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PartnerRe Slips to Neutral

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We have downgraded our recommendation on PartnerRe Ltd. to Neutral from Outperform based on its sluggish top line growth, exposure to weak property-casualty cycle and lack of near-term growth catalysts, which question the current sustainability factor. However, lower catastrophe losses, strong expense management and share repurchases have had a positive influence on the combined ratio, bottom line, return on equity (ROE) and book value per share.

PartnerRe reported second-quarter 2012 operating earnings per share of $2.20, which were well ahead ofthe Zacks Consensus Estimate of $2.02 as well as the year-ago earnings of 98 cents a share. As a result, operating net income soared to $142.0 million from $67.2 million in the prior-year quarter.

However, total revenue slipped 4.5% year over year to $1.29 billion. The deterioration was primarily based on low net realized and unrealized investment gains, continued decline in premiums earned due to cancellation and non-renewals in the prior quarters, along with lower investment income arising from low reinvestment and risk-free rates.

While PartnerRe has a straightforward investment portfolio of fixed income and equity securities that steer clear of alliances and hedge fund investments, the widened spreads and low reinvestment rates adversely affected the net investment income, which witnessed sharp declines throughout 2011 and in the first half of 2012. Moreover, higher catastrophe losses in the past year have pulled down the reserves and financial flexibility.

A sluggish top line and investment portfolio are slowly reversing the positive trend that PartnerRe had experienced over the past. Weak reinsurance and investment income not only marred the top- and bottom-line growth, but also affected the cash position of the company since the growth of net investment income is drawn on the basis of cash flow from operations. Consequently, operating cash flow declined 53.2% year over year in 2011 and 75.4% in the first half of 2012. These concerns have also impelled ratings agencies to trim their ratings and outlook on PartnerRe in the first half of 2012.

Nevertheless, PartnerRe emerged strong from the first half of 2012 with substantially low total expenses that plummeted 36.7% year over year, and improved combined ratio of 87.8% from 147.1% in the year-ago period, which indicate higher underwriting profitability. These factors have not only expanded the technical results, bottom line and book value, but also helped in achieving an annualized operating ROE of 11.7% in the first half of 2012, gradually moving toward the 13% long-term target benchmarked by management. Operating ROE also outpaced the negative 21.0% in the prior-year period.

The stable returns so far in 2012 coupled with the ongoing growth momentum cast a favourable outlook for the upcoming quarters, while enhancing the investors’ confidence. Alongside, a diversified business model with proactive underwriting approach have contributed to more stable earnings, increase in return per unit of risk and better underwriting practice as compared to many of its peers. A meaningful debt de-leveraging has aided in a modest capital and balance sheet position.

Moreover, the recent expansion in the stock buyback program along with dividend payments validates PartnerRe’s commitment of consistently enhancing shareholder value. Once the market stabilizes at its historical highs, the company’s diversified business model and improved pricing can help it generate higher underwriting profitability, investment returns and reserves, thereby further enhancing investors’ return. This will also enhance its competitive leverage against arch-rivals such as XL Group Plc (XL - Free Report) and W.R. Berkley Corp. (WRB - Free Report) .

Hence, based on the pros and cons, the Zacks Consensus Estimate pegs earnings for the third quarter of 2012 at $1.67 per share, which is about 31% lower than the year-ago quarter. However, for 2012, earnings are expected to soar about 189% over 2011 to $8.45 per share. Of the 17 firms covering the stock, three downward estimate revisions were witnessed in the last 30 days, while none revised its estimates upward.

Currently, the company carries a Zacks Rank #3, implying a short-term Hold rating, in line with its long-term Neutral recommendation.

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