Shares of Principal Financial Group (NASDAQ:PFG) are near a 52-week, though their 16% gain has lagged the S&P 500, as its asset management business has faced net outflows. I last wrote about Principal in October, when I rated shares a “hold,” since then, they have returned about 26%, nearly identical to the S&P 500. That is consistent with my view that shares should “perform broadly in-line with the market.” Still, with more recent financials, still elevated interest rates, and a meaningfully higher share price, it is an appropriate time to revisit the stock. After this move, I would take profits more aggressively.
In the company’s fourth quarter reported on February 12th, Principal earned $1.81 in adjusted EPS, which beat consensus by $0.12. For the full year, adjusted earnings were $6.92, up 6% from 2022. Within this report, there were both positives, as the company’s capital position improved, as well as concerning points that I will be watching for when PFG holds its conference call to discuss Q1 earnings on April 26th.
Looking across units, PFG had a variety of performances. On the strong side, retirement and income solutions earnings rose by 50% un Q4 to $280 million before taxes aided by strong net investment income, with sales also up 9%, thanks to $2.9 billion in pension risk transfer (PRT) activity. Its operating margin expanded from 33% to 38%. This unit is a beneficiary of elevated interest rates, as it is earning wider investment spreads on its product offerings as consumers seek to lock in yields. I also view its PRT business as attractive.
Management expects strong ongoing pension risk transfer activity, of about $2.5 to $3 billion. Given the rise in rates and strong equity market performance, many corporate pensions are fully funded, making it easier for corporations to sell this risk off to insurers who then seek to earn a profit by generating more income on the assets. The PRT business also offers a natural hedge to PFG’s life insurance business. In life insurance, you want policyholders to live as long as possible, to delay payments. In pensions, the sooner the pensioner passes away, the fewer payments you make. By adding PRT to its life insurance business, PFG essentially reduces its mortality exposure, which should reduce the volatility of earnings.
Elsewhere, its specialty unit saw an 8% growth in earnings to $121 million as sales growth offset slightly higher losses of 61% from 59.5%, still a solid level. I would expect a higher loss ratio in H1, given the seasonality of dental activity, but underwriting economics here are favorable. Its international business saw pre-tax earnings rise 20% to $75 million as revenue rose 14%. AUM was up 15% to $180 billion, given strong flows in Latin America. Asia is likely to be an increasing headwind in 2024 given moderating economic activity and PFG’s decision to pull out of more complex products, like guaranteed retirement policies in Hong Kong.
The area of concern for me is its asset manager. Principal Global Investors (PGI) saw pre-tax earnings fall 8% to $127 million as operating revenue fell by $6 million to $374 million. Performance fees have been falling, and these are relatively high margin, which drove the steeper drop in earnings. Revenue fell 6% for the year, worse than the 1-5% expected decline. PGI manages $500 billion from $465 billion last year, up 7%. With AUM growing to see revenue fall is a disappointment, and pressures on fees as well as a less favorable performance environment have been headwinds.
As you can see below, its investment results have been mediocre. Essentially, its core equity and fixed income strategies are median to slightly-above median over the past 1 and 3 years, a significant step-down from their 5 and 10 year track records. Now, these are not catastrophic results by any mean, and solid long-term performance should help to keep existing investors. Given the competitive nature of asset management, particularly with low-cost passive options gaining popularity every year, this more mediocre set of results could reduce new asset flows and make it more difficult to grow the business.
This led to negative fund flows over the year, and it was only stronger markets that drove AUM higher. Now, buoyant equity markets are likely to continue to be a tailwind, especially in H1, but flows are likely to be a negative. I also expect the real estate sector to be a headwind, and that will lead to ongoing weakness in lucrative performance fees in all likelihood, particularly with rates remaining so high. Management expects PGI revenue growth to be in the low-end of its 4-7% range, but even 4% strikes me as a reach, given the headwinds in real estate where valuations remain depressed.
We have all seen countless headlines about problems in commercial real estate, but PFG itself has several interest data points from its own balance sheet. PFG has a $76 billion investment portfolio, with about one-third in corporate bonds. However, 18% sits in commercial mortgages. Less than 3% of commercial mortgages are below investment grade, though the 14% rated BBB- to BBB+ could see some losses. Only 3.4% of the portfolio has a loan to value above 80%; 49% have loan to value below 50%. Due to this, it should have minimal losses. I do remain focused on the 2.6% that have debt service coverage ratios below 1.0x. Specifically, its office portfolio is $3 billion, and it has 89% current occupancy. PFG’s own valuation is 28% below peak levels, and as a result, 9.9% of these loans have an above 80% loan to value ratio.
Now, this is a fairly conservatively underwritten portfolio, and while there may be some losses, they are likely to be fairly low and spread out across several years. I will be watching the $440 million in remaining 2024 office maturities, with about $350 million coming in H2. Any issues with these could pose a risk to earnings, but defaults are not my base case. The 28% drop in valuation is notable. With interest rates staying higher for longer, valuations are likely to stay depressed. The bigger headwind for PFG is not on its own balance sheet, but that revenue, particularly performance fees, on its real estate funds in PGI is likely to be muted in 2024 and perhaps longer, given weak valuations. This poses a downside risk to earnings in my view.
Overall, PFG has a solid balance sheet, which enables capital returns, a core driver of any bullish argument for the stock. The company carries $1.7 billion of excess capital, which includes $935 million of holdco liquidity as well as $375 million of capital in excess of a 400% risk-based capital ratio (RBC). 400% is a key demarcation line for an insurer that points to a healthy capital position. PFG has a 427% risk based capital ratio. It built $200 million of Q4 capital by closing its Hong Kong guaranteed retirement product and opening a Bermuda reinsurer affiliate. Buoyant financial markets should support RBC in Q1, offset by ongoing sales growth, and I would expect RBC to be between 420-435% in Q1.
Given this capital position, PFG seeks to return free cash flow to shareholders. In 2023, it returned $1.3 billion to shareholders, and its share count is down about 3.2% from last year. It expects to return $1.5-$1.8 billion in 2024. It has authorized $1.5 billion for share repurchases, and alongside results, PFG also raised its dividend by 3% to $0.69, and shares currently offer a 3.1% yield. Given its dividend cost, that implies about $1 billion in repurchases in 2024. At its current share price, this would be an about an 8% capital return yield, and this will likely slightly erode its excess capital position.
In 2024, PFG expects operating EPS to rise 9-12%, which was below the 17% analyst consensus at the time guidance was given. Now, while PFG has units that benefit from higher rates, a positive for most insurers, this is being offset in my view by the pressure on its asset manager, in part because higher rates weigh on fixed income AUM and performance fees in real estate. This means PFG’s earnings growth is unlikely to be as impressive as insurers with purer rate exposure. On top of this, its Asian exposure is likely to be a headwind given its exit from its business line.
Now, over time, PFG targets 75-85% free cash flow conversion over the long term and a 14-16% adjusted return on equity. PFG has an adjusted book value excluding AOCI of $53.87. Shares are now 1.57x book value. Given its long-term 15% ROE target, this implies a return on share price of about 9.6%. At about 80% free cash flow conversion, that is a 7.7% return of capital payout over time.
Given the structural pressures facing active management as well as real estate valuations, PFG has unique headwinds that mean it may not benefit as much from higher rates as companies like Chubb (CB) or Corebridge (CRBG), and with a longer-term capital return yield of 7.7%, I believe shares are reached a full valuation, assuming a required rate of return of 8-10%, to match or exceed market returns. Now, barring a significant further shock in real estate or more severe drop in its investment results, I do not see shares having significant downside.
However, whereas I previously rated PFG a hold on the view it could be a market performer, I believe valuation has reached a point where it will struggle to match market performance to the upside, and shares are likely near a peak at $85. Given there are other insurers I believe have upside, I would be a seller of PFG to rotate into names with more upside.
I do not see PFG as a “short,” given it is not particularly over-valued, just fully valued. As such, I can see shares falling between the “sell” and “hold” ratings. While receptive to the hold argument, I rate PFG a sell, given it is less favorably impacted by higher rates, will likely struggle to keep pace with market rallies, and has a high opportunity cost given more attractive insurance stocks. As such, I recommend after the recent rally, investors sell PFG and rotate into stocks with more upside.