Good morning. My name is Ashley, and I'll be your conference operator today. At this time, I would like to welcome everyone to the Comprehensive Recapitalization Overview Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star, then the number 1 on your telephone keypad. If you'd like to withdraw your question, press the pound key. Thank you. Mr. Erik Helding, you may begin.
Thank you. Good morning, and thank you for joining us on CNO Financial Group's Recapitalization Overview Conference Call. Today's presentation will include remarks from Ed Bonach, Chief Executive Officer, and Frederick Crawford, Chief Financial Officer. Following the presentation, we will have a question and answer period. During this conference call, we'll be referring to information contained in yesterday's press release. You can obtain the release by visiting the media section of our website at www.cnoinc.com. This morning's presentation is also available in the investors section of our website and was filed in a Form 8-K this morning. Let me remind you that any forward-looking statements we make today are subject to a number of factors which may cause actual results to be materially different than those contemplated by the forward-looking statements.
Today's presentation contains a number of non-GAAP measures which should not be considered as substitutes for the most directly comparable GAAP measures. You'll find a reconciliation of the non-GAAP measures to the corresponding GAAP measures in the appendix. Now I'd like to turn the call over to our CEO, Ed Bonach. Ed?
Thanks, Erik. Good morning, everyone, and thank you for joining us today. We are pleased to discuss the significant steps we are taking to further improve our capital structure and shareholder value. Our strong operational and financial performance have positioned us favorably to execute on a recapitalization plan which we anticipate will lower our cost to capital and improve financial flexibility. This recapitalization plan is propelled by the strength of CNO's business strategy and performance. Before I dive deeper into the rationale, it's worth quickly reflecting on our business performance and current capital position noted on slide four. We are dedicated to the underserved and rapidly growing senior middle income market, which defines and differentiates us in the industry. We have been investing in the expansion of our distribution to this market while emphasizing profitable growth. This is continuing to yield solid sales and earnings results.
In the first half of 2012, sales grew nine % over the first half of 2011, and operating earnings were up eight % over the same period. We continue to generate and deploy significant amounts of excess capital with strength in both statutory earnings and cash flows sent to the holding company. Our strong financial position and our continued generation of cash and excess capital allowed us to continue to buy back stock at an accelerated rate. As previously announced, during the second quarter, our board of directors approved an additional $100 million for share repurchases, as well as approved initiation of a dividend program. These were significant milestones for CNO, marking the tremendous progress the company has made through some of the most challenging economic conditions in our history and also demonstrating confidence in our current and future cash flow and financial strength.
Even with the increased capital deployment in the second quarter, our key metrics of risk-based capital and debt to total capital further improved during the quarter, and liquidity at the holding company increased to nearly $200 million. These accomplishments have recently been recognized by the rating agencies, with S&P revising the outlook on our ratings to positive in early August and both AM Best and Moody's providing upgrades to our ratings within the last week. Turning to slide five. With the momentum we have in our strong operating performance, credit profile, and ratings progress, combining with favorable market conditions, we have the opportunity to further improve our capital structure and lower our cost of capital. As detailed in the press release we issued last night, the transaction is expected to be accretive to both EPS and ROE, with our diluted share count decreasing 12% as of June 30, 2012.
In addition to significant improvements in EPS and ROE, the transaction will further improve financial flexibility, push out near-term debt maturities, and rebalance our fixed and floating rate structure. Lastly, it is important to note that as a result of a privately negotiated agreement with Paulson & Co. to repurchase their convertible debentures at a discount to estimated market value, the transaction will significantly reduce the convertible overhang, which naturally leads to uncertainty over conversion timing or debt maturity and concentrated ownership. I'd like to hand it over to Fred to discuss the transaction and the impacts in further detail. Fred?
Thanks, Ed. Before jumping into the recapitalization plan, it's worth reflecting on our underlying capital strategy. The building blocks of the strategy include a capital base capable of absorbing market stress, maintaining ratios consistent with investment-grade ratings at the holding company, and lowering our overall cost of capital through proactive financing strategies and effectively deploying free cash flow. This strategy has yielded more specific capital targets, including leverage in the 20% range
RBC in excess of 350%, interest coverage of five times, and liquidity sufficient to service our required holding company cash outflows in excess of a year. Our announced recapitalization plan is guided by these strategic targets. For some time now, we have discussed recapitalization as a potential stairstep in terms of critical shareholder value metrics. Slide seven essentially pulls from our press release, which provides useful metrics on the impact of the recapitalization plan as if the transaction had taken place December 31st, 2010. Our plan is expected to lower our weighted average cost of debt by approximately 160 basis points. We're re-leveraging the balance sheet in part to redeem the majority of our convertible securities, reducing our diluted share count by 12% and springing forward our EPS and ROE. Our valuable tax asset and free cash flow are not impacted by the transaction.
In other words, the economic value of both our tax asset and ongoing free cash flow appreciate when considered on a per share basis. Of note, on a pro forma and diluted share basis, both ROE and book value per share benefit from our plan. We are very pleased with what has been accomplished in a short timeframe on the ratings front, capped off with AM Best upgrade announcement last night. We have briefed all four agencies on the details of our recapitalization plan. We expect the agencies to issue releases in reaction to our announcement. We are comfortable our plan is consistent with current ratings and outlooks and supports further positive actions. Slide nine provides a useful summary to understand more specifically the individual transactions involved in the recapitalization.
There are really three things that had to come together to make for an attractive opportunity: ratings, market conditions, and negotiations with Paulson Funds, the majority owner of our convertible debentures. Armed with Ba3 from Moody's and B+ positive outlook from S&P, we are tapping a sector of the credit markets where spreads have come in considerably. Our plan is to raise $900 million in the floating rate institutional loan markets and the longer-term bond market with staggered maturities. We have also obtained commitments for a $50 million three-year revolving credit facility for contingent capital and liquidity. With the proceeds, we are refinancing all of our senior secured debt at lower rates. Redeeming the 9% bonds requires a premium but locks in an attractive long-term rate, extends maturities, and reestablishes baskets that govern over future capital deployment after completion of what is effectively the repurchase of 36 million shares.
A critical component of the recapitalization plan is the repurchase of Paulson Funds investment in our 7% convertible notes. We believe this represents a good outcome, with CNO obtaining a discount to estimated market value by providing liquidity to a concentrated and sizable ownership position. Slide 10 simply lays out the pro forma capital structure. While we expect leverage to be up around 21% at closing, we anticipate there will be amortization and cash flow sweeps similar to our current credit agreements that will result in modest de-leveraging over time. We show here the traditional calculation of leverage and our 16.6% ratio as of the second quarter. We anticipate our leverage covenant will be substantially similar to the formula applied in our current agreements. The difference is about one percentage point, as shown in the schedules to our press release.
Turning to our debt profile, this was an important component of dialogue with the rating agencies. Our goals include lowering our weighted average cost of debt such that any additional leverage would have little impact to run rate free cash flow and coverage ratios. We also address financial flexibility, extending maturities, and restructuring cash flow sweeps, allowing us to better balance leverage and cost of capital. It's reasonable to expect an additional stairstep in our future as we progress towards investment grade. Having the dominant part of our capital structure floating not only acts as a natural low for long interest rate hedge, but provides greater flexibility should we elect to prepay or refinance in the future. I noted earlier that free cash flow is essentially uninterrupted by this plan. The core cash flow story remains the same.
We spent much of 2011 building RBC and holding company liquidity, with both now in excess of our capital targets. We view our current excess liquidity position over $100 million and RBC ratio above 350% as an insurance policy when considering the potential cash flows sent up to the holding company. As a result, we are maintaining our previous guidance on dividends to the holding company of $200 million-$275 million and share buybacks of $150 million-$170 million in 2012. I'll hand it back to Ed.
Thanks, Fred. Slide 13 demonstrates our strong record of execution. Towards the left portion of the timeline, you see a series of transactions that reduced risk and improved capitalization through reinsurance transactions and a spinoff of our former Closed Block LTC business. Concurrently, we began to improve our cost structure with actions taken to align our distribution and operations to better serve our target market. As we progressed to the center of the timeline, we were then able to focus on improving financial flexibility while lowering our cost to capital. Moving all the way to the right-hand portion of the timeline, as we began generating significant amounts of excess capital, we developed a balanced capital deployment strategy, returning value to our shareholders in the form of buybacks and dividends, while also aggressively paying down debt and continuing to grow our core businesses.
These actions have been noted, as Fred mentioned, by rating agencies with steady improvements in our ratings over the last few years. Turning to slide 14, I'd like to reiterate that CNO represents a compelling value proposition. We have been growing and have above-average growth potential as we are defined and differentiated by our market focus on the senior middle-income market, which is both underserved and rapidly expanding with the baby boomers now turning age 65. We continue to invest in expanding distribution, producing solid sales growth, and we have now a track record of stability and growth in earnings. We expect no interruption to our financial performance, capital generation, or ratings momentum with this transaction. This recapitalization plan is an extension of all of our accomplishments in the last several years as we continue to seek ways to provide value to our shareholders.
The plan is an opportunity for us to lower our weighted average cost to capital, improve financial flexibility and maturity profile, as well as reduce the overhang from the convertible debt while being accretive to EPS and providing a meaningful stairstep to ROE. Now we'll open it up for questions. Operator?
At this time, if you'd like to ask a question, please press star one on your telephone keypad. Your first question comes from the line of Randy Binner with FBR.
Great. Thank you very much. I guess the question from my perspective is on the remaining $93 million of the convert. Kind of just curious on why that was not brought in as part of this deal, if there's a potential to see a tender there, kind of any movement on the remainder of the convert.
Yes. Randy, it's Fred. There's really a couple of reasons. Why focus in on the Paulson ownership interest in the convert? There's really a few reasons. One is we could obviously negotiate a private transaction which allowed for both the discount that you see in the transaction, also certainty of execution. The problem, of course, naturally with a tender is uncertainty over what you'll get, what you won't get, certainly uncertainty over the premium that you're likely to pay to attract the bonds in. This gave us a chance to both execute on a discount and execute with certainty.
The other component that it addresses more specifically is those of you familiar with the 382 tax dynamics would note that this also serves to avoid the natural conversion of those shares and the change or shift in ownership interest that would go against the possible threshold levels associated with 382. While we have ample cushion in that threshold, anything we can do to further defend or reduce the risk profile is always a good economic outcome when considering the importance of the tax benefits to the company. When it comes to the remaining stub of the convert, just a couple of comments, we would view the potential repurchase of further converts as no different than we always do in terms of what's the highest and best use of our capital.
We're simply going to continue to generate free cash flow, and we'll make decisions as to what best to do with that capital, treating the convert stub period no different than any other option we may have in front of us.
Just a couple of follow-ups. First, I guess the discount, on a headline basis, obviously there was a make-whole. On a high level basis, it seemed like there was a premium to take out Paulson. The discount part was just to the fair value, and what was that % of the discount?
Yeah. The way to think about it is those of you familiar with convert pricing would note that there's three fundamental components to the pricing. One is so-called parity, or the value of the shares once converted into the structure and the share price as a result of that. The second is the economic benefit on the coupon payments that would be foregone if you were to retire the convert. In other words, owners of the convertible security logically are due another year's worth of coupon payments, there's a simple present value calculation to those economics. The third component of the pricing is the option value. Candidly, that option value is very small. It's small for the simple fact that we're trading so far out of the money. That is, as the stock price rises, that option value falls.
What you're really more fundamentally left with is the parity value of the convert and the present value of the cash flows due to a holder of the convert over the next year. It's essentially from that dynamic that we apply the discount. The way to think about it is eventually there will be a market transparent, if you will, pricing of the convert at which a discount will be applied to it, and that gives us confidence that the discount will fall through.
The discount, Randy, is 2.8% to that calculated market value.
All right. Got you. Just one more if I could. If you decided to do the 93 in a tender, would you be able to stick, do you think, with the capital return guidance you laid out before and still be able to call the 93?
It's sort of difficult for us to over-speculate on that point, but I would just make a couple comments. One of the unique natures of buying back a convert is the fact that it's treated in our ratios as debt, yet acts as a implied stock buyback, particularly when you're trading so far out of the money, up north of $9 a share, as we speak. Buying back the convert is somewhat more neutral, if you will, to your core capital ratios. I'd be mindful of those ratios. We talked today about what are the guiding principles that we try to manage to make sure we maintain ratings progression, which is critical to not only our business, but also the notion of an additional stairstep in our future.
We're always going to balance the accretive nature of buying back something like the converts with the balance sheet issues. Randy, we'll just take all that into account.
All right. That's helpful. Thanks.
Your next question comes from the line of Chris Giovanni with Goldman Sachs.
Good morning. Thanks so much. You both mentioned the ROE stairstep that this provides as well as the additional opportunity for another stairstep when you hit investment grade. Curious if the 8% ROE target that you guys have by the end of 2013, 9% by 2014, does that assume another stairstep from ratings upgrades, or is that purely off business growth, pricing actions, and then capital management?
Chris, this is Ed. It does anticipate contributions from all four of the levers that we've been consistently talking about. Profitable new business being layered on to managing our in-force business and maintaining growth and margins there, along with expense efficiencies and effective deployment of capital. We see those all continuing to contribute to a few more steps to get us to that 8% and then 9% ROE, as you noted, by 2014.
One other thing I'd add is in your early setup comment, Chris, this notion of I would rather the marketplace not view as a threshold point to further activity, i.e. lowering our cost of debt and our cost of capital as the achievement of investment grade in of itself. That's the goal. It's logical that as we progress towards that goal, there'll be opportunities to address the capital structure again. We're going to do what we announced here last night. I've read a few reports suggesting, hey, this seemed a little earlier than I thought.
If you think about it, when you're a company that's facing very strong market conditions in the capital markets with not only low interest rates, but a particularly strong bid on this sector of the corporate bond market, and a particularly strong bid on CNO's name, you have to really contemplate strongly whether it makes sense to lock in that longer cost of capital now when you have the opportunity. Particularly when you look out at macro conditions which may move against you over time. You don't want to be cute by half. As we go forward, we're going to look for the plain, simple economic opportunities to advance shareholder value, and we will pull the trigger on it if it makes sense. We're going to do it in a way that balances continued progressing on the rating side.
Okay. Appreciate those additional comments. This doesn't have any impact when the commentary you guys provided last quarter around sort of lower for longer interest rate environment. Obviously, this provides some hedging if rates continue to stay lower from a refinancing, but this doesn't alter any of those sensitivities you provided.
No, it doesn't.
Okay. Lastly, Ed, you had mentioned the onset of the execution of strategy began when you started with transactions on the Closed Block. Can you provide some commentary on how you're thinking about additional opportunities for your existing or the remaining runoff book?
Yeah, Chris. That is primarily housed in our OCB or other CNO business segment. They're, I think, quite similarly in one way to our former LTC Closed Block that we believe as we put in different price increases through changes to non-guaranteed elements that improve the economics and stability of that business, that it'll give us more flexibility and options to pursue other transactions, be that reinsurance or sales of parts of that business. That still is part of our toolbox in addressing OCB as well as adding value overall to CNO's EPS and ROE.
Thanks so much.
As a reminder, if you'd like to ask a question, please press star one. Your next question comes from the line of Paul Schranz with Evercore Inc..
Hi, good morning.
Morning.
I wanted to ask a couple questions about what kind of terms you expect on the
Term loan and the senior secured notes. Specifically in terms of what you expect any kind of sweep requirements to look like, also any prepay penalties or make-whole provisions you expect to face, and whether or not there'll be any sort of caps on restricted payments or kind of a bucket for restricted payments. Really, whether any of these features are going to be different than what you were looking at before.
Sure. Let me do this with you, Paul, and folks on the phone is first, on all of those, all very relevant questions, there's a extended marketing period of selling, distributing the bonds, and finalizing the term sheets, and we're just now starting to ramp up in that. Those of you who may be less familiar with the below investment grade market should take note of the fact that there is a period of time that ramps up to the eventual closing of these securities, including even some roadshow type dynamics. As we go through that process, you will see the formation of the terms and conditions solidify. We certainly come at it with the notion of what to expect. Let me give you some broad brush strokes on what to expect.
We would expect that dynamic on sweeps. The second would be, in terms of prepayment provisions. As I mentioned in my opening comments, we've skewed the funding towards floating rate dynamics to really address that very point, and that is to lighten the load of repayment penalty type provisions. What we would expect is certainly on the bond deal, we would expect customary make whole and redemption features substantially similar to the ones we currently have in our current high yield bond offering. When it comes to the floating rate institutional loan marketplace, you typically have what's called a 101 soft call, which means basically there is a modest prepayment penalty in the first year of those securities if you were to refinance at a lower rate.
It's meant to be sort of an ability for holders who get potentially refinanced very quickly after having bought into the securities to be helped out a bit through a small or modest prepayment penalty that quickly falls off as you get into the facility. Our expectation is as we go forward, it would be similar to today where we could retire those securities without penalty. In terms of the notion of a basket, I alluded to that in my comments in terms of what we were retiring. We would expect there to be a so-called restricted payments basket, which is sort of a basket that builds by virtue of cumulative income or cash flow over time and sets caps or creates an environment for limitations around cumulative buybacks and dividends over time.
It's meant to be sort of an ability for holders who get potentially refinanced very quickly after having bought into the securities to be helped out a bit through a small or modest prepayment penalty that quickly falls off as you get into the facility. Our expectation is as we go forward, it would be similar to today where we could retire those securities without penalty. In terms of the notion of a basket, I alluded to that in my comments in terms of what we were retiring. We would expect there to be a so-called restricted payments basket, which is sort of a basket that builds by virtue of cumulative income or cash flow over time and sets caps or creates an environment for limitations around cumulative buybacks and dividends over time.
Once again, while it's early days in terms of what we would construct there, we would look for it to be done in a way that allows us to manage our capital structure in a very efficient manner relative to leverage and use of deployable cash. I can't go into more specifics than that because we're really into the process of building out the securities, but we would take the same sort of philosophical approach to that type of a basket as we're taking to the sweeps to try to have that aligned. The last comment I would make, which you didn't ask, but I'll volunteer it, and that is covenants. We would expect the covenant package to be substantially similar to what we currently have today, with substantially similar room that we're currently enjoying in those covenants.
Obviously what we have as a company is the added benefit of stress testing, which has become obviously quite sophisticated in the industry and at CNO, to where we can really monitor those covenants in a way that allows us to feel very comfortable under stress conditions that we have the flexibility to move forward and continue to build the company. Okay?
All right. Thanks.
Your next question comes from the line of Sean Dargan with Macquarie.
Thank you, good morning. I was wondering if this changes your thinking of using non-life NOLs or if you have any update on that topic.
This transaction in of itself does not have implications for the current economic dynamics between our life and non-life tax position. Really for the simple reason that it has not really adjusted to a great degree our pro forma interest expense. I mentioned in my comments that there hasn't been any material adjustment in cash flows related to the new debt because of the lower coupon. You can imply from that there's not a material change in interest expense, it doesn't tend to alter the holding company dynamics.
I would say if there's a dynamic to address as it relates to tax, it would be what I mentioned in an earlier response to a question, and that is you have built up further defenses, if you will, from a 382 perspective by addressing the Paulson ownership interest and avoiding the potential shift in ownership that could result if those converts were to be converted and the ownership position spike up.
Thank you.
At this time, there are no further questions.
Thank you, operator, and thanks to all of you on the call for your interest and support of CNO.
This concludes today's conference call. You may now disconnect.