Dividend boost; CEO’s last year
Legal and General was able to increase dividends by 35% in 2011 despite an increase of a quarter in 2010’s payment. The dividend has now surpassed 2007’s high and looks set to continue to show growth. Regulatory risks are present but the long-term growth prospects for UK savings underpin the group. Although the stock is not expensive we move our rating to hold due to the recent share price rally.
Cash has been king at Legal and General as the company has focused on cash generation to support the balance sheet and dividends. This is as regulatory, economic and market uncertainty has meant that a strong balance sheet is needed. The below graphic shows operational net cash generation by the business since 2007:
The strong cash performance has helped Legal and General to robustly grow dividends during the last two years. The company has now surpassed the dividend payout made in 2007 of 5.97p with a payment of 6.4p for the current year. The strong increases in 2010 and 2011 show that LGEN is confident on future prospects while the dividend in 2011 is covered 2.25X by net cash generation per share (14.52p).
Legal and General Dividend growth
We last reviewed Legal and General (22nd September 11, FAT UK 404) rating the stock a buy at £0.92p. The turnaround in sentiment is clear evident in the near 50% gain in the shares since then although concerns over new regulations for the insurance sector remain.
On announcing the full year results the shares performed well with profits slightly above expectations and dividend growth well received. This follows weakness in the stock in the second half of 2011 as sovereign debt concerns hit the financial sector.
Prices broke above structural resistance at the 125p region, igniting a swift rally. The high print was 136p. In the near term, prices appear overstretched to the upside, with the RSI in overbought territory is suggestive of a short term corrective pullback at hand. Firm support is offered at the prior breakout level of 124.20p.
With reference to the weekly chart, prices are testing resistance at the 78.6% Fibonacci retracement. However, the bullish moving average cross in place is indicative of broader term momentum to favour the upside. Thus, once this pause in trend is complete, we would expect a resumption of the uptrend to follow.
The key for investors is that a strong dividend yield supports the shares, the dividend is well covered by earnings, and that long-term trends support dividend growth. Legal and General’s business is geared towards savings growth in the UK and is therefore supported by trends underpinning UK savings growth.
Supportive trends; growth plans
As we noted in our last report in September (FAT UK 404), Legal and General sees 18.5m UK adults over 65 by 2060 which compares to 11m today. Meanwhile companies are turning towards annuities, and away from defined benefit schemes, to reduce risk and individuals have to take more responsibility for their retirement.
The UK savings market is forecast by Legal and General to grow form £202bn in 2010 to £460bn in 2015. In the medium term difficult economic conditions boost the savings rate as attitudes become more conservative.
Specific opportunities include auto-enrolment for employees by their place of work into a pension scheme. Meanwhile longer-term growth opportunities outside of the UK are to grow the Investment Management business internationally – it has already been successful in the US.
Legal and General is also looking at growing its business through Bancassurance – an insurance company using a bank’s sales channel to sell insurance products – with emerging market partners. The group will look for the “right partners in the right markets” to grow a large and resilient business over time.
2011 Results
Legal and General’s 2011 results show a resilient performance. Operating profits grew in each business division – Risk, Savings, Investment Management and International. Meanwhile growth was strongest outside of the key risk division – annuities and insurance – which helps further diversify the group.
The risk business still generates more profits than the other businesses combined but its dominance is reducing each year. The investment management business saw IFRS profit growth of 13.6%, the international business saw IFRS profits growth of 34.3% and the savings business saw growth of 11.3%. By contrast the risk business saw IFRS profits growth of just 0.2%.
Total operating profit therefore increased from £1bn in 2010 to £1.05bn in 2011. Overall, the operating side of the business did reasonably well during 2011 while cash generation showed good growth with operational cash up 12%.
LGEN 2011 Cash and IFRS Operating profits performance
LGEN has also focused on diversifying its sources of cash with the proportion coming from annuities falling from 52% in 2009 to 31% in 2011. Over the same period the increase in cash coming from Investment Management and Savings rose from 22% of the total to 35%.
Profit before tax fell after a strong “investment variance gain” in 2010 of £185m was not repeated in 2011 - this is a volatile line-item and doesn’t reflect operational performance. Insurers like LGEN make assumptions about returns for their risk businesses (mainly annuities) and so adjust profits for changes in these assumptions each year.
Regulatory and leadership uncertainty
The financial services industry is seeing significant regulatory reform with the Retail Distribution Review (RDR) set to prohibit payments from funds to advisors from the end of 2012. It is not clear what effect this will have on Legal and General but the initiation of auto-enrolment into workplace pensions should be a positive as it encourages saving.
A key uncertainty is Solvency II which is the EU directive covering insurers that is set to come into force in 2014. The transitional arrangements, and indeed the requirements of this directive, are not known which has encouraged LGEN to maintain a strong balance sheet.
The wrangling over the directive have led to the Prudential consider moving its headquarters outside of the UK. This is as the group says that its US business would no longer be competitive if higher capital requirements were forced onto it – Prudential generates most of its profits outside of the EU.
On the leadership front CEO Tim Breedon is set to leave at the end of the year. No successor is yet lined up but clearly there is plenty of time and there are a number of strong internal candidates such as the finance director Nigel Wilson.
Summary
Legal and General has seen its UK focus play to its advantage as less exposure to Europe than rivals has allowed it to weather the sovereign debt crisis in Europe comparatively well. Despite the share price gain the stock still has an attractive dividend yield at an estimated 5% for the current year while the P/E ratio is low at 9.3X for 2012 (8.7 P/E for 2013 with a yield of 6%).
However, regulatory uncertainty does cast a shadow over Legal and General and the whole sector. Set against this the group has a strong balance sheet, looks set to see its key UK savings market grow strongly, is successfully diversifying its business and is looking to expand internationally.
Accordingly, we rate Legal and General a hold.
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