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Lincoln National Affirmed at Neutral

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Recently, we reiterated our Neutral recommendation on Lincoln National Corp. (LNC - Free Report) based on its current sustainability factor. The company’s first-quarter 2012 operating earnings of $1.00 per share edged past the Zacks Consensus Estimate of 98 cents but were in line with prior-year quarter’s earnings. However, operating net income dipped 8.1% year over year to $295.7 million.

Despite the initiatives and investments made toward business restructuring, Lincoln’s top line remained sluggish during the first quarter of 2012. The company’s life insurance sales continued to be dismal due to low demand and reduced client activity and pricing pressure given the ongoing market volatility.

In addition, total annuity deposits declined 6% over the year-ago quarter to $2.5 billion in the first quarter of 2012, due to customer reluctance, low interest rate environment and disruption in key channels, which significantly affected the fixed annuities.

Even group protection has been witnessing weak performance based on the fluctuation in mortality that leads to higher-than-expected claims. Intense competition from arch rivals such as Manulife Financial Corp. (MFC - Free Report) and Sun Life Financial (SLF - Free Report) also poses ample risk on the company’s market share through product pricing, new product offerings and client retention.

Moreover, Lincoln’s earnings are significantly exposed to the performance of equity markets, financial leverage and longer-term issues around funding the growth in reserves associated with life policies. Moreover, Lincoln’s financial leverage of 31% at the end of March 2012 remains higher than Fitch Ratings’ estimate of 25% for the current ratings.

While a high level of debt has escalated the borrowing costs, higher cost on investment-linked retirement products that guarantee returns, in order to retain and develop new customers, further weigh on the margins and bottom line.

This has also led to consistent deterioration of operating cash flow, which declined 26% year over year to $1.28 billion in 2011 and 17% to $282 million in the first quarter of 2012. Going forward, increased operating and capital costs amid volatile markets and pricing pressure could pose ample financial risk and in turn limit growth.

On the flip side, though, Lincoln has a diversified insurance products portfolio that is structured to suit the needs of all economic strata. It also adds value to the investment of its customers while mitigating their risks and helping them in retirement planning. Over the past few years, Lincoln’s earnings are being driven by higher asset-based fee revenue, improved spread income from interest-sensitive products and lower amortization of intangibles.

Moreover, Lincoln has made substantial progress in implementing long-term solutions for reserve financing that more closely align asset-liability duration, thereby reducing refinancing risks. The company’s consolidated deposits and ending account balances have also propped up margins in 2009, 2010 and 2011. Going forward, we believe that the economic recovery will further boost the company’s clientele and add new synergies to its business operations.

Additionally, Lincoln has taken successful steps in the past to protect and build its capital base and mitigate balance sheet risks. By securing a 4-year credit facility worth $2 billion in June 2011, Lincoln National also established a long-term solution to finance its statutory reserves and shore up its life insurance operations, thereby attaining additional capital buffer and modest accretion in return on equity. The upsides have also enabled Lincoln to drive book value per share and deploy its excess capital efficiently.

Lincoln is well poised for growth with superior financial strength ratings from A.M. Best, Standards & Poor’s, Moody’s and Fitch. The company’s respectable statutory capital, capable management and diverse distribution network have driven its operating leverage, according to the rating agencies.

Overall, based on the pros and cons, the Zacks Consensus Estimate pegs earnings for the second quarter of 2012 at $1.01 per share, which is about 8% lower than the year-ago quarter. Lincoln is scheduled to release its second quarter financials after the closing bell on August 1, 2012.

Currently, Lincoln carries a Zacks Rank #3, implying a short-term Hold rating, on par with its long-term Neutral recommendation.

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