Description

Special Situation: Cash Rich Restructuring

Recommendation

• Buy Phoenix Group (PGH NA) equity in advance of further restructuring efforts and ahead of a planned LSE primary listing in 1H10
• Our target price, with a realization time frame of ~ 3-6 months, is ~€16 (currently trading at €8.15).

Thesis

• Background: Phoenix Group (formerly t/b/a Pearl Group) is the largest UK closed-end life fund consolidator created out of the merger between Liberty (SPAC) and Pearl/Resolution (closed life operator). At its core, Phoenix is a fundamental capital restructuring story without the liquidity issues. Each of the catalysts is largely controllable by management and based on our conversations with the Company, is highly likely to occur over the next few months.
• The Company has a storied past (see background below) and its current valuation level appears to overly discount the significant restructuring levers management is currently pulling. Trading at an estimated 40% of Net Embedded Value ("EV"), we believe a significant margin of safety exists in the shares - in fact, we are hard pressed to find a fundamental downside below the current price.
• Catalysts: Currently listed on the Euronext, Phoenix's EV discount will re-rate to its UK peers following the sequential completion of several ongoing and pending restructuring events on a well defined timeline. To date, the Company has already removed 3 of the 5 major overhangs within the Company stated timelines:
  • o March: Issue IFRS accounts in early to mid March (currently issues only UK GAAP accounts) [COMPLETE]
  • o April: Restructure Tier I bonds [COMPLETE]
  • o April: Reinstate dividend (€0.50/share per annum, paid) [COMPLETE]
  • o May: Reduce total diluted share count via treasury share scheme or discounted exchange [PENDING]
  • o June: Initiate a primary LSE listing, shareholder rotation [PENDING]
• Consensus: Given the Company's historical restructuring, complicated equity structure & relative high gearing, misperception that the Company will undergo a dilutive rights offering in the near term, level of complacency by the analyst community prior to resolving the share structure, and its Euronext listing, the primary investors in UK life insurers are not represented in the shareholder base. In other words, lots of reasons on the surface to ignore this company today.
• Variant Perception: With multiple catalysts underway, its valuation (~ 40% EV), normalized free cash flow yield after debt service (21%), and normalized dividend yield (~ 12%) offer a compelling yet temporary discount. We believe a powerful shareholder rotation and value rerate will occur upon simplification of its structure and primary listing on the LSE.
• Risk Protection: With zero (repeat: zero) cash constraints on the business, the fundamental risk to our thesis is that the Company is unable to effect the necessary share restructuring to facilitate a primary UK listing, and as a result, share liquidity will remain constrained - given the levers available to management we assign a 10% probability of this occurring.
  • o Trading at ~ 40% of EV is arguably pricing in your downside - even if we factor in a market roll (7.5% decline in equities, 175bps increase in risk free rate, 175bps widening of I-grade credit) and a further EV valuation discount, we get a downside of €5/share - why is this unrealistic? Normalized dividend yield of ~18% vs. peers at ~ 5%, EV discount to peers unsustainable at 40% vs. ~ 90-100%, shareholders incentivized to achieve a primary listing. Even assuming only a modest re-rate upon a listing where the shares trade at 50% EV, downside price assuming a market correction is €7.58/share with a dividend yield >2x the peers.
  • o M&A activity in the sector is widespread and average transaction values range from 80% to 120% of EV - the Company will be sold in an auction if its EV/trading discount persists.
  • o Lastly, the Company has successfully completed 3 of the 5 restructuring initiatives needed to advance a primary listing - significant de-risking to revalution since March 2010.

Company Background

The Company in its current form developed over three principal stages:

• Sun Capital and TDR acquired three life companies from HHG in December 2004 in a largely distressed sale scenario (acquiring the businesses for 0.81x EV) and created the Phoenix Group of companies.
• In July 2007, Phoenix made an unsolicited offer for Resolution plc for 720p (1.2x, a cyclical high in closed-life acquisition multiples, 0.82x after divesting £1.3bn in assets to Royal London) in a levered transaction which led to Tier 2 capital violations.
  • o Rather than inject additional equity, Phoenix varied the structure of certain Tier 2 debt to become Tier 1, and the FSA imposed a number of restrictions on cash flow transferability within the group.
  • o As a result, Phoenix entered into negotiations with its lenders that led to debt for equity exchanges totaling £555m
• In June 2009, in conjunction with the debt exchanges, Liberty International Acquisition Company (a SPAC listed on the Euronext), offered £452m for a majority ownership in Phoenix. Phoenix's existing shareholders also invested an additional £75m in the acquisition. In total, Phoenix's liquidity profile was improved by £1.1bn, and the cash transfer restrictions were lifted.
  • o From the announcement of the acquisition (6/29/09), shares have traded off ~ 20% as SPAC holders exited and restructuring noise limited investor take up:
  • o With each overhang removal, shares have reacted positively, however the Company still trades at a significant valuation discount to its peers and underlying cash flow. 

Company Overview

Phoenix Group is the largest UK closed-life fund consolidator consisting of 8 closed-end life funds, two asset managers (Axial & Ignis), two management service companies, and one reinsurance business handling certain reinsurance contracts on the group’s annuity liabilities.  In total, the Company has over 7.6 million policies in force, £66.9bn of AUM, and total life liabilities of £53.9bn.  The Company’s life operations consist entirely of closed end funds, so no new origination takes place – it is effectively a cash flow wind down story.  

In addition to VIF policy rolloff, the Company extracts cash flow from existing policy portfolios through consolidation of policies within the group (effectively regulatory capital arbitrage), taxation savings on consolidated portfolios, as well as internal synergies created via backoffice consolidation.  In total, the Company anticipates it can generate an additional 3%-6% unlevered IRR on portfolio consolidations. The Company estimates approximately £500m of savings are imbedded in its existing portfolio (assuming portfolio consolidations within Phoenix and Pearl on an individual basis, ie no inclusion of consolidation between the fund groups - potential for an incremental £500m of synergies).  To illustrate, a step-by-step example is as follows:

• Phoenix acquires a fund policy at a 2.5% discount to EV, resulting in an intial targeted IRR of 10%
• Phoenix consolidates one of its unprofitiable funds into the profitable acquired fund and captures the benefits of the tax losses on the combined fund (1-2% IRR)
• Cost synergies of the additional policies under an existing structure realized (1-2% IRR)
• UK rules requred minimum solvency requirements based on the higher of Pillar I or Pillar 2 capital. If Phoenix consolidates one fund with Pillar 1 capital of £250m and Pillar 2 capital of £150m (capital differential of £100m) with a fund with Pillar 1 capital of £150m and Pillar 2 capital of £250m (capital differential of £100m), the combined fund now has total Tier 1&2 capital of £400m, resulting in a release of £100m+ to the group (to maintain a similar capital differential).

For all closed end life operators, the most critical issues are (i) maintaining sufficient regulatory capital and (ii) maintaining stable investment performance.  To this end, Phoenix maintains a relatively safe 132% capital surplus (£1.2bn, above 125% min target) and a low beta portfolio of investable securities comprised primarily of cash, government, and other liquid fixed income securities rated BBB or better (at 88% of total portfolio in bonds w/ 80% rated A or better,  2% equities, 1% properties, and 9% hedging and other instruments)

Source: FY2009 annual report

 Lastly, additional cost synergies are anticipated to be generated through the consolidation of its two asset management business, coupled with inflows of third party capital that have yet to be realized (let alone the potential to sell the asset managers all together).  Managing a total of £66.9bn AUM, incremental third party funds (from a low base of £4.1bn) and cost synergies, opportunities to extract incremental value appears attainable.  Latest performance snapshot below:

• (1) Includes Liberty fund assets
• (2) Transfer of £1.5bn to Royal London in 1H09

Source: FY2009 annual report

Shareholder Base

Under terms of the Liberty/Phoenix merger and restructuring, the Class B shares, Liberty/RLG warrants, and contingent shares remain unlisted and closely held by the original SPAC owners and lending group.  Note: shareholders below are locked up until September 2010 for 50% of holdings below, 50% until mid 2011.

Source: LSE Summary Document, 11/12/09

Capital Structure

The merger of Phoenix and Liberty created a highly complicated debt and equity structure, with several layers of warrants, contingent shares and dual class common shares held by the banks that financed the Phoenix/Resolution merger, Liberty holders, and Phoenix/Resolution holders.  Important to note is that the Company's bank debt resides outside of the regulated group and hence is not included in IGD and Pillar 1&2 capital requirements. Summary of the initial debt and equity structure is below:

Prior to achieving a primary LSE listing, the Company needs to reduce its total dilutive shares to < 20% (LSE listing guidelines).  In a first stage, the Company initiated an exchange offer for all of the Liberty/insider warrants (exchangeable into Class B shares) and 73% of the public warrants (exchangeable for ordinary shares) for 0.181818/share in December 2009, and full take up was achieved.  As a result, the % of dilutive instruments declined from 78% to 49%

Given management's stated intention to achieve a primary listing by 1H10 (dilutive securities must be below 20% threshold), we anticipate that management will convert the earn-out shares into class B ordinary shares (cashless transaction), held in escrow and thus removed from the LSE dilutive security definition, to be released over time at the current strike prices (equal installments at €13, 14, & 15/share).  RGL has stated its desire to hold its warrants so we do not believe a further exchange; rather the warrants will remain in place with their existing strikes.  As a result, we anticipate the pre-listing share structure to be as follows:

While a number of iterations are possible to reduce the total dilutive shares, we anticipate any offer will have a high likelihood of success given the holder composition concentrated among insiders looking for an appreciation and liquidity event.  For purposes of our analysis, we will refer to two share holding structures, no conversion (share count and structure remains as is today) and conversion (assuming shares are as shown under the Share Conv column above).

Cash Flow Profile

Managed effectively, a closed-end life fund operator is a highly stable, highly efficient cash flow machine.  With a conservatively managed balance sheet and no new business generation year over year, costs are diminimus and cash flow returns to the group dependable over the life of an insurance policy.  Given limited data currently, we have forecasted a conservative cash flow profile for the Company's existing portfolio, assuming no acquisitions, limited synergies from the asset management business, and approximately 72% of the life co synergies the company has forecasted (which they believe are conservative).  Meaningful cash realization synergies exist in closed end fund consolidations, all of which are excluded from the cash flow forecast below (see Company overview for details on capital release mechanisms).

Portfolio Sensitivity

The Company also discloses its relative portfolio sensivity to various changes in annuity/lapse rates, yields, spreads, and equity and property performance.  Shown below, we've outlined the anticipated change in EV based on market performance assumptions, coupled with managements estimate of full year incremental cash flow, to arrive at an estimated EV to use as the basis of our valuation:

Scnario/Valuation Analysis

We've outlined four scenarios with two relative valuation steps to probability weight our risk/reward.  We've utilized three primary sensitivites:

• EV discount: 33% of EV (discount to current levels), 50% of EV (50% discount to peers) and 100% of EV (re-rate to historical average)
• Share Exchanges:
• o No conversion: dilutive securities remain in place precluding an LSE primary listing
• o Conversion: contingent shares are exchanged and held in escrow and remain subject to existing strikes (€13, 14, & 15) but allows listing to occur
• Market Performance:
• o Market Rolls: Risk free rate + 175bps, equity and property markets decline 10%, credit spreads widen by 175bps.
• o No Roll: Neutral impact to EV

As shown below, we assign a very low probability of the status quo valuation given the high likelihood of management executing on its restructuring.  In fact, our probability weighted price of ~€12/share is highly conservative as it assigns no value to the significant level of positive EV effects from fund consolidations, synergies and increasing dividends over time.

Downside Protection/Implied Fair Value under status quo

Afforded via dividend yield (assuming a normalized €0.80/share dividend[1] remains constant).  Note, the implied dividend yield is nearly 2x comparables - for the largest closed-end life fund in the UK.  Probability weighted price under status quo implies ~ 45% upside.  Upside achieved upon relisting and anticipated re-rate and excludes incremental capital and cost synergies. 

Comps:

Simple comp analysis highlighting discount to EV and relative dividend yields underscores the valuation discrepency (note we have not evaluated P/E relative value due to the lack of IFRS accounts until 3/31, however the analyst community estimates the discount to peers is ~ 50-75% currently....although several maintain hold/inline ratings). 

[1] Dividends are currently limited to £65m for 2010 and 2011, rising to £80m in 2012 thereafter, however once 10% of bank debt is pre-paid, dividend can increase, and we reasonably assume a 50% of free cash flow payment stream in future years.

Catalyst

• May: Resolve contingent share overhang via treasury share uptake or discounted exchange.  Final restructuring overhang removed.
• June: Launch premium listing on LSE.  Traditional UK Life investor shareholder rotation.
• Post LSE Listing: Valuation re-rate, amend and consolidate loan facilities, dividend expansion, further fund consolidation, M&A