There is something very unusual going on in the Canadian financial services sector: a large-cap financial, Sun Life Financial (SLF), is being priced for a substantial dividend cut. Even those with a cursory knowledge of Canadian financial services know that investors in the sector consider dividends virtually sacrosanct.

Over the past many decades, there are just two instances of dividend reductions among the large-cap Canadian financials: National Bank in 1991 and Manulife Financial in 2009. Both decisions were driven by severe exogenous events – the former, a collapse in commercial real estate prices, and the latter, the Credit Crisis.

Attractive yield

Following a disappointing third quarter earnings (pre)announcement and a 30% decline in its stock through November 25th, SLF has a 7.9% dividend yield (with a quarterly dividend of $0.36 per share). This compares (un)favourably to its insurance peers, with Industrial Alliance (IAG) at 3.6%, Manulife (MFC) at 4.8% and Great West Life (GWO) at 6.3% (a surprisingly high, but we believe safe, dividend yield).

Speculation of a dividend cut by SLF has been fueled by what many considered to be a tepid defense of the current dividend during the most recent conference call by the retiring CEO. Many further speculate when the new CEO assumes his duties, he may choose to begin his tenure with a reduced payout (although we would note that SLF is not expected to declare its next dividend until February, coincident with its Q4 2011 earnings release).

How Large a Dividend Cut is the Market Pricing in for SLF?

It is difficult to say precisely how large a dividend cut is expected by the market. However, if one assumes that the market is pricing in a more sustainable yield equal to that of SLF’s peers, this would equate to a cut of ~40% (to $0.22 per share per quarter) to match MFC, or a cut of ~20% (to $0.29 per share per quarter) to match GWO.

To be clear, these are very large forecast reductions, especially when one considers that between Q3 2010 and Q2 2011, SLF’s quarterly operating earnings ranged from $0.71 to $0.85 – i.e., easily enough to support its current $0.36 dividend (as evidenced by a stable MCCSR ratio over that period).

Why is the Market Apparently Forecasting a Cut?

So, why is the market forecasting a large outright cut in SLF’s dividend? We believe there are four possible explanations. First, SLF reported an operating loss of $0.99 for Q3, and its key capital ratio declined by a noteworthy amount as a result (but remained solid). Even excluding a large actuarial reserve addition, its operating earnings would have been anemic, at less than $0.20 per share – obviously not supportive of a $0.36 per share quarterly dividend.

Second, in its October 17th pre-announcement (and reiterated in its Q3 release), SLF disclosed that it plans to “make a method and assumption change related to the valuation of its variable annuity and segregated fund liabilities whereby it will provide for the estimated future lifetime hedging costs of these contracts in its liabilities”. In its earnings release, SLF disclosed the estimated one-time charge to be between $550 million and $650 million (assuming market conditions as of September 30th).

Interestingly, it also disclosed that, as a result of this methodology change, it expects future in-force profits to be higher and required capital to be lower, although it also indicated that its net income sensitivity to changes in interest rates has significantly increased. This may have fueled concerns about the capital impact from the second consecutive large quarterly loss expected in Q4.

Third, the crisis in Europe has deepened, and since the end of Q3, the operating environment has worsened with long-term interest rates continuing to decline (albeit modestly). These low rates will continue to pressure lifeco earnings, including those of SLF.   

Fourth, a new CEO will be assuming responsibilities effective December 1st. As mentioned, many speculate that he will use this opportunity to “right-size” the dividend, and perhaps disclose other actions related to reserve levels and capital, with the full understanding that investor reaction would be exceptionally negative.

Bank History Underscores High Hurdle to Reducing Payout

There is no question that the insurers are facing some very severe headwinds, most notably extremely low interest rates, driven in no small part by the flight to safety in the global financial markets from equities and other risk assets. Given that no one knows when interest rates will normalize, this makes for an extremely challenging operating environment.

Unlike the Canadian banks, the life insurers have only been public companies since the late 1990’s/early 2000’s and therefore have little history in the markets. And this is by far the worst operating environment since they went public.

However, it is not the first time that the broader Canadian financial services sector has faced a challenging environment. Looking back at the Canadian banks, which have been public for generations, there have been many instances where the sector faced terrific challenges that contributed to severe declines in earnings and capital.

For example, in just the last 40 years or so, the “Big-five” Canadian banks faced dramatically rising inflation (deflating capital ratios); stagflation; the Less-Developed Country Crisis, or LDC, Crisis (when they were arguably insolvent); and the collapse of the real estate bubble in the early 1990’s.

Each time they persevered. And in every single instance they needed capital, they chose to access the equity markets rather than reduce their dividends, thereby giving them time to grow into a sustainable payout ratio. However, it is worth noting that this restoration process was also aided at times by de facto regulatory forbearance, something from which SLF is unlikely to benefit.

Will SLF Cut? What Investors Need to Consider 

As mentioned, very low interest rates and challenging equity markets are placing great pressure on lifeco earnings and capital. So, why might SLF reduce its dividend? In our view, for investors to believe that SLF would cut its dividend, they have to believe four things.

First, that the current macro-environment and Q3 operating results represent a “new normal” – i.e., that future earnings will be more like those of Q3 2011 than those of the preceding four quarters. Second, that SLF management believes the same. Third, that SLF management does not believe its current capital levels or forecast capital generation are sufficient to meet its strategic objectives. And fourth, that management does not believe any anticipated shortfall can – or should – be made up completely by issuing equity, but instead should (at least in part) be funded by internal capital generation (i.e., earnings after dividends).

With SLF’s 7.9% dividend yield, the market appears to have answered “yes” to these questions. 

Of course, it is possible that the answer may not come for months, and may very well be dependent on changes in the macro-economic outlook, and interest rates in particular.

Either way, it is not a decision management will make lightly.

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