Can Manulife get the money back?

[biaggio]

http://www.theglobeandmail.com/globe-investor/investment-ideas/streetwise/can-manulife-get-the-money-back/article1663107/

 

I am just starting to do some research on MFC.

 

Any comments +opinion appreciated.

[Smazz]

Chief executive Donald Guloien called the results dissappointing.

approx 10% Ent Value gone  and thats how bad he feels? Damn, someone sleeps too well at night.

 

I do not own. Prob will have alot of time to do research on this one before it goes anywhere fast!

[Uccmal]

I have a tiny position in this now and getting smaller all the time.  I am disappointed with management who are disappointed with their earnings.  Alot of this is mark to market losses which could have been avoided had they put in more hedges this past spring.  They appear to be floundering in the dark right now.

 

All things being said though they still have an incredible franchise.

[bonechip1]

If you are starting your research on Manulife, Rod McQueen's book "Manulife: How Dominic D’Alessandro Built a Global Giant and Fought to Save It"  is pretty good at bringing the reader up to speed on the history/culture of the company up to 2008, and is a fairly quick read.  Also McQueen's blog postings prior to the start of the promotion of his new book on RIM (starting around January of this year) are worthwhile reading (although they don't contain much quantitative analysis) at http://www.rodmcqueen.com/

 

MFC does seem cheap on a P/B measure, but I don't own Manulife - the worst case scenario is too tough to gauge - as unlikely as it may be, I don't know how much the balance sheet could handle another 40 or 50% equity market slide due to remaining exposure on the variable annuity/seg fund side.  Also, OSFI could change the rules at the most inopportune time and require MFC to do an extremely dilutive financing to shore up the balance sheet.  There are easier pitches to hit. 

[biaggio]

Is there a price where it may be worth buying?

 

You have to wonder what the management has been thinking. They seem to be doing the opposite of FFH, where the FFH boys are thinking about all the possible scenerios + risks and hedging appropriately.

 

Could this be the start of MFC's so called "7 lean years" like what FFH had? With a buying opportunity at a lower price.

 

So far what I have learned is:

 

-excellent franchise

-all their businesses are doing well, except for the mark to market accounting charges due to their sub-optimally hedged exposure(51% hedged now up from 26 %) to markets+ interest rates.

 

Am I right to assume that if interest + equity markets remain unchanged then no further charges will need to be made + you'll have a company earning $5 billion  pretax (assume they will have same profitability before current mess).

 

According to co. "net income sensitivity to a ten per cent market decline was $1.1 billion" & sensitivity to a one per cent decrease in government, swap

and corporate bond rates across all maturities with no change in spreads has increased to $2.7

billion as at June 30, 2010"

 

They currently have $18 billion in equity ($27 billion stated equity less goodwill + intangibles)

 

if:

i. scenerio 1 50% decrease in markets + 1% decrease in interest rates:

5 x $1.1 billion/10% decrease=will cost MFC $5.5 billion

                 +1% decrease in interest rates=$2.7 billion

 

                                                             $8.2 billion loss of equity

=leaving $9.8 billion  or  $5.50/share in shareholder equity

 

 

90% decrease like in Great Depression=$9.9 billion cost to balance sheet

+ 1% decrease in int rate=$2.7 billion

=$11.6 billion cost to MFC

 

=leaving $6.4 billion or  BV   $3.63/share

 

If they lose 30% of equity they'll need to raise money to keep their mandatory capital above 150 (MLI MCCSR of 221 per cent at June 30)

 

Bottom line: at $14 probably not a good place to be if you think we re in for lower interest rates + lower markets...but maybe at some point at <$6-8 it may be worth looking at???  if markets + interest rates increase they'll be able to hedge more, reduce risk, will be worth more.

 

above may be an oversimplification from an amateur

 

 

 

 

 

[alertmeipp]

i think u ought to look into embedded value for insurance companies as well - especially for companies like MFC.

 

[biaggio]

Thanks Alertmeip

 

"The Embedded Value (EV) of a life insurance company is the present value of future profits plus adjusted net asset value. It is a construct from the field of actuarial science which allows insurance companies to be valued."

 

Would one then add the present value of future profits to the equity values I calculated above for the various scenerios?

 

MFC was earning ~$5B pretax before...it does not seem right that you would add a multiple of this to valuation based on book value, as doesn t the insurance company need that book value to generate the pretax profit....i.e, would that be double counting

 

If true could you add say a multiple of 7 (x $5 billion=$35 billion= $20/share for future profits) to the above scenerio?  

 

Would embedded value be the same(close to ) as IV for investment purposes?  EV-~$23-26 ($20 for PV of future profits + net asset value)per share if market tanks?? This seems too good to be true (and probably is)

[Uccmal]

FFH got rid of its life division a few years ago.  I am beginning to understand why.  I am not sure on this but Berkshire doesn't have any significant life exposure either.  That got me to thinking about how one values an MFC.  

 

FBK has a few moving parts:  pulp chip input, currency exp., output price, power and labour cost.

 

KO has similar moving parts as FBK - more elaboarate with more middle men

 

HD is also similar:  buy products, move them around, and resell them.  Credit division for extra punch; same with WMT

 

JNJ moves up the complexity chain with the drug divisions and the R&D but it is still relatively simple; as is KFT.  

 

Then we have BRK, FFH, and MKL - the P&C business is fairly straight forward but involves some convolusions such as re-insurance; IBNR claims etc.

 

Somewhere above these in complexity lies MFC, and SLF.  The straight up life biz is the same as the P&C biz with longer tails and less precise actuarial assumptions.  The mutual fund and wealth divisions are also fairly clean.  The health divisions are also fairly easy and have a quick turnaround.  The complexity with MFC arises in the black box section which is dependent on stock and interest rate levels.  It is completely incomprehensible and you are totally reliant on management.  And not only does present management appear to be somewhat not up to the task but past management now appears not to have understood what they were doing.  And if D'Allessandro didn't know what was going on after a lifetime in the biz what chance do I have?

 

 

I am moving this to the too hard pile....

[biaggio]

 It is completely incomprehensible and you are totally reliant on management.  And not only does present management appear to be somewhat not up to the task but past management now appears not to have understood what they were doing.  And if D'Allessandro didn't know what was going on after a lifetime in the biz what chance do I have?

 

 

I am moving this to the too hard pile....

 

Thanks Uccmal, I have always appreciated your various insights.

 

Don't a lot of companies have black boxes. We just don t realize it. Are these not the so called black swans.

 

I have not followed MFC to any extent in the past.

 

It seems that MFC management got overconfident. This has to be humbling for them. The new CEO has been on the job for only the last year but I have to believe he was very involved with the current unhedged positions.

 

What is the old saying about a bad business + a good manager? Is this the reverse, a good business + bad management? Reminds me of the saying that a good business is one that any idiot can run, because eventually...well you know the rest.

 

Does anyone feel that this experience will have a positive effect on management?

 

Is this an honest + able management? Are they unlikely to repeat the mistakes of the past? If price gets low enough would be people be willing to buy with current management? Is there any hope for these guys?

 

Does anyone know how much skin current CEO has in company?

[beerbaron]

In the Q2 conference Call Donald Guloien says that under Canadian GAAP they had a 2.4B$ loss but if they reported in US GAAP they would show a small profit. Also he stated that in Canadian GAAP their shareholder equity is 7B$ smaller then US GAAP.

 

Can anybody explain what accounting differences are in play here?

 

BeerBaron

[twacowfca]

In the Q2 conference Call Donald Guloien says that under Canadian GAAP they had a 2.4B$ loss but if they reported in US GAAP they would show a small profit. Also he stated that in Canadian GAAP their shareholder equity is 7B$ smaller then US GAAP.

 

Can anybody explain what accounting differences are in play here?

 

BeerBaron

 

 

I'm no expert, but it could be MTM difference.

[alertmeipp]

Yes, it is.

Canadian rules need them to take projected potential loss in the current Q.

US rules allow companies to take realize those potential loss later on.

[Uccmal]

I suppose discussing the merits of the various accounting systems still leaves one problem.  The losses whether realized or not are real in terms of maintaining their capital ratios.  The 2/3 decline in their currency presents another problem.  This comes on the heels of the CEO bragging that they would have a fortress of capital when they cut the dividend last year  The constant renewal of capital via preferreds and bond issues becomes more problematic as the company loses value.  Kind of a modified death spiral.  Believe me I am not happy about this.  I have some MFC shares bought at a higher price, in a tax sheltered account, meaning no tax loss if I sell.

 

That is what you get for nor understanding exactly how a company makes its money. 

[oec2000]

Interesting comments, biaggio and uccmal. Allow me to add my own.

 

FFH - don't think they avoid the life business because it is too complicated. Those guys are so smart they could turn the complexity into a competitive advantage. Prem has said that the problem with the business is that it is subject to a "run on the bank." Any event that triggers mass policy surrenders can kill the company. I don't know what WEB has said about lifecos but would be interested to know if his view coincides with Prem's.

 

Also, while the business may appear complicated to outsiders, this is because of reporting rather than underlying complexity of the business. After all, it's just a matter of understanding probabilities and pricing adequately - not so different from P&C. If anything, life insurance is easier in that the contingencies are in most cases binary (dead or alive :)) and the claims amount is fixed and finite. So, I don't think that the people running the businesses have problems with complexity. Besides, you have to be pretty smart to become an actuary!

 

MFC management - obviously, this is a subjective judgement but my view is that Dominic D'Alessandro and Don Guloien are neither fools nor integrity-challenged. (Rod McQueen's biography of D'Alessandro is a worthwhile read; and both Dominic and Don are quite impressive in all the interviews I've seen.) Under Dominic's long watch, he earned the reputation of being a good capital allocator as a strategic investor in the financial sector - no dumb or overpriced acquisitions).

 

Embedded value - is akin to intrinsic value with a difference. EV does not take into consideration the value/cashflows from potential future new business. So, it is a more conservative measure than IV provided the assumptions they make in calculating EV are reasonable. EV is a good starting point for valuing lifecos - you can then make your own adjustments for losses from equity movements, more conservative actuarial assumptions, etc.

 

Problems with MFC - there are a few:

 

Lifecos are in general more leveraged than P&C cos. Maybe, 10x vs 4x assets: equity. Also, their liabilities are much longer duration and therefore more sensitive to interest rate fluctuations.

 

MFC has two key risks that are non-diversifiable (but hedgeable): Major equity risk (from their variable annuity business), and interest rate risk (long duration liabilities). In theory the interest rate risk should be hedged through asset-liability matching - if you hold assets of similar duration to liabilities, interest rate movements should have offsetting impacts on the balance sheet. I'm not sure why MFC was not hedged this way. On the equity risk, I've also not been able to understand why they never hedged it out. I think D'Alessandro may have given a vague explanation that they were in the process of looking into this when the markets went south and then it was too late - I thought this was a pretty lame excuse which showed that they launched the product before they were ready with their hedge tools. It also seemed like they were reluctant to incur the hedging cost - again, it is difficult to tell whether this was the products were priced too aggressively or whether they were just being greedy.

 

They have some of the "institutional imperative" type of thinking that WEB criticises. It is apparent in their focus on market share, pandering to Bay/Wall St, and the committee style of risk mgmt and exec compensation that produces important sounding statements more than practical solutions/results.

 

Purely conjecture on my part, but I think that some of the problems were caused by Dominic D'Alessandro's planned retirement which unfortunately coincided with with the financial crisis. Seemed to me that there was a bit of GE/Jack Welch thing with him wanting to leave on a high note - may have been the motivation to delay the hedging program to sustain profit growth in the short term. Welch was lucky with his timing and left Immelt holding the can. D'Alessandro was less lucky and took a big hit in the value of his holdings in MFC ($100m+?).

 

Conclusion: I have mixed feelings. MFC has a strong franchise both in N America and in Asia. On the other hand, a great franchise is no use if you use it to chase market share with unprofitable/risky products. I get the sense if they survive this debacle (I think they will) that mgmt will have learned its lesson (sort of like FFH did).

 

There is a an opportunity for Don Guloien to make drastic changes to cut away from the old culture of going for market share. There could be a great buying opportunity at some point - I think we are not quite there yet.

 

 

[SharperDingaan]

Only because we’re waiting for a suitable entry point.

 

MFC’s basic business is relatively straight-forward & reasonably well run. The problem is the MTM accounting impact on the ALM of their seg fund liabilities, & the fact that they took on a material quantity of new seg fund liabilities near the top of the market. Unrealized gains/losses on the guarantees are immediate P&L hits, but realized gains/losses on the liabilities are actuarial gains - amortizing forward & over the remaining life of the actuarial liability.  Yes it sucks today, but it will be very useful tomorrow.

 

Should the market suffer a 10% drop, there will be another big hit to P&L. At a 15% drop, it is highly likely that equity dilution & a total dividend cut also come into the picture. While hedging will reduce the impact, & there is very little ‘real’ possibility of insolvency – if there is a 10-15% drop, Mr Market is unlikely to perceive it that way.

 

Obviously there are positives as well, but we’ll decline to comment until we have our position.

 

SD

 

[Uccmal]

Should the market suffer a 10% drop, there will be another big hit to P&L. At a 15% drop, it is highly likely that equity dilution & a total dividend cut also come into the picture. While hedging will reduce the impact, & there is very little ‘real’ possibility of insolvency – if there is a 10-15% drop, Mr Market is unlikely to perceive it that way.

 

Thanks for the great posts OEC and Sharper.  OEC, I think you are correct in the assertion about Mr. D'Allesandro wanting to exit of a high note.  The comparison to Welch is apt. 

 

At this point the company may well eliminate the dividend, and raise capital at pricey rates.  They are probably in a relatively good position to raise capital due to high institutional ownership.  The big pensions in Canada wont have a choice.  MFCs position is probably no where near where FFH was at in 2003/04/05.  Manulife's core business is undamaged as noted unlike FFH whose core business was severely damaged in those years. 

 

I figure there will be some time to get to further know the company before committing any money, as it continues its modified death spiral down to below its 1999 IPO price.  What MR. Guloien will take away is the need for this business to have stability.

[oec2000]

Only because we’re waiting for a suitable entry point.

 

MFC’s basic business is relatively straight-forward & reasonably well run. The problem is the MTM accounting impact on the ALM of their seg fund liabilities, & the fact that they took on a material quantity of new seg fund liabilities near the top of the market. Unrealized gains/losses on the guarantees are immediate P&L hits, but realized gains/losses on the liabilities are actuarial gains - amortizing forward & over the remaining life of the actuarial liability.  Yes it sucks today, but it will be very useful tomorrow.

 

Should the market suffer a 10% drop, there will be another big hit to P&L. At a 15% drop, it is highly likely that equity dilution & a total dividend cut also come into the picture. While hedging will reduce the impact, & there is very little ‘real’ possibility of insolvency – if there is a 10-15% drop, Mr Market is unlikely to perceive it that way.

 

Obviously there are positives as well, but we’ll decline to comment until we have our position.

 

SD

 

 

One point I forgot to mention in my earlier post. I get the impression that some of MFC's variable annuity products have minimum withdrawal guarantees which means that their potential liability increases every quarter even if equity markets stay flat. (Maybe I need to take English lessons to understand their reports.) Does anyone know whether I'm reading this correctly?

[biaggio]

http://www.canadianinsider.com/coReport/allTransactions.php?ticker=MFC

 

-tiny amount of recent insider buying. $36,000 by a director

[Uccmal]

oec, I dont think you need English lessons.  :-).  More like MFC needs to simplify the business. 

 

I believe you are correct but will not commit.  Because these entities have a certain guaranteed rate of return per period the longer the equity markets stay flat the more they need to make up in the future as the liability adds up. 

 

I read through the most recent Q and was left with the thought that there are many much more simpler businesses trading at similar discounts.  If MFCs fortunes are tied to the equity markets then it is much simpler to just buy the S&P500. 

 

The company appears to have locked themselves into a box.  If markets dont go up they continue to hemmorage more and more each Q.  If they hedge at these prices they lock in a huge loss.  When the markets go up they wont gain back what they have lost due to the drag.  The same issue is facing them on the fixed income side.

 

I am sure there is a price to buy the stock at but am not sure I can place it.  They certainly have no trouble rasing cheap cash.  I just think it may be a real long wait to see them recover to their former bluster.  They can grow their way out but it will take years.

 

Investing truly is a long term learning process. 

[oec2000]

http://www.canadianinsider.com/coReport/allTransactions.php?ticker=MFC

 

-tiny amount of recent insider buying. $36,000 by a director

 

Problem is it is difficult to have a great deal of confidence in the ability of their directors to evaluate risk in MFC's business. Anyone who was rushing in to sell (or give away, who knows?) equity guarantees after an extended liquidity driven bull run (in 2005-7) without hedging or understanding the potential impact of a margin call on their balance sheet either does not understand risk or was ignoring it. I think senior mgmt was ignoring it and directors did not understand it.

 

Read the sections on risk mgmt in their AR and see if you come to the same conclusion as I did. Heavy on words but light on substance! Then, compare that with WEB's remarks on risk, especially his comments on the equity puts BRK sold. BRK and MFC took on similar equity risks - unfortunately, their understanding was far from similar!

[biaggio]

Thanks oec2000

Appreciate your comments.

"Read the sections on risk mgmt in their AR and see if you come to the same conclusion as I did. Heavy on words but light on substance! Then, compare that with WEB's remarks on risk, especially his comments on the equity puts BRK sold. BRK and MFC took on similar equity risks - unfortunately, their understanding was far from similar!"

 

I think actions speak louder than words(I skimmed thru the AR section on risk management-they say all the right things). I suspect they were probably not thinking along the same lines. Probably not fair to compare WEB to MFC management. But is it possible that they were thinking along the same lines? Did the just take too much risk relative to their balance sheet? Something happened while they were trying to hedge?

 

The risks do appear similar. If I recall, BRK's price  got hammered as a result during the market cash as well. (It was a good thing, it allowed me to buy in at a great price. I am wondering if I am seeing the same patter here?)

 

If price gets low enough I am thinking that it would compensate the uncertainty of these un-hedged positions, especially IF  one thinks that you have honest and able management.

 

I have no position.

 

 

 

[Estimated Profit]

*i haven't read the co.s annual report so this is all tongue in cheek*  :P

 

Looking at their Canadian segregated fund business.

 

1. The MER's for their seg funds are approx 50% higher than MERs on comparable mutual funds. (approx 1.2% higher)

2. Presuming they get a discount on volume on the average MER from the fund companies they use they probably make 1.5% more on the seg funds than they would on a comparable mutual fund sale.

3. MOST seg funds have guarantees that aren't paid out until

          a. death

          b. 10 years after the last reset

          c. Many, though not all have maturitiy guarantees that range from 75% - 100%

4. They have, in the prospectus for their seg funds, a clause that allows them to raise the cost of insurance for their product. CI used this on their Sunwise Elite platform last year, earning them additional sums on all existing policies.

 

Now if we presume that the vast majority of these funds will not pay out for 10 years then the chance that the company will be underwater when the funds mature is very low. Also, they will have enjoyed 10 years of revenue at 1.5% more than they would have realised on similar mutual funds.  These contracts hedge themselves to the tune of approx 15% over the years and have the opportunity to maintain these ratios by increasing the fees on existing policy holders.  If we use the last ten years as a guide, the incredibly huge fall from the 2000 bubble's popping, they are making money on all of those contracts. Similarly, most of the contracts that they entered into in 2008 won't mature for the mostpart until 2018. I think there is a pretty good chance that the market will be at least flat by then.

 

In other words, there is a great chance that the majority of these contracts will all end up being profitable, no matter how much is marked to market in the interim.  The company has already hedged them through the additional fees and if it comes down to the company needing to issue more equity to hedge these shadow losses, there should be no problem doing so. I hope for existing shareholders that it doesn't come to this, but it may given that the mark to market is crippling the company.

 

At any rate, I'm going to open up the annual reports and analysts reports to find out if my presumptions are all garbage or if there is a remarkable hidden asset here.

[biaggio]

"Sales pros are bullish on Manulife"

http://www.theglobeandmail.com/globe-investor/investment-ideas/streetwise/sales-pros-are-bullish-on-manulife/article1690245/

 

-not a good sign for price of stock if there has been strong recommendations, yet price lags (for good reason)

-technically might be ready for a bounce