Financial services group Phoenix (LSE: PHNX) currently supports one of the highest dividend yields in the FTSE 100. According to the company’s own forecasts, this year the stock is set to yield 8.5%.
Unlike many other high yield stocks, what is really interesting about Phoenix is the fact that it has laid out a plan to return cash to investors over the next two years. Beyond that, management has a plan to generate billions of pounds in additional capital, which will help support dividend growth.
Put another way, Phoenix knows how much cash it is going to generate over the next five years and this means we have a high level of visibility around its dividend plans.
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Phoenix knows how much cash it will generate
Phoenix’s visibility over future cash flows is incredibly rare. With most companies, we can only make an educated guess as to how sustainable a dividend is based on the size of the market, potential capital spending commitments and market growth. This FTSE 100 company is different because it buys and manages books of pension and life insurance policies.
As these are generally long-term commitments, lasting many decades, Phoenix can estimate how much cash it is going to generate from these policies years in advance. Management can then use these figures to estimate how much cash is available to return to investors and reinvest back in the business.
There are two sides to the group’s business model. It buys so-called “heritage” assets or books of policies from other insurers and then migrates these policies onto its own platform to improve the customer experience. The main customers for the other side of the business are individuals and businesses that want to offload their pension management to Phoenix.
The firm has an advantage in both markets because it can use its size and scale to lower costs and achieve economies of scale, while offering customers a more attractive alternative to other providers.
Deals will help the company boost growth
One of the big themes that could drive the company’s growth over the coming years is pension de-risking by big corporations. These transactions have boomed in recent years as corporations have sought to lower their exposure to costly pension policies and draw a line under liabilities.
And the market is set to continue growing according to projections, with some estimates suggesting deal volumes could hit as much as £50bn a year over the next five years.
Phoenix isn’t the only company in the sector that’s set to benefit from this trend, but it might be able to grab a large share of this new business.
Management is also eyeing up potential heritage deals. One of its biggest deals in recent years was the near £3bn acquisition of Standard Life Assurance, which bought with it £240bn of legacy assets and 10.4 million policyholders. At the time, Phoenix estimated that the transaction would generate £5.5bn of cash over the life of the policies.
This simple example illustrates how lucrative these deals can be. Management believes there are £480bn of further heritage assets out there, and it estimates Phoenix will have £1.3bn of free cash over the next two years to deploy.
Phoenix’s plans to return capital are impressive
Between 2022 and 2024, Phoenix’s figures show it has the potential to generate £5bn of cash. Of this, £3.3bn will cover operating costs, debt interest and the dividend (expected to cost £1.5bn in total), leaving £1.7bn for deals and other uses.
In other words, the company has enough visibility to guarantee the dividend for the next two years and longer term projections point to the same conclusion.
After all, Phoenix is managing pension assets that can have a multi-decade lifespan. Assuming it has its sums right, the firm should be able to predict with a high degree of certainty how much it can pay out, and how much it needs to hold back over the life of each policy.
Further, life insurers such as Phoenix tend to invest their reserves in inflation-linked assets such as infrastructure, which give some protection against rising interest rates and prices.
There could be risks below the surface
However, I should also point out that life insurance can be a tricky industry. Small changes in interest rates can have a huge effect on future liabilities and a company’s solvency.
Phoenix’s numbers suggest that higher rates will positively affect its solvency, but if rates go into reverse, the opposite could happen. The company’s sums could also be thrown out of whack by longer life spans, new regulations, additional regulatory costs and equity market volatility.
Then there are hidden risks to consider. Financial companies like Phoenix often use derivatives to match assets and liabilities.
Once described by the US investor Warren Buffett as “financial weapons of mass destruction”, derivatives can expose investors to huge financial risks that may not immediately be apparent. Granted, if the company has solid risk controls this should not be an issue, but it is something investors might want to keep in mind.
Even after taking these risks into account, I think Phoenix has all the hallmarks of a great income play. As such, I’d buy the stock for its 8.5% dividend yield (rising to 8.7% next year).
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