APO - F&G Annuities & Life: The Stock Has Quickly Doubled And The Upside Is Less Appealing

2023-11-17 04:41:39 ET

Summary

• F&G Annuities & Life stock has doubled quickly, exceeding expectations.
• The Company remains the only independent fixed annuity provider in the US after the acquisition of American Equity Investment Life.
• FG has shown positive developments, including growing results, an informative Investor Day, and an increase in its regular dividend.

Those who followed my call to buy F&G Annuities & Life ( FG ) in " F&G Annuities & Life : Likely Acquisition Target With Projected 30%+ Annual Return" and " How To Benefit From Brookfield's Acquisition Of American Equity" should not be disappointed - the stock has doubled very quickly. Do not blame the author - I expected a more gradual ascend.

Some of my readers asked me to update my guidance. Here it is.

The short content of the two previous episodes

You can find the company description and investment thesis in my previous posts. Here I will just summarize the main points:

• F&G is almost exclusively a fixed (including fixed index) annuity provider with a single small life line. Its investments are managed by Blackstone ( BX ) which makes F&G similar to Apollo's ( APO ) Athene.
• Fidelity National Financial ( FNF ) acquired F&G on June 1, 2020. In December 2022, it spun off 15% of F&G shares to FNF shareholders tax-free. Starting from June 1, 2025 (after 5-year ownership), FNF can spin off the rest of F&G to its shareholders tax-free.
• After the acquisition of American Equity Investment Life ( AEL ) by Brookfield (the acquisition is expected to close in early 2024), F&G remains the only remaining independent fixed annuity provider in the US.
• Independent annuity providers have been targeted by alternative asset managers or big life companies for the last 10 years or so. In the last transaction, AEL was acquired for its book value ex-AOCI.

What has happened since?

Let me list the recent important developments besides the stock appreciation:

1. F&G keeps growing with the results exceeding expectations.

2. It was a very informative Investor Day.

3. F&G unexpectedly bumped its regular dividend by 5% not waiting for the end of the year (the company started paying dividends in Q1 23).

4. Its parent FNF has just announced an additional investment of $250M in F&G to be made in late 23 or early 24 without any further details.

Let us try to balance these signals.

Valuations

Our valuation was based on the assumption that upon full spin-off, F&G is likely to become an acquisition target at a price close to its book value ex-AOCI in line with the AEL acquisition price.

The slide above shows the progress on this front. Currently, BVPS ex-AOCI is $43.30 and it has grown ~6% year-over-year or ~7% counting dividends. We can expect an ROE of 10% based on the company's latest results that might make its BVPS equal to ~$55 including dividends on June 1, 2025. F&G's current price is ~$41 which implies ~13% IRR over the next 2.5 years. I will call it the base case scenario.

However, our base scenario warrants some caution because of 2 reasons:

On Jan 1, 2023, insurers adopted a new GAAP standard called Long-Duration Targeted Improvements ("LDTI", I will not plunge into the arcane details of accounting) which changed many line items including book values. For AEL, it raised the company's book value but Brookfield is acquiring AEL for its old, pre-LDTI book value or at a discount to its after-LDTI book value. In our calculations for F&G, we used its book value after-LDTI but I do not know how the new standard will affect the acquisition practice.

F&G is still not fully scaled up and produces a lot of accounting noise which the company calls "significant items". They can be positive or negative but are always unpredictable, sometimes big, and tend to distort earnings and ROE.

The slide above lets you feel the size of the "significant items". To estimate growth, we used ROE~10% excluding significant items but unadjusted ROE can vary depending on the size and sign of the "significant items".

These two issues make our prediction of a 13% annualized return shakier than otherwise.

Positive developments

FNF's announcement of an additional $250M investment in F&G appears bullish. It gives F&G a better chance to capitalize on high interest rates by issuing more annuities. Apollo did something similar when issued a new preferred stock several months ago and downstreamed proceeds to Athene. What can go better than our base case?

It seems unlikely that F&G can trade or get acquired above BVPS ex-AOCI. In my recent publication on Apollo , I showed that the market values superior Athene below BVPS (Athene generated ROE of 16-17% for many years with low accounting noise and an A+ credit rating vs A- for F&G and AEL). Consequently, the base case scenario can be beaten only if F&G can increase its ROE above 10%. Then F&G's BVPS including dividends in 2025 will be higher than the $55 we assumed.

Recent Investor Day does not leave any doubts that this is precisely what the company intends to do.

The slide from Investor Day shows multiple paths to rerating the company based on earnings multiples (I prefer to use BVPS multiples assuming the eventual acquisition). And investors have noticed: since Investor Day on 10/3/2023, the stock has appreciated $13 (from ~$28 to ~$41). Granted, some of the gains should be ascribed to the strong Q3.

Some of the upsides on the slide above seem more realistic than others. For example, strong asset growth is virtually guaranteed under the current interest rate environment. At the end of Q3, AUM was ~53B before flow reinsurance vs. $44B at the end of 2022 (in 2023, F&G started reinsuring a significant part of its fixed annuities flow to use its capital more efficiently).

Core margin expansion is quite probable as well. It should happen at least due to the scaling up of AUM as it will produce operating leverage. For a life insurance company, F&G is still rather small - its AUM is roughly 5 times smaller than Athene's.

The company is also hopeful of increasing its investment spread and generating non-investment income by investing in its distribution channels. This is more iffy, in my opinion, and remains to be seen.

As to multiple expansions on the slide, it is guesswork. A possible catalyst would be an upgrade of its ratings. Currently, 3 main rating agencies (S&P, Fitch, and Moody's) maintain an A- rating with a stable outlook. AM Best has an A- rating as well but with a positive outlook. The last upgrade by Moody's happened in July 2023.

The most encouraging sign of the progress is a gradual increase in adjusted ROE:

Every extra 1% in ROE should produce an extra 1% in annual returns for investors. Should F&G reach 12% ROE within the next couple of quarters, investors can generate something in the line of 15% until mid-2025. But again, these calculations disregard unpredictable "significant items".

Conclusion

F&G still has a lot of potential but it is somewhat undermined by the uncertainty of complicated accounting. I would also like to know more about the coming FNF investment. Is it in the form of common or preferred equity? It may affect the balance.

For those, who have already realized big gains, I suggest taking some money off the table. In line with this, I rate the stock "Hold" at this point.

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