Principal Financial: Expensive Insurance Company With Limited Near-Term Upside (PFG)

Investment Thesis

Principal Financial (NASDAQ:PFG) is a diversified financial services company with a focus on retirement, asset management, and insurance services. After a strategic review to move more into higher margin and higher growth businesses, we’ve seen little improvement at the company to grow earnings in a meaningful way. While the recent quarter showed mixed results, with notable growth in the retirement solutions business but challenges in asset management and specialty benefits, management’s confidence in the international and specialty benefits sectors suggests potential future growth. The increased dividend and expanded stock buyback program underscore Principal Financial’s commitment to returning value to shareholders. But in my view, the primary concern remains the company’s valuation, with P/E and P/Book multiples I’m uncomfortable assigning to a low-growth, mostly insurance stock. As such, I rate shares of Principal Financial as a ‘hold’.

Company Overview

Principal Financial is a diversified financial services company that serves businesses, individuals, and institutional clients. The primary services it provides are retirement, asset management and insurance services.

In retirement solutions, which makes up 41% of pre-tax earnings, Principal Financial offers a wide range of products like defined contribution, defined benefit, pension risk transfer, employee stock ownership plans, and more. With relationships with 48,000 employers in the United States serving 13 million individuals, the company has leadership positions in many of the markets it serves.

In the asset management business, which accounts for 36% of pre-tax earnings, the company divides this into two subsegments. Through Principal Global Investors, it provides investment strategies and asset allocation for equity, fixed income, real estate, and other alternatives, and through Principal International it sells pension products for Latin America and Asia like mutual funds, income annuities, and other asset management services.

Finally, on the insurance side of the business, the company sells life insurance, dental insurance, disability insurance, and other specialty benefits for both individuals and small and medium-sized businesses.

Business Strategy

After a strategic review a few years ago, Principal Financial’s strategy for navigating the new business environment was to get out of fixed annuities, reducing overall exposure to the insurance business. While it did keep variable annuities, it did stop selling consumer life insurance products. In my view, this highlights that the company doesn’t see much growth in their insurance business going forward, especially after divesting several billion dollars’ worth of assets in the last two years.

With the divestment, this led the company to go out and pursue other opportunities in businesses with better margins and improving economics. Two such areas are the U.S. retirement and global asset management business.

Management views these businesses as attractive longer term because they are positioned for growth, are more capital efficient, have better margins, and have the potential to be differentiated against competitor products, enhancing the value Principal is able to provide for its customers. Being better positioned in higher-growth markets also means that principal can set itself up for cross-selling opportunities and underscore a commitment to creating long-term value for its shareholders.

Recent Results

While we should expect to see Q4 results sometime in mid-February, let’s take a look at the Q3 numbers announced in October to get a better sense of the recent financial performance.

In its most recent quarter, Principal Financial had non-GAAP operating earnings of $420 million or about $1.72 per share on a diluted basis. This represented a beat by 10 cents compared to estimates, and was supplemented by good growth in both assets under management and assets under administration of $651 billion and $1.5 trillion, respectively.

The big standout in the results, in my view, was the retirement solutions business where sales were up 30% from Q3 2022 and pre-tax operating earnings were up 48% (leading to 950 bps improvement in operating margins). The main reason for the growth was driven by fee-based transfer deposits (increased 78% from last year). This is a rather unsustainable growth rate and can be attributed to the lumpiness in sales and lapses in the large plan segment. Year over year, both sales and net revenue on a trailing twelve month basis are down 5%.

In the asset management business, year over year results for the quarter in Principal Global Investors saw pre-tax operating earnings for the quarter up 7% to $151.6 million as well as Principal International’s pre-tax operating earnings up 11% year over year to $70.8 million. That said, for trailing twelve months numbers, just like the retirement side of the business, we did see a decrease of 20 and 13%, respectively.

Lastly, in the Specialty Benefits segment, Principal Financial pre-tax operating earnings for the quarter were essentially flat, down 1%, but year over year trailing twelve months was up 23%, driven by a 9% increase in premium and fees.

Overall, I’d say this was an okay quarter for Principal Financial. At present, the company’s balance sheet is in a healthy position with a loan-to-value ratio of 47% and a debt service coverage ratio of 2.5x, thus the company has adequate solvency in my view.

For the office real estate portfolio, investors might be wondering about the outlook with respect to the current struggles in the office real estate market and the current interest rate environment. During the quarter, there was no major revisions downwards in the assessed value and the company’s commercial loan portfolio looks solid. The company does have a small loan maturing next quarter and management reiterated their confidence in the 11 maturities set to come due in 2024 (only 3 will come around in H1 of 2024).

Looking ahead, while I would have liked to see more growth in the asset management business, I suspect management is fairly confident in the future outlook in the business. On the earnings call, CFO Deanna Strable commented the following:

The other thing I would say is, we have high-growth operations in our Specialty Benefits business. We have high-growth expectations in our international business. And I come back to the fact that we have – we think we can deliver 9% to 12% EPS growth. That won’t always be at that level. There will be some years where it’s slightly lower, some years where you might benefit more from macro. But again, I come back to strong free cash flow. We are committed to being a growing company, and we are committed to returning that growth back to our shareholders. And ultimately, in pressured time because of our diversified model relative to pure asset managers, we’re actually able to have consistent dividends versus a lot of volatility. So, I like the pattern and the consistency. And as you say, over the long-term, you’re right, we should be able to increase that dividend and return to our shareholders.

What I think this highlights is the potential for the international and specialty benefits business going forward. Overall, with around 9 to 12% growth, I’d say that’s decent growth for a diversified financial services company. Moreover, with returning cash to shareholders as I’ll discuss shortly, I think this further showcases the longer term potential of Principal Financial.

Highlighting management’s confidence, following the quarterly results, the company raised its quarterly dividend to $0.67 (an increase from the $0.65 previously), implying a payout ratio of 40%. With $156 million paid out in dividends for the quarter and about $200 million returned to shareholders via stock repurchases, management has made an excellent display of returning cash back to shareholders, highlighting their confidence in the business.

Adding to this was an upwards revision in stock buybacks for the 2023 year, with management confident that they would be able to return an extra $100 million higher than previously expected. Both dividends and share repurchases are expected to total $1.3 billion for the full year, which is pretty impressive in my view considering the market capitalization is just a little over $19 billion.

Valuation and Wrap Up

With $4.73 generated nine months into 2023, the trailing P/E ratio is about 12.8x, which doesn’t exactly scream cheap for a financial services company. At 11.3x forward earnings, I’m still inclined to value this more as an insurance business rather than a higher growth asset management business given the cyclical nature of the company’s earnings and the fact that it still makes up a fairly substantial portion of the company’s revenues.

When looking at analysts estimates on the stock, based on the 10 sellside analysts with one-year target prices on Principal Financial’s stock, there are 2 sell ratings and 8 buy ratings. The average target price is $78.90, with a high estimate of $88.00 and a low estimate of $72.00. From the current price to the average target price one year out, this implies downside of 0.7% (not including the current dividend yield of 3.4%). This suggests analysts are moderately bearish on the outlook of the stock with the group target prices implying shares are likely overvalued for now.

I’d tend to agree with analysts assessments here. We can see that the Price to Book valuation has also been creeping back up close to its highs with the current multiple around 1.79x. With not much evidence of value creation just yet and the growth just not showing up in the numbers even after divestments, I’m not comfortable paying 1.79x book for the company.

In addition, investing in Principal Financial is not without its risks. While the company should generally do well if the economy does well (PFG in particular is very much tied to small businesses’ growth in the U.S. market), it is exposed to long-term interest rate risks and sharp changes could adversely impact the asset and liability duration matching on the balance sheet.

Finally, with a 3.4% dividend, I think there’s a lot better options income investors and retirees can consider rather than Principal Financial, with many other insurers yielding 4% to 5% at better valuations and similar payout ratios. If we were to hit the $60 level as the stock did back in June and October, it might be enough to get me interested. But for now, I’ll be sitting on the sidelines.