PRINCIPAL FINANCIAL GROUP INC quarterly report, Q2 FY2013

Principal Financial Group, Inc. — Q2 2013 Form 10-Q

Reporting period: Three and six months ended June 30, 2013; balance-sheet comparisons are with December 31, 2012. Amounts are in U.S. dollars. Principal provides retirement and investment products, asset management, international financial services, and U.S. insurance.

Financial performance

Metric	Q2 2013	Q2 2012	First half 2013	First half 2012
Total revenue	$2,210.6 million	$2,118.6 million	$4,377.3 million	$4,214.5 million
Income before tax	$265.6 million	$229.5 million	$493.8 million	$507.5 million
Net income	$236.6 million	$178.6 million	$426.6 million	$399.9 million
Net income available to common stockholders	$222.3 million	$167.6 million	$400.6 million	$371.5 million
Diluted EPS	$0.75	$0.56	$1.35	$1.22
Operating cash flow	Not presented quarterly	Not presented quarterly	$783.6 million	$1,502.0 million

• Q2 revenue increased about 4% and common earnings about 33% year over year. First-half revenue rose about 4% and common earnings about 8%.
• Approximate pretax margin was 12.0% in Q2 2013 versus 10.8% in Q2 2012; for the first half it was 11.3% versus 12.0%. These are calculated from reported revenue and pretax income.
• Net investment income declined to $749.7 million in Q2 from $801.0 million, and to $1,539.0 million for the first half from $1,625.8 million, reflecting lower U.S. investment yields and lower inflation-based returns in Chile.
• Net realized capital losses were $80.1 million in Q2 and $131.0 million for the first half, versus a $0.2 million gain and a $6.5 million loss, respectively, in 2012. Derivative and hedge results, including guaranteed minimum withdrawal benefit exposures, were major drivers.

Financial position, liquidity, and capital

• Total assets were $196.5 billion, compared with $161.8 billion at year-end; total liabilities were $187.1 billion versus $152.1 billion. Much of the increase reflects Cuprum-related consolidation of separate-account assets and matching liabilities, including $33.2 billion each at June 30; these client-directed assets do not expose Principal to the associated investment risk.
• Stockholders’ equity was $9.4 billion, down from $9.7 billion. Other comprehensive loss was $650.3 million for the first half, driven principally by unrealized losses on available-for-sale securities and foreign-currency translation. AOCI moved from positive $640.3 million at year-end to negative $0.5 million.
• Cash and cash equivalents fell to $1.11 billion from $4.18 billion. First-half cash flows were $783.6 million provided by operations, $1.92 billion used in investing, and $1.93 billion used in financing. The Cuprum acquisition was a major investing outflow.
• Total debt was $2.75 billion versus $2.71 billion; debt-to-equity and debt-to-capitalization, excluding AOCI, were 30% and 23%, respectively, unchanged from year-end. Short-term debt rose to $175.3 million from $40.8 million; long-term debt was $2.58 billion versus $2.67 billion.
• Management reported $167.1 million of excess holding-company capital and committed short-term credit facilities totaling $1.113 billion, with $175.3 million outstanding. It stated existing liquidity sources were adequate for current needs and reasonably foreseeable contingencies.

Material changes and operating drivers

• Principal completed the acquisition of 91.55% of Chilean pension manager Cuprum on February 4 for approximately $1.3 billion. Cuprum contributed $58.4 million of Q2 revenue and $26.1 million of Q2 net income after acquisition; acquired goodwill was $633.3 million. The acquisition materially expanded Principal International.
• Segment operating earnings increased in Retirement and Investor Services ($172.3 million versus $141.7 million), Principal Global Investors ($29.0 million versus $18.2 million), and Principal International ($58.3 million versus $31.5 million) in Q2. U.S. Insurance Solutions declined to $47.2 million from $50.2 million. Corporate operating loss widened to $35.4 million from $30.7 million.
• Retirement and Investor Services benefited from stronger equity markets, business growth, and higher fees. Principal Global Investors benefited from higher average AUM and a real-estate performance fee; ending AUM was $271.2 billion. Principal International earnings benefited from Cuprum, while foreign-exchange translation reduced segment AUM. U.S. Insurance Solutions faced higher life reserves in the lower-rate environment.
• First-half operating cash flow was substantially below 2012, which management attributed mainly to timing fluctuations in receivables and payables. Operating expenses increased to $1.60 billion from $1.28 billion, including acquisition and growth costs and comparability effects from the 2012 change in individual-life DAC and actuarial-balance amortization.

Outlook, risks, and unusual items

• No formal earnings guidance was provided. Management estimated that, if market interest rates stayed at June 30 levels through June 2015, investment margins on approximately $21 billion of domestic contracts with guaranteed minimum interest rates could be reduced by about $30 million after tax in the 12 months ending June 2014 and $65 million in the 12 months ending June 2015, versus the prior 12-month period. The estimate excludes potential DAC and other actuarial-balance effects and new sales.
• A hypothetical immediate 100-basis-point rate increase implied a $1.94 billion net fair-value loss at June 30, compared with $1.77 billion at year-end. This sensitivity is not a forecast and excludes separate accounts and certain insurance liabilities.
• Principal cited sustained low rates, market and credit volatility, investment valuation and impairment judgments, policyholder guarantees, foreign-exchange movements, acquisition integration, regulatory changes, cyber and vendor risks, and litigation as risks. A 10% unfavorable currency move was estimated to reduce international operating earnings by $6.5 million for Q2 and $11.5 million for the first half. A 10% equity-market decline followed by quarterly recovery was estimated to reduce annual operating earnings by approximately 4% to 6%.
• Available-for-sale fixed maturities had $934.3 million of gross unrealized losses at June 30, up from $871.1 million at year-end; management attributed the increase mainly to higher interest rates and said it did not expect to be forced to sell the securities before cost recovery. Commercial mortgage loans on the internal problem, potential-problem, or restructured list fell to $130.5 million from $217.7 million.
• Disclosed litigation includes the Principal U.S. Property Account class-action matter and a stayed Lehman bankruptcy-related claim seeking an unspecified amount, potentially up to approximately $440 million plus interest. No loss was accrued for the matters discussed because management considered loss not probable and not reasonably estimable; it said an adverse outcome could nevertheless require unestimated payments. Separately, guarantees to third parties had a maximum exposure of about $252 million, with material payment considered remote.
• Management revised accounting for Mexico’s AFORE retirement accumulation product to treat it as a long-term service contract and revised prior-period statements; it said the revisions were not material in prior periods. The 2013 interim results are unaudited and not necessarily indicative of full-year results.
• Standard and Poor’s affirmed Principal Life’s financial strength rating and changed its outlook to stable from negative in early July. Fitch affirmed ratings but moved its outlook to negative after the Cuprum acquisition, citing pressure on cash-coverage and debt metrics and integration risk. Disclosure controls were concluded effective, with no material quarterly change in internal control over financial reporting.

Important facts for investors to verify

• How much future earnings growth is attributable to underlying business trends versus Cuprum and other acquisitions, and whether Cuprum integration and expected synergies meet management’s assumptions.
• Whether lower investment yields, unrealized securities losses, rate-sensitive guarantees, and related derivative volatility affect future margins, capital, or realized losses.
• Whether cash generation and holding-company liquidity remain adequate after the acquisition, dividends, debt activity, and any constraints on dividends from Principal Life.
• Whether mortgage-credit trends, investment impairments, litigation outcomes, and guarantee exposures change materially from management’s current estimates.
• How reported growth compares on a consistent basis, including the acquisition and the revised Mexico accounting; review the filing’s pro forma acquisition disclosure and segment reconciliations for comparability.