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Morningstar | Great West Hit by Higher Taxes and Outflows in 1Q; Positive Market Impact Cushioned Earnings

Great West was affected by several headwinds in the first quarter, resulting in an annualized decline in earnings of 10%. Still, apart from continued net outflows at Putnam, we don’t believe these difficulties represent long-term threats to the business. In the U.S., results were pretty good, with sequential income growth of over 15% in both individual markets and Empower Retirement. Empower benefited from a large sale in the quarter, which should provide momentum for fee income growth over the next 12-18 months. In Canada, higher net investment income was more than offset by lower fee income and higher taxes. The Europe segment also experienced a material increase in income taxes, though earnings before taxes remained the same as in the fourth quarter. The effective tax rate for Europe in the first quarter was 11% compared with a positive tax impact of 3% last quarter. We continue to expect the effective tax rate to remain somewhat unpredictable, and management didn’t provide much guidance on the call for segment-specific tax run rates.

Rising equity markets in the quarter led to a CAD 4.3 billion fair value adjustment on the income statement, the first such positive adjustment since the second quarter of last year. These income gains were offset by higher market-driven liabilities and, on balance, EBIT was up 5%. However, higher taxes and lower premium income led to overall sequential net earnings decline of about 7.5%. Even considering the challenges faced in the quarter, Great West’s annualized ROE was a healthy 13.5%, above our 11% cost of equity. Overall, earnings were generally in line with our expectations, and we’re maintaining our fair value estimate of CAD 31 per share.

Great West started off the year with a few substantial strategic and business decisions. On April 3, Great West announced a rebranding initiative to consolidate its Canadian operations under the Canada Life brand. Under this initiative, Great-West Life, London Life, and Canada Life will amalgamate into a single legal firm. This change won't affect the businesses in Europe and the U.S., and the parent company will continue to be referred to as Great West Lifeco. This initiative follows the declared sale of the insurer’s U.S. life insurance and annuity business, and a CAD 2 billion substantial issue bid for 6% of outstanding shares. This bid for shares was made at CAD 33.5, a 2.2% premium to the current share price and an 8% premium to our fair value estimate of CAD 31.

On the asset management side, continued subpar results at Putnam makes us doubt that management’s turnaround will be successful. Putnam posted a fifth straight quarter of losses, and net outflows accelerated, at nearly CAD 2.7 billion for the quarter. While we are used to seeing Putnam struggle to maintain consistent inflows, the high level of redemptions considering recent gains in the markets was surprising. Even still, quarterly losses at the unit weren’t as steep as last year’s, with a net earnings loss of CAD 4 million. On the quarterly call, management mentioned expense reduction of $12 million, and it’s clear expenses will need to be reduced even further for the business to have long-term success. We continue to believe the 2007 acquisition of Putnam has been value-destructive, at least in recent years, and we’re not overly optimistic that Putnam can return to stable profitability.

Strong results in the retirement business were a bright spot for Great West this quarter, but Empower is potentially exposed to increasing competitive risks from consolidation. Principal Financial has agreed to purchase Wells Fargo’s defined-contribution recordkeeping business for $1.2 billion as Wells continues to streamline after recent scandals. The deal, which was announced in March, would give Principal over $400 billion in DC-plan assets, on par with Empower and placing them solidly among the top five recordkeepers. Based on the latest market data available, Empower is the number-two player by number of participants and the fourth-largest recordkeeper by plan assets. Apart from this acquisition, additional consolidation is possible as recordkeepers strive to compete with Fidelity, the DC-recordkeeping behemoth.

The Central Bank of Canada kept interest rates at 1.75% after its March meeting, holding the benchmark rate stable since its increase from 1.5% in October 2018. In its policy statement, the bank advised that current economic conditions continue to justify a policy interest rate below neutral, and that the slowdown in late 2018 was sharper than anticipated. The 0.4% annualized GDP growth in Canada in the fourth quarter was the slowest level of growth since the mid-2016 recession. The International Monetary Fund is forecasting 2019 real GDP growth in Canada to reach 1.5%, lower than both the U.S. and all advanced economies, at 2.3% and 1.8% respectively. Continued sluggish growth in the Canadian economy would negatively affect Great West and could result in lower revenue and curtailed earnings growth.