Doubling Down On Prudential Financial


Doubling Down On Prudential Financial

Prudential Financial (PRU) has dropped precipitously in the 4 months following my initial article on the company.

While there are risks associated with Prudential such as lower interest rates and an increased probability of a recession in the next 12 months, I find the stock price to be highly attractive for long-term investors (so much so, I put my money where my figurative keyboard is and initiated a whole share position in Prudential, with the company accounting for just under 2% of my portfolio’s value and annual dividends compared to the microscopic position it once was at less than 0.1% of my portfolio’s value and dividends).

I’ll be recapping Prudential’s dividend safety and growth profile, as well as discussing the company’s fundamentals/risks and its valuation profile.

I’ll then conclude with my parting thoughts, offering an estimation of Prudential’s annual total return potential over the next decade.

Prudential’s Dividend Is Safe And Comes With Mid-Single Digit Growth Potential

The key principles of being a dividend growth investor revolve around 1) ensuring that a dividend is safe and 2) ensuring that a dividend will outpace inflation or at the very least keep pace with inflation.

In order for us to accomplish the former, we will be examining Prudential’s adjusted after tax operating income payout ratio. While I would typically use a company’s FCF payout ratios as well, these metrics aren’t as useful for insurers such as Prudential, so we’ll stick to solely Prudential’s adjusted after tax operating income payout ratios.

In fiscal year 2018, Prudential generated adjusted after tax operating income of $11.69 a share against dividends per share of $3.60 during that time, for an adjusted after tax operating income payout ratio of 30.8%.

Given that CFO Ken Tanji didn’t want to update guidance in the most recent earnings call, we’ll look to the analyst estimates for guidance.

Yahoo Finance and Nasdaq are expecting adjusted after tax operating income of $12.11 and $12.43, respectively, for the current fiscal year against $4.00 in dividends slated to be paid this year, for a payout ratio of 32.6%, using the midpoint of $12.27 a share in adjusted after tax operating income.

The above payout ratios remain safe despite the downward projections in Prudential’s earning capacity in the near term, per Yahoo Finance.

Image Source: Simply Safe Dividends

With the above in mind, it should come as no surprise that Prudential’s dividend is also rated as safe by Simply Safe Dividends.

In fact, readers will recall from the previous article that Prudential’s dividend safety score was 61 when I initiated my coverage 4 months ago. Simply Safe Dividends recently upgraded its score of Prudential to 75.

Having established that Prudential’s dividend is safe for the foreseeable future, we’ll now transition into what I expect for Prudential’s dividend growth going forward.

Image Source: Simply Safe Dividends

While Prudential won’t be able to replicate its 5-year or 10-year DGR over the long term, I do believe that Prudential is well positioned to deliver dividend growth slightly exceeding earnings growth over the long term.

With analysts at Yahoo Finance and Nasdaq expecting 7.9% and 9.0% earnings growth, respectively, over the next 5 years, it seems reasonable to assume that the dividend will certainly be able to grow at least in the mid-single digits over the long term, and there is a strong possibility that the dividend will grow at a high-single digit clip over the next few years.

We’ll now discuss the notable developments since I last covered Prudential and why I believe Prudential’s fundamentals appear intact.

Prudential Is Equipped With A Strong Management Team To Navigate Short-Term Headwinds

Image Source: Prudential 2Q19 Earnings Call Presentation

Although Prudential’s Q2 2019 non-GAAP EPS of $3.14 missed the analyst consensus of $3.22 by $0.08, I believe Prudential is doing well from a business standpoint in an increasingly uncertain market and economy.

This still represents a 4.3% YOY growth rate compared to Q2 2018, which isn’t extremely impressive, but it’s a respectable growth rate over a decade into economic expansion.

Prudential’s record AUM and record life planner count continued to move the company’s financial results forward and in line with my expectations of mid-single digit earnings growth and book value growth.

Image Source: Prudential 2Q19 Earnings Call Presentation

Despite Prudential’s earnings miss, the company delivered a record adjusted book value per share figure of $97.15 compared to $92.60 in Q2 2018, for a respectable YOY growth rate of 4.9%.

Furthermore, Prudential’s YTD adjusted operating return on equity of 12.9% is well within the company’s near to intermediate term ROE objective of 12-14%.

As I alluded to earlier, Prudential didn’t offer any official updated guidance for this fiscal year. However, the company is expecting $3.00 in adjusted after tax operating income per share for 3Q19, so it’s quite likely the company will earn at least $12 a share and deliver mid-single digit earnings growth in the near term.

It is worth reiterating that Prudential still holds strong investment grade credit ratings of A, A3, and A- from S&P, Moody’s, and Fitch, respectively.

Image Source: Prudential Acquisition of Assurance IQ Presentation

Prudential also recently acquired Assurance IQ, a leading consumer solutions platform for health and financial wellness solutions, with the deal expected to close before the end of this fiscal year. Prudential will be acquiring Assurance IQ for $2.35 billion through a mix of cash, debt, and the issuance of stock. An additional earnout of $1.15 billion also is in place should Assurance IQ meet financial targets.

Prudential is expecting that this deal will be accretive to EPS and ROE as soon as next year by $0.10 per share, and by 2021, the deal is expected to be accretive to the tune of $0.30-0.35 a share. It’s worth mentioning that Prudential’s above estimates are based on the assumptions that there will be minimal synergies, the $500 million increase to share buyback authorizations will offset equity issued in the deal, and that the effective tax rate will be 24%.

Even more encouraging is the fact that this platform will allow Prudential to create a new and more stable earnings stream that isn’t sensitive to interest rates, credit, and equity markets.

Image Source: Prudential Acquisition of Assurance IQ Presentation

Finally, the deal will help to expand Prudential’s addressable market through winning and retaining institutional clients in the Retirement & Group Insurance segment and providing individuals with retail solutions that address their individual needs.

Given Prudential’s recent financial results were what I expected they would be (considering we have been in an expansionary economic period for over a decade) and that the company is continuing to execute upon its vision to provide financial services that cater to individual needs, I remain bullish on the company from an operating standpoint.

Risks To Consider:

While we have established that Prudential’s investment thesis remains intact, that doesn’t mean the company comes without its risks.

For an insurance company such as Prudential, interest rates are a key way that the company is able to generate its earnings.

According to PIMCO’s Tiffany Wilding, the Fed needs to respond to signs of weakness in the economy, and she believes the Fed will likely cut rates once again later this month to potentially alleviate and address the concerns of a potential recession.

This would have a detrimental impact on Prudential’s earnings capacity in the short term, which would likely weigh on the company’s stock price during that time as well.

Another concern is that these possible rate cuts may not be enough to stave off a recession, and this could also weigh on the company’s short-term financial results, sending the stock price dramatically lower. A few weeks ago, Bank of America estimated the probability of a recession in the United States within the next year to be about 33%, so it’s quite possible a recession will occur in the near future. The key questions are how severe the recession will be and how long it will endure when it potentially arrives.

For those that are kept up at night by volatile holdings that are subject to the ebbs and flows of the economy, Prudential is not an ideal holding. It’s very likely that the next recession will see Prudential get cut in half as the company’s earnings decline (potentially turning into an operating loss for a year before rebounding as was the case in the Great Recession) and investor sentiment turns irrationally pessimistic.

Fortunately, I don’t believe any long-term risks have materially changed since I last covered Prudential. For the sake of conciseness, I’ll refer interested readers to both Prudential’s most recent 10-K and my previous article on Prudential for a more complete listing of the risks associated with an investment in Prudential.

I Liked Prudential At $100, And I Love It At $80

Now that we’ve established I believe the investment thesis for Prudential is intact, I will delve into the valuation aspect of an investment in Prudential.

The first valuation metric we’ll examine to arrive at a fair value for Prudential is the 5-year average yield.

According to Simply Safe Dividends, Prudential’s current yield of 4.87% is well above its 5-year average of 3.26%.

Even assuming a reversion to 4% and a fair value of $100.00 a share, Prudential is trading at a 17.9% discount to fair value and offers 21.8% upside from the current share price of $82.12 (as of September 8, 2019).

The next valuation metric we’ll examine is the 13-year median Shiller PE ratio to assign a fair value to Prudential.

According to Gurufocus, Prudential’s current Shiller PE ratio of 9.91 is considerably lower than its 13-year median of 15.48.

Assuming a reversion to a midpoint valuation multiple of 12.7 and a fair value of $105.24 a share, Prudential is trading at a 22.0% discount to fair value and offers 28.2% upside from the current share price.

The first valuation method we’ll use to determine Prudential’s fair value is discounted cash flow or DCF.

Image Source: MoneyChimp

Using Prudential’s TTM adjusted after tax operating income of $11.73 a share and a discount rate of 10%, we arrive at a fair value of $117.30 a share.

This implies that shares of Prudential are trading at a 30.0% discount to fair value and offer 42.8% upside from the current price.

The other valuation method we’ll use to arrive at a fair value for shares of Prudential is the dividend discount model or DDM.

Image Source: Investopedia

The first input into the DDM is the expected dividend per share, which is another term for the annualized dividend per share. In the case of Prudential, that amount remains unchanged since I last analyzed the company, and is $4.00.

The next input into the DDM is the cost of capital equity, which refers to an investor’s required rate of return. In my case, I require a 10% rate of return because I believe that adequately rewards me for the effort I put into researching investments and monitoring my investments on occasion.

The final input into the DDM is the dividend growth rate, which I’ve found is the most difficult input to estimate because of the variety of factors involved in a long-term DGR.

When we consider that Prudential’s payout ratio could slightly expand and that the company is likely to deliver at least mid-single digit earnings growth in the years ahead, it seems reasonable to believe that my initial 6.25% long-term DGR remains intact.

This indicates that Prudential is fairly valued at $106.67 a share, which means shares are trading at a 23.0% discount to fair value and offers 29.9% upside from the current price.

When we average the 4 fair values together, we arrive at a fair value of $107.30 a share. This implies that shares of Prudential are trading at a 23.5% discount to fair value and offer 30.7% upside from the current price.

Summary: Short-Term Pain Will Lead To Outsized Long-Term Gain

Prudential is a Dividend Contender, and there is no reason to believe that, over the long term, Prudential will be unable to continue its streak of increasing its dividend.

While the risk of a recession in the next 12 months is absolutely higher than it was 6 or 12 months ago and interest rates are likely to be cut once again in the near future, these events are short-term headwinds to Prudential as the company continues to progress toward the achievement of its strategic goals.

I believe this short-term pain and volatility offers long-term dividend growth investors a fantastic opportunity to initiate a position in Prudential, and investors with existing positions in Prudential should at least consider adding a bit to Prudential here if their position isn’t already full.

Between Prudential’s 4.9% yield, likely annual 5-6% earnings growth, and 2.7% valuation multiple expansion, Prudential is likely to deliver annual total returns of 12.6-13.6% over the next decade.

Disclosure: I am/we are long PRU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.