Legal & General Group (OTCPK:LGGNF, OTCPK:LGGNY) is a leading international insurer, pensions, and financial services provider based in the U.K., with a strong commitment to inclusive capitalism and ESG-aware investments. The company, recognizable by its iconic umbrella logo, was formed as a life insurance company for legal professionals in 1836. Today, it goes far beyond life insurance and consists of the following business units:
- L&G Institutional Retirement (LGRI) and L&G Retail Retirement (LGRR), herein abbreviated as L&G Retirement (LGR), offer annuity contracts with guaranteed income and other retirement-focused investment products.
- L&G Capital Investment (LGC) is the company’s alternative asset originator, which is strongly engaged in housing, SME finance, specialist commercial real estate and clean energy infrastructure projects.
- L&G Investment Management (LGIM) is an investment manager with £1.3 trillion in assets under management (AUM), which provides a diversified range of pooled index funds but is also engaged in build-to-rent schemes from LGC.
- L&G Insurance (LGI) provides life, health, business, home, disability, accident and critical illness insurances.
L&G’s business model has stood the test of time, is very resilient (as is underscored by its continued strong performance in 2020), and is highly profitable. The company benefits from several structural and capital synergies (slide 5, 2021 capital markets event presentation) as it has built what I see as a self-reinforcing and to some extent autonomously-operating business:
- LGRI and LGRR are the main providers of capital, the former via pension risk transfer (PRT) programs.
- LGI operates somewhat isolated, but is also seen as a provider of capital to LGR and certainly facilitates cross-selling synergies.
- LGIM invests in the open market but also in LGC’s alternative investments (e.g., U.K. housing and infrastructure). The business unit also provides asset management services to LGR and LGC.
- LGC provides consultant activity but most importantly manufactures Solvency II Own Funds-eligible assets that are marketed via LGR.
L&G has been growing its operating earnings very consistently at a ten-year CAGR of 9% (excluding mortality reserve releases but including the 2020 results). Largely due to the pandemic, the company’s operating profit declined slightly in 2020 but is expected to rebound, as can be learned from the HY2021 earnings presentation. Between 2011 and 2019, the company grew its earnings per share (EPS) at a CAGR of 9.7%. For the half year 2021, the company reported EPS of 17.78p, up 265% from the 2020 low and up 9.8% based on a two-year CAGR.
L&G’s return on equity (ROE), which is quasi-identical to its return on tangible equity due to the negligible amount of goodwill and intangibles, came in very respectable at 16% in 2020, a decrease by four percentage points from 2019. For 2021, ROE is expected to rebound to at least 20% due to the ongoing recovery from the pandemic. For the first half of fiscal 2021, the company reported an ROE of 22%.
L&G’s current market capitalization is £17.4 billion and it is one of the world’s biggest insurance companies. The company is headquartered in London and its common shares are listed on the London Stock Exchange (ticker symbol LGEN). They are available to U.S.-based investors through OTC exchanges (OTCPK:LGGNF) or via ADRs (OTCPK:LGGNY) that are administered by Deutsche Bank Trust Company Americas. Each ADR represents five shares of L&G’s common stock.
A closer look at L&G’s Long-term Performance
The company’s largest business units are LGRI and LGRR, which together generated an operating profit of £1.73 billion in 2020 (including mortality release), up 10% YoY. The LGR business units are performing very well and their success is attributed to the robust demand for the company’s PRT program and its annuities portfolio (£78.2 billion in bonds as per August 2021). However, as LGR’s performance is strongly reliant on its asset base, the current low-interest rate environment and the accompanying artificially high bond prices will remain a key (market) risk going forward. The portfolio’s credit risk appears relatively low, considering that two-thirds of the bonds (in terms of value) are A-rated or better.
Accounting for 67% of the group’s total operating profit, the LGR segments are the largest contributors to L&G’s operating profit and are also the main drivers of growth. The combined segment’s five-year CAGR of 16% is certainly spectacular. However, the segment saw its strongest growth in 2016 and 2017, and its operating result stagnated until 2020 (see below). For 2021, the segment’s operating profit is expected to increase YoY, mostly due to retail-related demand, and partially offset by a decreased demand from institutional customers (slide 5, HY2021 earnings presentation).
While L&G’s retirement business is experiencing healthy growth, its much smaller insurance business unit (LGI) continues to be pretty volatile in terms of premiums earned, which is attributed to the COVID-19 pandemic but also several divestitures such as that of its Mature Savings business in late 2017 to Swiss Re (OTCPK:SSREF) and the General Insurance business in late 2019 to Allianz (OTCPK:ALIZF).
LGI is the biggest provider of life insurances in the U.K. and leading in the individual market. In 2020, the insurance business earned £9.4 billion in premiums, a material decline from the 2019 level (slide 5, 2020 results presentation). In terms of operating profit, L&G’s insurance business has been very robust apart from the dip in 2020, typically delivering a fairly consistent £300 million per year.
As L&G is often (and inaccurately) referred to as an insurance company, a review of its combined ratio (i.e., net premiums earned versus total operating expenses) comes to mind. However, this metric is not expected to yield meaningful results, as the company’s 2020 combined ratio of 5.2 suggests. As we already know, the insurance business is only a small part of L&G (i.e., 7% of 2020 operating profit), whereas the operating expenses reported in its consolidated income statement relate to the entire company.
LGIM, the company’s investment management business, continues to book net inflows (see below). This is attributed to the company’s diversified range of pooled index funds but also to inflows from government pension funds (e.g., a £37 billion mandate with the Japan Government Pension Investment Fund in 2019).
LGIM contributed about 14% of L&G’s operating income in 2020, a similar size to the insurance business (LGI) and the investment unit (LGC). On a four-year CAGR basis, and ignoring the pandemic-related decline in operating profit, LGC stands out at a growth rate of 9% per year.
LGC grew its Alternatives AUM at a compound annual growth rate (CAGR) of 11% from £2.3 trillion in 2008 to £7.9 trillion in 2020 and expects to manage £12.7 trillion by 2025 (i.e., a forward-CAGR of 10%). Noteworthy areas of expansion are housing, SME finance, specialist commercial real estate and clean energy infrastructure. Note that L&G has become increasingly vocal about its ESG agenda and the company views addressing climate change as one of its six main market opportunities (p. 9, 2020 annual report), citing that $130 trillion of investments are needed to achieve global net zero emissions ($20 trillion thereof by 2025). It should also be noted that the adoption of “stakeholder capitalism” – which now appears to be in vogue – is nothing new at L&G, as evidenced by previous annual reports (e.g., 2017, 2015 and 2013), although the tone has nevertheless become harsher. I will not detail this controversial topic in this article as I would only repeat most of the information outlined in the excellent summary published by fellow contributor Retirement Pot in mid-2021. In short, I also doubt that L&G’s ESG agenda will have a material negative impact on shareholder returns, but it will likely result in slower dividend increases than has been the case in recent years (see, e.g., slide 32, HY2021 earnings presentation).
LGC’s strong growth until the onset of the pandemic is attributed to consistent increases in direct investments in climate, housing, infrastructure, and SME finance, at a five-year CAGR of 29% (see below). The segment’s operating profit fell by 24% in fiscal 2020 but is expected to rebound in FY2021, as it has already achieved good results so far in the first six months of fiscal 2021 (i.e., an increase by 103% to £250 million).
A quick Assessment of L&G’s financial Stability
L&G is a financial company that is required to maintain certain capital quotas. Its Solvency II coverage ratio declined slightly in 2020 but remained strong at 177%. At the end of June 2021, the ratio increased to 183% (slide 4, HY2021 earnings presentation).
Its equity ratio naturally remains very stable and even slightly increased from 1.58% in 2015 to 1.75% in 2020. Also, L&G’s equity is not tainted by excessive amounts of goodwill and intangibles (currently 4% of equity).
The company’s debt has been rated AA- by Fitch Ratings, Aa3 by Moody’s and AA- by S&P. Until 2024, the company expects its leverage to decline as it aims to prioritize EPS growth over dividend growth. Likewise, its Solvency II leverage will decline, broadly in line with the ratios of the rating agencies (slide 31, HY2021 earnings presentation).
The main risk of investing in L&G is the strong correlation of the stock with the general stock market, and thus the pronounced draw-down in the event of a stock market crash. However, an investor who is risk-tolerant (in the sense that they can tolerate increased volatility) might actually see this as an opportunity to increase their stake in the company, given that fundamentals remain intact. Operationally, L&G appears to be a mixed bag during a stock market crash, as its asset management business is likely to generate lower volume-based fees while its retirement division will be able to acquire bulk annuities at premium prices. In a rising interest rate environment, I generally view L&G to be favorably positioned, with the exception of its bond portfolio as outlined above.
The barriers to entry into the insurance and asset management businesses, both of which are highly regulated, can generally be considered high. Therefore, L&G can be considered to operate in an oligopoly with, e.g., Prudential (NYSE:PUK) and Aviva (OTCPK:AIVAF). However, the agility of fintechs should not be underestimated and L&G’s ongoing efforts related to digitalization (e.g., increased operational efficiencies, improved and simplified onboarding experience) should be closely monitored.
The company still has a geographical concentration in the U.K. and would therefore be affected to an above-average extent in the event of a local economic downturn. However, given the increasing geographic diversification of L&G and the advanced state of globalization state we find ourselves in, I deem it quite unlikely that the U.K. would suffer from a stand-alone economic crisis.
Legal & General pays a generous dividend of currently 17.57p (2020), which is paid in two installments, a smaller interim payment and a larger final payment. Since 2011, the company grew its dividend at a CAGR of 12% and the current dividend translates to a yield of 6.3%. Together with the solid growth rate, the stock appears to be a very interesting dividend pick. Note, however, that the dividend growth rate has declined in recent years but has remained constant at 7% per annum since 2016, with the exception of 2020, where no increase was announced. L&G increased its interim dividend for fiscal 2021 by 5% to 5.18p and is expected to also grow the final dividend by the same percentage. Over the five-year period of 2020 to 2024, the company expects to pay out £5.6 billion to £5.9 billion in dividends, which translates to a growth rate of 3% to 6% annual growth rate, in line with the company’s announced prioritization of business growth over dividend growth.
L&G does not repurchase its own shares, so the number of diluted shares has increased slightly in recent years, likely due to granted performance shares. The somewhat more significant increase in diluted shares in fiscal 2020 (i.e., +5.2%) is attributable to the conversion of restricted tier 1 convertible notes.
The payout ratio in terms of net earnings is acceptable, hovering around 60% over the last six years while increasing to 69% in fiscal 2020 due to the pandemic-related decline in earnings. I believe L&G’s dividend is reasonably safe, but I want to emphasize that as a systemically important financial company, L&G could face a mandatory dividend suspension in the event of a severe economic downturn. While not related to L&G, I want to draw the reader’s attention to the statement of the European Banking Authority released in March 2020, where it urged banks to follow prudent dividend and other distribution policies. As a consequence, several country-specific banking authorities have communicated to banks general expectations or engaged in bilateral dialogues in order to limit or refrain from dividend distribution and share repurchases.
Since L&G is a financial company, its cash flows from operations are not necessarily meaningful and, as a consequence, a discounted cash flow analysis and a valuation based on enterprise value appear nonsensical.
L&G’s forward P/E ratio, based on the earnings estimate for fiscal 2021, is approximately 9. This compares favorably to its six-year average P/E ratio of 11, taking into account the share price observed after the announcement of each year’s earnings. Likewise, its estimated forward P/B ratio of 1.7 also indicates that the shares are undervalued compared with the six-year average P/B ratio of 2.0.
The dividend discount model (Gordon growth model) as a valuation method considers dividends as the only form of return. While this might be inaccurate for many companies, it can be viewed as a useful approach to valuing L&G, as the company distributes a substantial amount of its net income and the stock has not experienced significant capital appreciation over several years. With a 2020 dividend of 17.57p and a cost of equity of 10%, a terminal dividend growth rate of 3.6% would be required to justify the current share price of £2.77 (approximately $19 per ADR). This corresponds to the lower end of the dividend growth rate anticipated by management over the period of 2021 to 2024 (slide 32, HY2021 earnings presentation).
Legal & General is a solid company which relies on its self-reinforcing system of retirement-related products, asset management services, direct investments and insurance products. It is growing largely thanks to the ongoing trend of private companies offloading their bulk annuities to insurers like L&G. ESG-conscious investing is a controversial topic, and L&G is pushing hard for such investments, having adopted stakeholder capitalism already several years ago and taking advantage of its size in terms of assets under management. Through its Alternatives portfolio, L&G continues to benefit from the ever-increasing demand for government-mandated green housing and infrastructure projects. Further growth opportunities arise from an aging population and higher life expectancy (i.e., increasing and prolonged demand for reliable pension products) as well as a globalization of asset markets, as becomes evident from L&G’s expansion to China, Japan and also Canada. Finally, the company sees itself in a position to benefit from upcoming welfare reforms and the associated onus placed on individuals to build and maintain their wealth.
L&G’s stock was certainly a true bargain in 2020, where savvy investors were able to lock-in a yield on cost of 9% to 10%. However, I still believe that the company is attractively valued today, at a dividend yield of 6.3% and a 2021 P/E ratio of 9. While the dividend is expected to grow at an annualized rate of up to 6% per year until 2024, a growth rate of 3% per year appears to be a realistic long-term expectation and seems to be priced into the stock at an assumed cost of equity of around 9%. As for full disclosure, I am considering opening a small initial position in L&G, which I plan to add to over the next few months. Still, as a financial company, Legal & General will never become a core position in my income-oriented portfolio.
Thank you for taking the time to read through my article. If you have any comments or criticism to share, I am happy to read from you in the comments section below or via private messaging. Also, if you have any questions regarding the calculation of any of the presented metrics, I am happy to answer these as well.