JXN - Jackson Financial Isn't Quite As Cheap As It Seems

Summary

• Jackson Financial appears to be astonishingly cheap based on its earnings results.
• However, there is complicated insurance accounting involved and much of the earnings are due to interest rate movements and hedging.
• Jackson Financial may be a good investment, but investors should be aware of the volatility in earnings results.

Jackson Financial ( JXN ) has been showing up on investors' radars recently. The annuity insurance company was long a part of the British financial firm Prudential ( PUK ). However, Prudential spun the firm off in 2021 in an effort to refocus its operations more around growth opportunities in emerging markets.

This created a classic orphaned security situation. Existing Prudential shareholders got just one share of Jackson for each 40 shares they held of the parent company. As a result, most shareholders ended up with an inconsequential holding in Jackson and likely disposed of it. In addition, having Prudential listed in a different continent as Jackson led to a lot of shareholders that got shares that they didn't want to hold onto. Prudential quickly sold down its remaining shares in Jackson following the spin-off, as well.

Jackson shares initially traded poorly, as is common with this sort of spin-off. However, shares have now picked up momentum and moved to new highs recently:

Adding to these favorable spin-off dynamics, the stock is gaining momentum with quantitative screeners. For example, at the time of this writing, Jackson Financial is the top-ranked stock in the financial sector according to Seeking Alpha's quant system. Moreover, it is the #8 stock out of the thousands tracked by the quant overall:

Jackson Financial has scored an A+ rating in four out of five categories, and the A- in earnings revisions isn't bad either.

Looking at the trailing earnings numbers, it's not hard to see the excitement. Jackson's shares are trading at a rock-bottom P/E ratio while selling at a major discount to book value. Meanwhile, earnings have been growing, and shares are hitting fresh 52-week highs. There are a lot of positive factors here. However, let's dive in a little deeper.

Big Beneficiary From Higher Interest Rates

While Jackson Financial is reporting tremendous earnings, it's important to note that the company sells annuity insurance policies. These have intricate accounting, thanks to the variety of moving parts that create complexity when translated through GAAP standards.

An insurer gets premiums upfront from policyholders, and then owes a larger sum at a much later date in the future. Jackson's results will depend in large part on the returns it can get from its investments in both equity and fixed income products in the interim.

Not surprisingly, insurers tend to prefer higher interest rates. They can get higher returns on their fixed income holdings in a high rate environment. Furthermore, the future value of money declines in a higher rate/higher inflation environment, causing the future liabilities of the insurer to decline in real terms.

In its 10-K , Jackson Financial notes that:

"Interest rate risk exposure for variable annuities increases when the present value of expected future benefit payments increases.

The present value of expected future benefit payments increases due to factors including equity market underperformance, low interest rates, adverse policyholder behavior and increased longevity.

As a result, lower interest rates increase the present value of our variable annuity exposure and generally lead to increased hedging needs and associated costs."

This may sound confusing, but, in effect, when interest rates are low, Jackson Financial has higher effective liabilities. Furthermore, it has to take out more interest rate hedges when rates are low to ensure it can meet policyholder claims, which is a drag on profitability.

Now, let's flip this around. In 2022, interest rates enjoyed a historic surge. Since low rates are bad for Jackson Financial, we can apply the inverse. The company enjoyed a tremendous tailwind last year as rates soared, thus improving its future liability position and moving its hedging book sharply in its favor.

Later on, in its 10-K, Jackson notes that lower interest rates would adversely affect its financial results and that:

"The way we hedge optional guaranteed benefits of our annuities could cause significant variability in our U.S. GAAP accounting results".

And indeed, that is very much the case. The majority of Jackson's earnings volatility in a given year appears to be caused by the firm's hedging program rather than the underlying insurance business.

To that point, here are Jackson's GAAP earnings per share over the past four years:

• 2022 (first nine months): $71.73
• 2021: $33.86
• 2020: -$24.14
• 2019: -$13.16

Obviously, if the company could keep delivering results like 2021 or 2022, it would be an exceptionally cheap company. On the other hand, the company lost a combined $37 per share in 2019 and 2020. When considering the very low P/E Jackson trades at presently, remember that these earnings can swing dramatically to the negative when rates turn unfavorable.

This is the issue with using earnings per share to judge insurance companies with huge hedge books and interest rate sensitivity. Short-term results are going to be a highly magnified reflection of whatever direction interest rates are swinging at the moment. As long as rates are trending favorably, Jackson should post high reported GAAP earnings. On the other hand, when interest rates move back down, Jackson will likely return to reporting outright losses, perhaps of a considerable amount.

I'd also note that Jackson's book value has fallen since January 2022, in large part because higher interest rates cause the mark-to-market value of existing fixed income securities to fall:

Is it bad that the firm's book value has dropped significantly? Not really. This is common with insurance firms and banks that hold lots of bonds on their balance sheets in a rising interest rate environment. That said, investors should note that accounting is complex when a company can report $71/share in earnings and yet have its book value go down.

The Brighthouse Example

Jackson Financial isn't the only sort of company we've seen in this lane. Years ago, giant insurer MetLife ( MET ) spun off its annuity business Brighthouse Financial ( BHF ).

Brighthouse attracted a large value investor contingent, including David Einhorn, thanks to looking really cheap and having the favorable spinoff dynamics. And yet, Brighthouse has been a bumpy ride.

At one point, the company reported more than $40/share in earnings in 2020. On the other hand, it would go on to report a $70/share loss not too long thereafter. Trailing twelve-month earnings topped $20/share last year before recently moving back into the loss-making territory:

How has Brighthouse, the stock, performed amid such a roller coaster of earnings? It's been volatile:

Shares have recovered most of their losses but still trade below where MetLife originally spun them off at. In any case, having (at times) a very low P/E ratio didn't guarantee home-run investment returns.

Jackson's Bottom Line

I'm on the fence between a hold and a buy outlook for Jackson's stock. Interest rates are rising once again, meaning that the company should kick off 2023 with more favorable earnings. There are also the positive spin-off dynamics; it appears that shares are finding a more enthusiastic ownership base, and real momentum is building behind the company's story.

Jackson is returning lots of capital to shareholders as well. Shares yield 4.5% and there is a considerable buyback program as well.

At the end of the day, I just can't get past the weird earnings dynamic, however.

I bought into the Brighthouse story shortly after the MetLife spin-off and thought I'd found a very cheap stock that the market was missing. Instead, it turned out, I had failed to understand the complexity of the business model. I fear that once Jackson's reported earnings head back into negative territory when interest rates reverse themselves, we'll see a significant decline in the share price as well.

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