Description

Principal Financial Group (PFG) recently converted to a stock insurance, and represents an attractive company. They sell life insurance, mutual funds, 401k plans and also operate an interesting mortgage investment/servicing unit. All told, they have $117 billion assets under management (AUM), but I would not use any standard measurement against their AUM, as much of it is pension and 401(k) monies. The best way to value PFG is how it generates earnings, although I will provide AUM figures for reference.

The first segment is US Asset Management and Accumulation (“US”), from which it derives over half its earnings. Of the total income of $224 million for the first six months of 2001, this segment earned $125 million. PFG is a large provider of 401(k) and pension products to small and medium sized firms. The prospectus alludes to a general industry trend for assets under 401(k) plans in the United States to grow at an annual rate of 14% through 2006, and that only 18% of their target market have 401(k) plans. I believe most of the 14% will be the mad dash by boomers to save money. Part of that may stem from the 2001 Tax Act that expanded the amounts that people may defer, particularly 401(k)’s for self-employed/small-employers. The Act also opens the 403(b) and 457 markets to 401(k) providers, and simplifies the administration and distribution of these plans. PFG has a competitive advantage because they already service the small employer and have invested in the technology to simplify the biggest impediment for this market, the administrative piece. Most of the transactions can be efficiently processed through telephone menu systems or over the Internet. They have also introduced a “self-service” Internet site, Impact401.com. It is a niche being ignored by most asset managers.

The $78.7 billion of this segment’s AUM are split with fee-based at $41.3 billion, spread-based at $30.6 billion and third-party at $5.8 billion. Most of the assets are pension related, but they do include some retail mutual funds. PFG markets 26 funds in the US, including 15 that they manage. Although their managed funds are small, all are under $500 million in assets, they do provide some insight into their investing as a whole, because while the 401(k) assets are separated from the mutual funds, they usually mirror the retail funds. Their funds are average performers, with most receiving a “3” rating from Morningstar. Four of the funds are rated “2” (Balanced, Blue Chip, Growth and Capital Value), while their Limited-Term Bond and International Small-Cap funds are rated “4”. In general, PFG has a better track record with debt security than with equity investing. This is less a factor for the 401(k) market, and is helpful for their other segments.

The International Asset Management and Accumulation (“International”) segment is a relatively new area that PFG is growing through both acquisition and organic growth. In 1999, they paid $1.4 billion for the Australian-based Bankers Trust and have infused $452 million of capital in other operations. Earnings through 2nd Quarter 2001 were ($25.9) million, of which ($21) million came from realized losses on the sale of their operations in Spain. Another contributing factor to the ($4.7) million in operating losses has been the weakening Australian dollar relative to the US dollar. With AUM of $25.7 billion ($23 billion fee-based and $2.7 billion spread-based), there is potential for International to begin contributing to earnings within the next year or two. Helping that will be Australia’s superannuation that requires employers to fund a defined contribution plan at 8% (rising to 9% in 2002) of employee salary.

Life and Health (“L&H”) consists of individual life and annuities, and group life, disability and health. With first earnings of $86.3 million, L&H is an important contributor to PFG. This despite the fact that PFG is curtailing the medical they write, which was accomplished by spinning off the HMO business in 1998, reducing writings in selected states and 100% reinsuring their medicare supplement business. Their group business is an important complement to their retirement business, as it allows them to offer a broad range of products to employers. From their group life policies, you can gain some insight into their market. Group life had 80,000 policies inforce covering 5 million lives with $70.7 billion in coverage, or an average of 63 lives per policy and an average coverage of $14,000 per life. They have 750,000 individual life policies inforce with $81.8 billion in coverage, and are increasing sales of their annuities, universal and variable life products. The life piece also includes a closed-block of policies created when Principal converted from a mutual to a mutual holding company (MHC) in 1998. Creating the closed-block when converting to MHC, rather than at IPO, was beneficial to PFG because they didn’t over fund the closed-block as some recent mutuals have had to do at IPO in wake of SOP 00-3. L&H’s AUM consist of $2.0 billion in fee-based and $7.5 billion in spread-based assets.

The Mortgage Banking (“MB”) seems like a curious fit, but the net margins on this business have averaged 19.7% over the last three years. For half of 2001, MB has netted $68.8 million on revenues of $181 million. The bulk of earnings come from servicing $64.4 billion in mortgages, but loan production is an important factor as it is counter-cyclical to servicing. Most of the mortgages that they produce are “A” grade loans and fixed rate; they only service “A” or “A-“ graded loans. They are retaining more of their loans, with $11.5 billion now held for investment, but they also securitize and sell mortgages. They can warehouse up to $1 billion in mortgages in one off-balance sheet entity, and $250 million in delinquent mortgages in another. Not only does this segment make money, in part because of their processing efficiency, but it also has an ancillary effect for improving L&H investment income. In the early 90’s, some insurers experienced pain in their investment portfolios when the mortgages defaulted, but I think PFG has a good understanding of mortgages and a good source to buy them from. MB only has $0.3 billion of AUM, all spread-based.

Corporate and Other had $2.7 billion of unclassified AUM. Part of that includes a 25% stake in Coventry Health that they are carrying on the books for $143 million and which is now worth over $300 million. I will also include Principal Bank. Although a new bank (online at that), they already have $900 million in assets. The basic concept is to give the customers of their other products another option for their money, and more importantly, allows PFG to retain their assets. They don’t waste money on advertising.

Earnings: Using 360 million shares, the pro forma EPS since 1996 are:

Year EPS
1996 $1.46
1997 $1.26
1998 $1.92
1999 $2.06
2000 $1.72
2001 $1.04 (estimated)

Since PFG converted to a mutual holding company, they have been cleaning house, so the 2000 and 2001 earnings have been depressed by one-time charges. My estimate is that 2002 EPS will be at least $1.50, based on US earning $310 million, L&H earning $150 million, MB earning $80 million (due to decrease in loan production from higher interest rates) and nothing from International or Corporate and Other. If International begins contributing to earnings and the 401k business expands at 10%, EPS could be nearer $1.85. At $21.50, that would result in a 14 P/E, and 12 at $1.85. For 2003, I would expect to see something north of $2.00 as the asset management businesses take off.

Book Value: PFG’s book value as of 6/30/01 was $18.39. At current prices, it's trading at about 17% premium to book. In contrast, AIG paid almost 3X book for American General; however, I don’t view PFG as a takeover candidate at this point.

Negatives: The most obvious is when International will begin earning money. Another is the class-action suit against them for certain sales practices, and whether they have set aside enough to cover a settlement. Finally, 22% of their mortgages held as investments are located in California.

Catalyst

- Earnings should return to 1999 levels and beyond as a stock company
- Projected increase in 401(k) assets, and hence earnings
- International beginning to earn money
- Good long-term potential as PFG can retain 401(k) monies by offering life insurance, annuities, CD’s, and income-producing mutual funds
- Attractive book value
- Increased demand for guaranteed income products