PRUDENTIAL FINANCIAL INC quarterly report, Q2 FY2011

Prudential Financial, Inc. — Q2 2011 Form 10-Q

Reporting period: Three and six months ended June 30, 2011; balance-sheet comparisons are to December 31, 2010. Prudential provides insurance, annuity, retirement, investment management and related financial services. Its reporting separates the Financial Services Businesses from the legacy Closed Block Business. Amounts below are in U.S. dollars; financial-statement figures are generally in millions.

Key financial results and position

Metric	Q2 2011	Q2 2010	Six months 2011	Six months 2010
Total revenue	$12,247	$10,987	$22,433	$20,234
Income from continuing operations before tax and equity in joint-venture earnings	$1,172	$1,506	$1,876	$2,515
Net income attributable to Prudential Financial	$838	$1,077	$1,446	$1,774
Diluted EPS, Common Stock — continuing operations	$1.65	$1.66	$2.83	$2.81
Diluted EPS, Common Stock — net income	$1.68	$1.70	$2.89	$2.85

Revenue grew year over year, while attributable net income declined, reflecting substantially lower realized investment gains and weaker Closed Block results. Revenue also reflects the February 2011 acquisition of Japanese insurance businesses. Financial Services Businesses income from continuing operations was $844 million for Q2 and $1,444 million for the first six months, versus $810 million and $1,317 million, respectively, in 2010.

Management’s segment measure: Financial Services Businesses adjusted operating income before tax was $1,159 million in Q2 2011 versus $536 million in Q2 2010, and $2,313 million for the first six months versus $1,457 million. This is a non-GAAP segment measure, not a substitute for GAAP income.
Cash flow: For the first six months, operating cash flow was $5,174 million (2010: $2,551 million); investing activities used $6,307 million (2010: $3,958 million); financing activities provided $2,048 million (2010: used $265 million). Cash and cash equivalents increased $994 million to $13,909 million.
Balance sheet: At June 30, total assets were $613,377 million, total liabilities $577,741 million and total equity $35,636 million. At December 31, 2010, these were $539,854 million, $506,926 million and $32,928 million.
Debt and liquidity: Short- and long-term debt totaled $26,730 million, compared with $25,635 million at year-end. Parent-company cash and short-term investments were $5,276 million. The company reported $4,108 million of committed credit facilities with no outstanding borrowings under them. Consolidated cash was $13,909 million.
Investment and credit indicators: Available-for-sale fixed maturities had a fair value of $238,087 million and amortized cost of $229,152 million. Fixed-maturity other-than-temporary impairments recognized in earnings were $629 million for Q2 and $1,204 million for the first six months, partly offset by amounts transferred to other comprehensive income. Commercial mortgage and other loans were $33,528 million, net of allowances.

Material changes versus comparable periods

Consolidated Q2 revenue increased to $12,247 million from $10,987 million, but attributable net income fell to $838 million from $1,077 million. For the six months, revenue increased to $22,433 million from $20,234 million while attributable net income declined to $1,446 million from $1,774 million.
Realized investment gains were materially lower: $468 million in Q2 2011 versus $1,786 million in Q2 2010; $418 million for the first six months versus $2,175 million. The prior-year comparison included much larger derivative gains.
Closed Block income from continuing operations before tax fell to $9 million in Q2 from $404 million and to $36 million for the first six months from $663 million. Lower realized gains and increased policyholder dividend-obligation expense were key factors.
Adjusted operating income improved in Individual Annuities, Asset Management, Individual Life and International Insurance in the periods described by management; Retirement also improved. Group Insurance improved modestly for the six-month period, while Corporate and Other losses increased.
Assets and liabilities rose substantially, largely reflecting the Star and Edison acquisition and growth in investment and separate-account balances. Separate-account assets of $222,892 million were matched by equal separate-account liabilities.

Outlook, management commentary and key risks

Japan acquisition: Prudential completed the Star and Edison acquisition from AIG on February 1 for a total purchase price of $4,709 million, comprising $4,213 million cash and $496 million assumed debt. Management expected integration to be substantially completed by early 2012, subject to approvals; it forecast approximately $500 million of pre-tax integration costs over five years, including approximately $400 million in 2011–2012, and approximately $250 million of annual cost savings after integration. These are expectations, not guarantees.
Japan earthquake and tsunami: Management reported $50 million of pre-tax charges for Q2 and $69 million for the first six months, primarily estimated claims. It said it did not expect a significant impact on Japanese investment valuations or ability to operate.
Portfolio repositioning and interest rates: Prudential said it was repositioning Star and Edison assets to improve interest-rate exposure, diversify risks and reduce unhedged currency positions, with substantial completion expected by year-end 2011. Management identified low interest rates, reinvestment yields and changing rates as risks to spreads and investment results.
Other corporate actions: The Global Commodities Business sale to Jefferies closed July 1, 2011, after quarter-end, for $420 million of preliminary proceeds, with final purchase-price adjustments expected in Q3. The Board authorized up to $1.5 billion of common-stock repurchases through June 2012; no shares had been repurchased under that program at June 30.
Capital and regulation: Management reported a 23.8% capital-debt-to-total-capital ratio for the Financial Services Businesses. Prudential Financial became subject to Federal Reserve supervisory authority effective July 21, 2011 under Dodd-Frank. The company stated that domestic and international insurance capital measures exceeded applicable regulatory minimums; its reported Prudential Insurance RBC ratio was 533% at December 31, 2010.
Risks and contingencies: Disclosed risks include market and interest-rate movements, variable-annuity guarantees and hedge effectiveness, investment impairments and defaults, foreign currency exposure, reserve assumptions, ratings and access to financing, and regulatory changes. Legal and regulatory matters include retained-asset-account litigation and unclaimed-property reviews. Management said outcomes are uncertain, could materially affect results or cash flow in a particular period, but were not expected, after reserves and indemnification, to have a material adverse effect on financial position.
Unusual accounting and tax items: A $95 million first-quarter out-of-period adjustment reduced pre-tax continuing income for amortization of unrealized losses on certain Gibraltar Life securities; management said it did not affect adjusted operating income and was not material to prior periods. The filing also describes an IRS proposal of approximately $200 million in tax and penalties related to foreign tax credits, which Prudential disputes and intends to contest. Utilization of acquired Japanese deferred tax assets was estimated to result in approximately $450 million of future tax expense.

Most important facts for investors to verify

How much of reported revenue and International Insurance growth is attributable to Star and Edison, and whether integration costs and expected savings track management’s estimates.
Underlying earnings excluding realized investment gains and losses, fair-value effects, acquisition-related items and other adjustments; reconcile adjusted operating income to GAAP results.
Potential further impairments, particularly in asset-backed securities and Japanese foreign-currency-denominated securities approaching maturity, and the assumptions supporting recoverability.
Variable-annuity guarantee exposure, hedge results, reserve assumptions and sensitivity to equity markets, interest rates, policyholder behavior and Prudential’s own credit spreads.
Liquidity and capital availability at the parent and regulated subsidiaries, including dividend restrictions, debt maturities, committed facilities and the effect of any share repurchases.
Developments in legal, unclaimed-property and tax matters, including the disputed IRS adjustments and potential future tax expense from acquired deferred tax assets.