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Morningstar | Fiscal-Year 2018: Typically Robust Results From Prudential plc

Prudential plc reported operating profit of GBP 4.8 billion for full-year 2018. This is slightly ahead of our expectations. Preparation for the demerger looks to be progressing quite well with the M&G Prudential part of the business reporting a 20% rise in operating profit. The full-year dividend has been declared at GBP 49.35, and this gives the business a 3.2% dividend yield. On the back of GBP 156.6 IFRS earnings per share, this is a 30% payout ratio. We are holding our fair value estimate at GBP 16.9 per share until the business published full earnings and balance sheet data at which time we can roll our financial model. We maintain our no-moat rating.

What we are seeing at Group level is a small compression in the investment margin that we would expect to see given the compression in yields. This has contributed to a small reduction of nearly GBP 200 million in spread income. Account balances for investment margin business have dropped by GBP 3.0 billion with GBP 1.3 billion of that coming out of the U.S.

Going forward, we expect to see some continued compression in spread income as yields on 10-year U.S. Treasuries had a decent run in 2018, peaking over 300 basis points but have given up most of these gains at the end of the year and are now standing at 264 basis points. This is lower than where the yield lay over most of the prior year and so we think there could easily be continued outflows from traditional fixed rate business as well as margin compression.

We think outflows for traditional business are probably driven by a combination of political uncertainty joined with the forecast for interest rates. But margins are more likely driven purely by rates. We think there is a decent chance that margin on average liabilities will drop to around 100 basis points across the Group as we see average yield compression considering that even if we do get a quarter point rate rise it probably will not come until near the end of this year.

Net flows in the United States also look depressed and although this will be across traditional fixed rate business as well as fee income and insurance, we anticipate withdrawals of investment margin business will remain. And more broadly, that premiums will stay low, having dropped from GBP 15 billion 2017 to GBP 14 billion 2018, compounded by elevated outflows that have risen from GBP 10 billion to GBP 12 billion. We do think these outflows may normalise a bit, maybe dropping back to 2017 levels if the political volatility of this year is a little more normal compared with the last. There should not be much more movement in maturities and deaths of GBP 2.0 billion across the U.S. business. There is a trend in increasing longevity that should apply downward pressure to this. Though this trend is slowing.

The Group fee income margin has remained stable at around 155 basis points despite the compression in equity markets we witnessed in the fourth quarter. This line item delivers GBP 2.7 billion of operating income across the Group. And there has actually been a GBP 10 billion rise in average fee income liabilities across the Group to GBP 175 billion and this initially seems decent considering the stock market volatility of the prior year. However, market downturn really came in the last quarter, and as this line of operating profit is largely driven by the United States as well as the nature of the variable annuity market and Jackson's riders, we think this business behaves similarly to the with-profits that Prudential still writes in Asia and the United Kingdom. So when market volatility or uncertainty picks up, the smoothing effect that you have in with-profits business is simulated by guarantees and so is sought after as a safe haven versus direct market investments, though still not as secure as traditional guarantees.

Considering the S&P 500 was the best performing between the three including FTSE 100 (12%) and the MSCI Asia ex Japan (18%), at 6% over the year, this leaves a robust set of inflows probably accounting for a significant portion of the Prudential Group, across lines, GBP 41 billion. We think net flows will probably come in at around 300 basis points of average liability and this will be further by long-term average equity market rate of return of 5.0%. With more stable markets we think the Group margin on fee business should rise by 5 basis points to 160.

The with-profits business remains a small contributor, and we don't think there is much to write about. Margins of 27 basis points look stable.

Insurance margin continues to be the second dominant force for Prudential’s operating profit, coming in this year at around GBP 2.5 billion. While this life and health protection business line is insensitive to equity and credit markets in terms of profitability, we think volume is linked, based on the embedded nature of the product, with the above long-term savings vehicles. As we have written above, at the moment, we anticipate insurance margin operating profit will continue to improve but at a slowing rate.

Net flows for policyholder assets in Asia have held up well at GBP 5.2 billion versus GBP 4.6 billion a year prior. We think this is pretty decent considering the overall concern for the business around the slowdown in Asia and the impact this has had on valuation.