PRINCIPAL FINANCIAL GROUP INC quarterly report, Q2 FY2015

Principal Financial Group, Inc. — Q2 2015 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2015. Unaudited consolidated financial statements; amounts are in U.S. dollars unless noted.

Business context

Principal provides retirement and investor services, asset management, international retirement and insurance products, and U.S. life and specialty benefits insurance. Its reportable segments are Retirement and Investor Services (RIS), Principal Global Investors (PGI), Principal International, U.S. Insurance Solutions, and Corporate. Separate-account assets and liabilities are generally pass-through balances, with investment risk borne by clients.

Financial performance

Metric	Q2 2015	Q2 2014	Six months 2015	Six months 2014
Total revenues	$3,259.2 million	$2,606.7 million	$5,916.5 million	$5,085.3 million
Income before taxes	$294.5 million	$407.5 million	$752.6 million	$783.9 million
Net income	$264.9 million	$319.2 million	$694.0 million	$643.3 million
Net income available to common stockholders	$241.1 million	$306.3 million	$655.3 million	$600.0 million
Diluted EPS	$0.81	$1.03	$2.20	$1.98
Dividends declared per common share	$0.38	$0.32	$0.74	$0.60

Q2 revenue rose about 25%, mainly from higher premiums on single-premium group and individual annuities. These sales also increased policy benefit reserves and expenses. Q2 common income fell about 21%, reflecting a swing from realized gains to losses, particularly on derivatives and real estate-related items.
Six-month revenue increased about 16% and common income rose about 9%. The improvement in common income included a $105.2 million benefit from revised deferred tax balances following a merger of Chilean entities; realized investment losses partly offset it.
Q2 net investment income was $789.9 million, down from $829.0 million; six-month income was $1,513.8 million, down from $1,673.7 million. Management cited lower investment yields, prepayments, weaker Latin American currencies and lower inflation-based returns.
Q2 net realized capital losses were $114.6 million versus gains of $86.8 million a year earlier; six-month losses were $48.4 million versus gains of $87.4 million. Derivative mark-to-market results and reduced real estate gains were key factors. Q2 effective tax rate was 10% versus 22%; the six-month rate was 8% versus 18%.
Six-month segment operating earnings: RIS $427.6 million (prior year $428.6 million); PGI $62.2 million ($54.3 million); Principal International $119.2 million ($131.3 million); U.S. Insurance Solutions $113.9 million ($92.4 million); Corporate loss $72.6 million ($66.4 million). These are management-defined, non-GAAP segment measures.

Financial position, cash flow and capital

At June 30, 2015, total assets were $222.3 billion, including $143.0 billion of separate-account assets matched by equal liabilities. Total liabilities were $212.4 billion; total stockholders’ equity was $9.8 billion, down from $10.2 billion at year-end 2014.
Cash and cash equivalents were $2.264 billion, up from $1.864 billion at December 31, 2014. For the six months, operating cash flow was $2.117 billion, investing cash outflow $937 million, and financing cash outflow $780 million.
Total debt rose to $3.343 billion from $2.559 billion. Debt-to-equity excluding AOCI increased to 33% from 25%, and debt-to-capitalization excluding AOCI to 25% from 20%.
In May, the company issued $400 million of 3.4% senior notes due 2025 and $400 million of 4.7% junior subordinated notes due 2055. On June 30 it redeemed $550 million of Series A and B preferred stock. The proceeds from the debt issuance were primarily used for the redemption.
The company returned $293.9 million to common stockholders in the first half through dividends and share repurchases. It also had $1.005 billion of committed short-term credit facilities, with $26.6 million outstanding, and reported $867 million of cash and liquid assets at the holding companies.
Other comprehensive loss was $349.6 million in Q2 and $371.8 million for the first half, largely reflecting unrealized investment losses and foreign currency translation. AOCI shifted from $50.4 million at year-end to a deficit of $326.6 million.

Material changes, outlook and risks

Management said planned 2015 organizational changes are intended to better align businesses, distribution and products; they are not expected to materially affect consolidated financial statements. Reporting under the new structure is planned for the 2015 Form 10-K.
No overall earnings guidance was provided. Management expects 2015 pension expense of $123.3 million before tax, versus $85.0 million in 2014, citing a lower discount rate and a mortality assumption change. Contributions to pension plans were $42.6 million in the first half; combined 2015 funding could be up to $150 million.
The pending AXA Hong Kong pension business acquisition, announced at approximately $335 million, was expected to close September 1, 2015, subject to regulatory approval. The company owned 97.5% of Columbus Circle Investors and expected to acquire the remaining 2.5% in April 2016.
Principal International operating earnings were reduced by currency movements by $12.5 million in Q2 and $22.8 million in the first half. Management also cited unfavorable market changes on mandatory Chilean pension-fund investments.
Market risks include interest rates, credit spreads, equity markets, foreign exchange, investment valuations and policyholder behavior. A hypothetical 100-basis-point parallel rate increase implied a $2.282 billion net fair-value loss; management cautioned this is a point-in-time sensitivity, not a forecast. It estimated a 10% equity-market decline scenario could reduce annual operating earnings by approximately 4%–6%.
Tax matters remain material: a court ruling on uncertain tax positions reduced first-quarter net income by $30.3 million. Unrecognized tax benefits totaled $217.1 million at June 30, with $137.0 million of accumulated pre-tax interest and penalties. Management said it did not expect a significant change in unrecognized benefits over the next 12 months.
Litigation includes ERISA and investment-fee cases and a disputed Lehman estate claim of approximately $550 million including interest through November 2014. No loss was accrued for the cited matters because management considered loss not probable and not reasonably estimable. Other guarantees had maximum exposure of about $232 million; the Chilean minimum-return guarantee has no determinable maximum exposure.
Rating agencies affirmed key ratings with stable outlooks. Management reported disclosure controls and procedures were effective and no material change in internal control over financial reporting during the quarter.

Important facts for investors to verify

How much of the premium and revenue growth reflects large, episodic annuity transactions, and the related reserve and earnings effects.
Underlying operating trends apart from volatile realized gains and losses, the Chilean tax benefit, and other tax-related items.
Whether investment spreads, derivative hedges and policyholder guarantees remain resilient under changing interest rates, equity markets and credit spreads.
Progress and final terms of the AXA Hong Kong acquisition, and performance of Principal International after currency translation effects.
Developments in the uncertain tax positions, Lehman claim and ERISA/investment-fee litigation, including any change in estimated exposure or accruals.
Debt and capital levels following the note issuance and preferred-stock redemption, and the effect of higher leverage on ratings, liquidity and capital flexibility.