Introduction
- BHF is one of the largest providers of annuities and life insurance in the US, with $150.2 billion of annuity assets under management (“AUM”) and $568.1 billion of life insurance face amount in-force.
- Spun off from Metlife in 2017, the stock has been very much unloved, falling steadily from its debut at ~$60 to a low of ~$16 in March 2020. It has since recovered roughly to pre-pandemic levels.
- Their primary product is variable annuities, though for the most part they are allowing their VA book to run off as they shift toward products like their new Shield annuities.
- With a difficult to understand business, significant perceived tail-risk, high macro-sensitivity, GAAP accounting rules that make profitability difficult to determine and no dividend to put a floor on the price, the stock has been unable to escape from its extremely low valuation.
Volatile GAAP Earnings
- The liabilities associated with Brighthouse’s VA business takes the form of guaranteed minimum payments to the annuity holder. As the the investments in the holder’s account earn returns, the probability that the assets will be insufficient to cover the annuity payments, and therefore Brighthouse’s liability, decreases.
- Variable annuities are a particularly risky product for the issuer because the risk (poor stock and bond market returns) can not be diversified away.
- Brighthouse uses derivatives to hedge its variable annuity block against adverse movements in equity markets and interest rates. Under GAAP accounting, these derivatives must be marked-to-market, while the liabilities they are designed to hedge against are not.
- This produces wild swings in reported earnings. When stocks do well and interest rates rise, the derivatives lose value and Brighthouse reports losses, often very large losses. In Q4 2020 on strong equity markets, Brighthouse reported an $11.69 per share loss, more than 30% of the share price of ~$36 in just three months.
- I believe it is losses such as these that, in part, discourage investors who do not understand the fundamentals of the business. Some bears have even pointed to the GAAP losses and made the argument that the business is doomed to perpetually lose money and erode book value.
- In Q1 of 2020 BHF reported GAAP earnings of $47.11 per share. With even a basic understanding of how variable annuities work, it is clear that BHF benefits from better, not worse, investment returns. With GAAP earnings showing the opposite, it follows that they are not an appropriate metric for the company’s profitability.
Valuation
- The obvious question, then, is what are Brighthouse’s earnings?
- In my opinion, there are three potential options: management’s adjusted earnings, distributable earnings, and cash returned to shareholders (with no dividends, this figure is equal to their share repurchases).
- Adjusted earnings were $10.19 per share in 2020 vs $9.58 in 2019. With the shares trading at ~$47, that makes for a very attractive earnings yield.
- The second, and my preferred measure of profitability, is distributable earnings. These are earnings that BHF does not need for reserves and that can be paid out as dividends or used to repurchase.
- BHF regularly releases projections for distributable earnings based on several different capital market scenarios. The following charts are from a report released in March.
- With separate account returns of ~16% in 2020 vs. ~16%, 20%, and ~10% for the S&P, Russell, and 10-year Treasury, respectively, separate account returns are pretty correlated with stock and bond returns.
- That being said, I would argue that 4% separate account returns from 2021-2030 is a pretty conservative scenario. Even using the bottom of the range for the scenario, BHF would be trading at ~10x distributable earnings. While this is not terribly low for an insurance company, it is still very attractive relative to the S&P which trades at ~24x forward earnings especially given the potential for considerable upside if separate account returns are higher.
- While it is true that these numbers still rely on accurate projections by management, they more or less line up with the cash that BHF has generated since being spun off.
- Per the Q4 2020 conference call, BHF’s holding company is currently sitting on $1.7B of liquid assets and expects an additional $800MM of dividend capacity from the subsidiaries in 2021. They also repurchased $1B of stock through February of 2021, bringing their total cash generated to $3.5B in a span of less than 4.5 years or just shy of $800MM per year.
- Based on management’s “upside” scenario, 9% separate account returns would provide ~$750MM per year in cash. With ~15% per year for the S&P 500 and ~4% per year for 10-year Treasuries since August 2017, a mixed portfolio probably would have delivered returns in the vicinity of 9%, indicating that management’s projections for distributable earnings are likely in the ballpark.
- The third and final way of thinking about earnings would be cash returned to shareholders. With no dividend, this metric basically amounts to their share repurchases.
- Between 2019-2020 BHF repurchased $915MM in stock and management also set a goal for $1.5B in repurchases between August 2018 through the end of 2021, and they have reiterated multiple times their intention to hit that goal.
- BHF then trades at ~9x FCF, assuming that their FCF is only enough to continue repurchasing at this rate, though the reality is that the share repurchases amount to less than half the cash they have generated post spin-off.
- Based on cash generation so far, management’s projections of distributable earnings, and the $2B of excess capital that BHF will have at year end after completing their $1.5B repurchase target, it seems highly likely that BHF could continue repurchasing at this rate, with potential for considerably more if markets do well.
- If you are not convinced by any of these metrics that BHF is undervalued, consider also the fact that it trades for less than 0.25x book value.
Safety
- The reality is that BHF is positioned for disaster. With loads of excess capital and no debt maturities until 2027, BHF has the flexibility to weather any storm. According to management, they could comfortably manage an ’08-like crisis.
- In fact, management’s position has been viewed as almost unnecessarily conservative. On the company’s Q4 conference call, most analyst questions revolved around the company’s liquid assets that by year end would total more than 50% of their market cap. One analyst referred to this cash pile as “the elephant in the room.”
- While that cash could potentially provide a lot of value to beleaguered shareholders, I sympathize with management’s decision to err on the side of caution. Particularly, I understand their concern about building a reputation of stability and balance sheet strength that will allow them to compete for business with larger insurance companies.
- With all that being said, at this point the signs indicate a strong economy (which in theory should drive strong equity returns) and an uptick in inflation, which should further raise stocks as well as interest rates.
- If the signs prove correct, then cash could really start to pour out of BHF as they have already built up their capital buffer. If management continues to prioritize share repurchases, with the stock trading where it’s at, the share count could be reduced very quickly.
Others Buying
- It’s also always nice to see people who should be well informed about the business buying.
- BHF is a top position for David Einhorn’s Greenlight Capital. He has followed BHF since before it was even spun-off. With his investment track record, history of cutting through complex accounting, and the fact that he sits on the board of a reinsurance company, his is a friendly face to see among fellow buyers.
- There have also been two times in the last few years that management has made large purchases: 31,441 shares by five members in August of 2019 and at the beginning of the COVID-19-induced market crash in March when eight members purchased 51,120 shares.
- Between the insider transactions and emphasis on share repurchases, it is clear management thinks the stock is a buy.
Conclusion
- The stock is cheap no matter how you look at it.
- Management is very conservative with regard to risk.
- Continued strong equity markets and rising interest rates could catalyze a large increase in cash returned to shareholders.