the trailing 12 month ROE will be at least 12%. This target is general and conservative. It is likely that AMP can generate a ROE at the high end of the target range because of the business mix relative to industry peers.
First, as indicated above, approximately 30% of the profits for AMP are fee-based asset management in nature. Very little capital must be retained in the business to grow. Most publicly traded asset management competitors have ROE of between 20% and 30%, which includes a large amount of goodwill.
The approximate 70% of profits generated from insurance should earn a consistent 11%-12% ROE. The 10 or so different insurance businesses in which AMP operates are low volatility, commodity-like, predictable profit streams. The insurance businesses are characterized by straightforward product pricing, few unquantifiable risks, and low yield curve sensitivity relative to banks and other financial institutions. The ROE goals are modest and attainable for a company like AMP that has assets and liabilities matched appropriately.
Unless a company has either terrible pricing and risk management as shown by CNO, a lack of sufficient scale, excess capital from a demutualization or spin-off, or an aggressive balance sheet as seen with UK life insurance companies from 1998-2002, returns tend to gravitate around the mean very tightly over the long-run. An analysis of AMP’s earning assets in the insurance business indicates only 0.1% of the assets are invested in equities and only 7% invested in below-investment-grade paper. This is conservative and appropriate.
On a weighted basis, AMP should be able to achieve a 15% ROE on FY2009 earnings—at the high-end of management’s range. When asked on a recent conference call in the Q&A, the CEO specifically stated that there is nothing different about AMP that would prevent it from earning industry returns over the long-run.
Although it is challenging to determine the precise amount, AMP continues to have a large amount of excess capital at its disposal similar to many spin-offs and demutualizations. The CFO of AMP indicates that around $3.00 a share or $750 million of excess capital would be available for acquisitions or further share repurchases.
In the next eight quarters, it is likely that this target will be met and exceeded. AMP is consolidating five life insurance subsidiaries into two subsidiaries. The risk-based capital level and debt to capital level are very high relative to rating agency standards for competitors with an A3 / A- rating. This is typical when a Company has a limited amount of operating history as an independent entity combined with a high credit rating.
Acquisition Candidate
Finally, AMP would be an excellent acquisition candidate for several firms in the near future. There is an above-average chance management is preparing for a sale. All evidence indicates the management team intentionally does an awful job of appeasing investors and playing the Wall Street game; options were struck at very low prices to provide upside for executives.
However, American Express and AMP management have little incentive to pursue a sale before two years and risk a large tax liability that would result from AMP’s long history and low cost base. Although the $15 billion plus price tag on the Company would be a large acquisition to digest, it is likely that AMP will receive interest and/or shop itself around as the two year anniversary of the 24 month spin-off rule date of September 2007 nears.
The interest in MFS and Putnam is supposedly very strong according to various newspaper reports. AMP would be a much better acquisition candidate given the brands are unscathed. Potential acquirers include an asset management firm such as Franklin Resources or a large bank such as Wachovia, Wells Fargo, or Morgan Stanley. In addition, securities processing firms such as Mellon Financial or Bank of New York have superior brands that would appeal to AMP’s focus on the mass-affluent. Insurance companies such as MetLife, Genworth, AIG, or SunLife may be interested in the insurance businesses exclusively. AMP may be broken up and sold in parts. Private equity interest is possible but less likely given the industry nature and lack of potential marketing synergies and cost cutting opportunities.
Improved Fund Performance and Prospects
Many investors believe AMP’s outflows in the flagship RiverSource platform will continue due to poor performance in the 5 year and 10 year Lipper rankings. AMP is considered to be a second-tier manager with mediocre performance and limited marketability. Despite the fact that management is implementing an open-architecture platform where RiverSource funds will be sold outside AMP for the first time ever, few believe the RiverSource funds have much potential for growth.
That being said, recent data show that 66% of RiverSource equity funds outperformed competitors in the last 12 months. CEO James Cracchiolo fired the old management team of RiverSource and taking the right steps to improve performance. A lot of RiverSource’s poor performance was based on owning over-valued growth stocks including large-caps and Internet companies from 2000-2002. However, with the DJIA and S&P 500 valued at about 15x forward earnings, valuations are more reasonable now and the prospects of large continued withdrawals and lousy absolute performance are less likely. In addition, the UK Threadneedle division owned a large stake in the London Stock Exchange and is receiving good press in the investment community for its global reach.
One of the most impressive attributes about RiverSource is being free of recent industry scandals. Although RiverSource does not have a pristine reputation for superior company cultures and strong track records in the fund rankings like industry leaders Vanguard or Blackrock do, it is no worse than Franklin Resources, Morgan Stanley, or T Rowe Price. Unlike Janus, Alliance Capital, Bank of America, Putnam, Gamco Investors, and others, RiverSource has never been involved in a high-profile scandal to diminish investor confidence. The bar is set very low for large mutual fund companies; the fact that RiverSource is scandal free is enough to assume that it is at least an average quality company in the industry regardless if mediocre performance continues.
Finally, RiverSource and other mutual fund families are positioned to benefit from the Pension Protection Act of 2006 signed by President Bush. Many workers will now be automatically enrolled in retirement plans through mandatory contributions—versus an estimated 1/3 of workers who elect to not enroll in defined-contribution plans.
Although the specific benefit is difficult to calculate, it is likely workers will save more money and invest in many of the large mutual funds that offer stability and safety over the long run. The legislation requires that pension money has to be invested in a “qualified default investment alternative.” Possibilities include a life-cycle or target-date fund which weights stocks, bonds, and cash relative to the amount of risk appropriate. Given RiverSource’s strong marketing platform and long company history free of scandals, RiverSource should get at least its fair share of an increasing amount of retirement savings invested in the stock market over time.
Valuation and Price Target
In the second quarter of 2006, AMP earned approximately $3.20 a share on a run-rate, pro-forma for one-time adjustments and add-backs. Book value at Q2 2006 excluding accumulated other comprehensive income from bond mark-to-market adjustments (AOCI) was $32.37 per share.
At the end of FY2006, AMP will have a book value excluding AOCI of between $33.25 and $33.75 per share. AMP is valued at approximately 1.5x FY2006 book value.
However, in 2007 and 2008, earnings per share should continue to accelerate dramatically from $3.20 per share on a run-rate in Q2 2006. In Q2 2006, adjusted earnings per share grew 22% Y/Y. Over the next eight quarters, the ramp in EPS will surprise investors to the upside. Above-average growth will continue until AMP reaches its ROE and margin potential in FY2009.
A combination of decreased separation and overhead costs, Threadneedle integration, removal of excess capital from the life insurance subsidiaries and corporate segment, decreased fund outflows and improved fund performance, and a properly geared balance sheet permitted by the rating agencies will drive profitability. By the end of FY2008, AMP should be earning $5.00 per share on a run-rate. Long-term net income growth according to management targets of 10% - 13% will drive FY2009 EPS to the $5.50 to $6.00 range.
Assuming 30% of the profits are from asset management and 70% of the profits are from insurance, AMP deserves a 13.5x to 14x multiple of forward earnings as a stand-alone company. This is based on the asset management segment deserving a 19x multiple of forward earnings and the life insurance segment deserving an 11.5x to 12x multiple of forward earnings. Currently, sell-side firms project $3.62 of FY2007 earnings. AMP is being valued at 13.8x forward earnings. The P/E multiple is appropriate but the earnings estimates are still too low.
On a price to book value basis, AMP’s 15% ROE business should price to a 2.0x multiple of book value. Morgan Stanley has an excellent October 9, 2006 research report on the life insurance industry with a detailed regression chart of various insurers for review. AMP should have a book value excluding AOCI of approximately $39.00 per share at the end of FY2008.
A valuation of 2.0x book value at the end of FY2008 yields a price target of $78.00 per share in slightly over two years. Applying an appropriate P/E multiple of 13.5x to 14.0x FY2009 earnings yields a similar $79.00 price target or a 50%+ return by January 2009.
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