PRUDENTIAL FINANCIAL INC quarterly report, Q3 FY2009

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Business context and reporting period

Prudential Financial, Inc. filed this unaudited Form 10-Q for the quarter and nine months ended September 30, 2009. It provides insurance, annuity, retirement, investment-management and related services. Results are reported across the Financial Services Businesses and the separately managed Closed Block Business. Unless stated otherwise, amounts below are in U.S. dollars.

Financial results and key metrics

  • Revenue: Third-quarter revenue was $8.564 billion, up from $7.030 billion in 2008. Nine-month revenue was $24.029 billion, versus $22.291 billion.
  • Profit: Net income attributable to Prudential was $1.082 billion for the quarter, compared with a $176 million loss; nine-month net income was $1.259 billion, versus $465 million. Continuing-operations pretax income before joint-venture earnings was $852 million for the quarter and $856 million for nine months, compared with a $196 million loss and $494 million of income, respectively, in 2008. Diluted Common Stock EPS was $2.35 for the quarter and $3.72 for nine months, versus losses of $0.25 and earnings of $1.26.
  • Segment operating measure: Financial Services Businesses adjusted operating income before tax was $933 million for the quarter, up from $616 million, and $2.636 billion for nine months, slightly below $2.674 billion. This is a non-GAAP measure and is not directly comparable to consolidated net income. The filing does not present a single consolidated operating margin.
  • Investment results: Net investment income was $2.858 billion for the quarter and $8.548 billion for nine months, down from $2.931 billion and $8.983 billion. Net realized investment losses were $457 million for the quarter and $2.587 billion for nine months. Nine-month fixed-maturity other-than-temporary impairment losses recognized in earnings were $3.497 billion, with $2.033 billion of impairments transferred to other comprehensive income under newly adopted accounting guidance.
  • Cash flow: For the first nine months, operating activities provided $4.703 billion, investing activities used $1.396 billion and financing activities used $6.447 billion. Cash and cash equivalents declined $3.057 billion to $11.971 billion.
  • Balance sheet and debt: Total assets were $475.467 billion, up from $445.011 billion at year-end 2008; total equity was $24.847 billion, versus $13.786 billion. Consolidated short- and long-term debt totaled $24.941 billion, down from $30.825 billion; short-term debt fell to $2.182 billion from $10.535 billion, while long-term debt rose to $22.759 billion from $20.290 billion. Including asset-based financing, borrowings and financing were $36.109 billion, compared with $43.376 billion.
  • Liquidity: The parent holding company had $4.233 billion of cash and short-term investments at September 30. Prudential Insurance reported $3.5 billion of FHLB borrowings, supported by $7.530 billion of pledged collateral. Management said available cash flows and liquidity sources were sufficient for current needs, while noting continued monitoring of capital and liquidity.

Material changes versus comparable periods

  • The earnings recovery reflected improving markets, variable-annuity-related accounting effects and lower losses in some areas; it was not solely a change in underlying operating performance. Individual Annuities adjusted operating income was $166 million for the quarter versus a $307 million loss, and $615 million for nine months versus a $38 million loss.
  • Management cited favorable variable-annuity DAC and reserve adjustments of $629 million for the quarter and $727 million for nine months versus prior-year charges. Nine-month results also included a $895 million favorable variance in mark-to-market results for living-benefit embedded derivatives and associated hedges, largely related to the change in the company’s nonperformance-risk adjustment; this was partly offset by $641 million of increased DAC and other-cost amortization. These estimates and market-sensitive items may reverse or vary.
  • Other comprehensive income improved materially: Prudential reported $8.084 billion for the first nine months, versus a $4.272 billion loss in 2008. Available-for-sale investment valuations and other market movements contributed to the change.
  • Common Stock was issued in a June public offering: 36.9 million shares at $39 per share, generating $1.391 billion net proceeds. Prudential also issued $2.5 billion of medium-term notes and $500 million of exchangeable surplus notes.
  • Individual Annuity sales strengthened: third-quarter variable-annuity sales were $5.829 billion and net sales $4.385 billion, versus $2.507 billion and $519 million. Full Service Retirement net additions were $1.502 billion, versus $393 million. Asset Management nine-month adjusted operating income fell to $61 million from $301 million, reflecting lower fees and transaction and incentive revenues, as well as commercial mortgage pressures.

Outlook, management commentary, risks and unusual items

  • Management said equity markets had appreciated and bond spreads had tightened since late in the second quarter. It gave no specific consolidated earnings or revenue guidance in the supplied filing text. Management warned that renewed market disruption could require further capital actions or external financing, if available.
  • Ratings were downgraded during 2009. The filing warns that further downgrades could increase borrowing costs, restrict product sales, prompt surrenders, require additional collateral or allow counterparties to terminate derivative contracts. Prudential had $47 million of estimated additional collateral exposure on specified derivative agreements if their credit triggers were met at quarter-end.
  • Investment valuation and credit remain significant risks. At September 30, the company reported $4.542 billion amortized cost of Financial Services sub-prime mortgage-backed securities and $3.671 billion for the Closed Block. For certain sub-prime securities, management’s fair values were $795 million above third-party pricing estimates, based on its conclusion that the market was inactive and its own cash-flow valuation. Gross unrealized losses and future cash-flow assumptions remain important to monitor.
  • Commercial mortgage and other loan allowances increased to $511 million from $211 million at year-end. Asset Management interim loans had a $1.8 billion principal balance, a 109% weighted-average loan-to-value ratio and $186 million of allowances or credit-related market-value losses.
  • The company acquired Yamato Life in Japan on May 1, contributing $72 million of capital; the September balance sheet included about $2.3 billion of related assets and $2.3 billion of liabilities. Prudential expected about $35 million of non-capitalizable Japanese technology-system costs in the fourth quarter of 2009 and first half of 2010.
  • Prudential exercised its put right for its Wachovia Securities interest; it expected a transaction around January 1, 2010. Management estimated proceeds of about $5 billion and a gain of about $2.8 billion pretax, or $1.8 billion after tax, but stated that final value and consideration were undetermined; Wells Fargo indicated it intended to pay with an unspecified mix of cash and stock.
  • Litigation outcomes remain uncertain. The Lehman-related dispute includes a counterclaim seeking return of $372 million plus interest. The company also disclosed securities, insurance and other legal matters, including a stated $6.5 billion damages demand in the Lederman matter. Management believed, based on information then known and after reserves and indemnification, pending matters were not likely to materially harm financial position, while acknowledging a material adverse outcome was possible.

Most important facts an investor should verify

  1. How much of reported earnings came from recurring business results versus variable-annuity assumption changes, fair-value marks, impairment accounting and tax benefits?
  2. Whether credit losses, commercial mortgage loan allowances and sub-prime valuations prove consistent with actual cash flows and recoveries, especially given Level 3 estimates.
  3. Current statutory capital, rating-agency capital measures, liquidity at regulated subsidiaries and the ability to upstream dividends under regulatory and contractual restrictions.
  4. The final consideration, timing and realized gain on the Wachovia Securities put, including exposure to Wells Fargo stock and any sale restrictions.
  5. Developments in ratings, policyholder withdrawals, derivative collateral requirements, the Lehman dispute and other material litigation or guarantees.