JXN - Jackson Financial: Risk-Reward Is Becoming Exceptional Again

2023-05-16 08:44:59 ET

Summary

• Jackson Financial has had a volatile 2023 so far. After shooting up in the beginning of the year, the stock has come down rather dramatically again in recent weeks.
• Even taking into consideration a soft start into Fiscal Year 23 and disappointing annuity sales, the sell-off can only be partially attributed to business fundamentals.
• In the aftermath of what seems to be a rather resilient and consequential banking crisis, sentiment is very bad for anything Financial, including Jackson.
• The company has actually increased its dividend and has just re-affirmed its commitment to a capital return target of $450-550 million.
• After a steep decline following Q1 earnings, JXN at $29 is trading at a roughly $2.5 billion market cap, implying a ~8.6% dividend yield and a ~11.2% buyback yield.

After having published an article on Jackson Financial ( JXN ) at the start of the year and with the stock once again trading at very attractive levels, I think it is time for an update.

My core thesis and why I have owned Jackson stock for a while now was the following: Jackson Financial is a misunderstood yet actually decent business operating in a difficult industry, whose true business value is obscured by nasty US GAAP mark-to-market accounting of their hedges, which are a requirement for the business they operate in. I have also stated that I believe that there is long-term upside in being a top retirement service provider for an ever-aging US population. In this update I want to outline why I am not worried about JXN´s recent performance and why I still believe in my long-term thesis.

It has been a roller-coaster so far this year with JXN shares, which shot up more than 30% within a month at the start of 2023, which admittedly was a strong period for many kinds of stocks. However, the rally suddenly ended with the release of the company´s Q4 2022 earnings , which was promptly followed by the SVB fiasco, the first domino in what can be described as an ongoing US banking crisis. This put further pressure on sentiment, which we can measure for example by looking at the SPDR S&P Insurance ETF (KIE). This broad financial and insurance index quickly declined from a high of $44 in February to roughly $38 a couple of days later in March, and is still underwater since then. For individual companies, charts look even more brutal. Annuity businesses in particular have not been spared, with Jackson peer Brighthouse Financial, Inc. (BHF) down ~30% from its February highs, Lincoln National Corporation (LNC) down ~42%, and Jackson itself at minus 40%. This sort of decline in an industry within a couple of months is rare, and it spells opportunity for JXN stock in my eyes. But before I go into that, I want to acknowledge why the market might not have been pleased with JXN´s operating results in the last two quarters.

The Bad

Declining Sales

Jackson´s annuity sales are declining year over year, with full year 22 sales at $15.7 billion, down 19% from full year 2021. This is still a healthy level, and 2021 was a record year. However, in light of a booming overall annuity industry with growth in 2022 as well as in 2023, this is clearly unsatisfactory. The most recent quarter indicates a continuation of this dynamic, with first quarter 23 annuity sales of $3.1 billion versus $4.7 billion 12 months ago. Why is Jackson underperforming so dramatically versus the overall industry?

The answer can be found in the product mix. JXN is really only a leader in Variable Annuities, i.e. annuities that may be linked to a market or an index and generally offer more upside potential to customers. The crux is this: For more upside participation, the customer accepts more downside exposure. With broader bond and equity market declines since 2022 and especially with the heightened volatility and uncertainty of the current situation, this model is really not as appealing to a potential annuity buyer as it would be in a bull market. The effect is amplified by the fact that we currently have real interest rates at ~5%, something that simply was not there for a very long time. Yes, that is still lower than inflation, but it is not such a bad deal when you consider the risk embedded in alternatives like equities. As stated in the article linked above, many customers at the moment simply want to "lock up" favorable interest rates while they are there. And for this purpose, they are not buying the riskier variable annuities, which might offer more upside in the long run. They are buying fixed annuities with minimal risk, which really are responsible for the boom in the industry and, unfortunately, only make up a relatively small part of Jacksons product mix, as the company has heavily bet on the Variable Annuity concept in the last decades. Other players in the industry with more exposure to Fixed Annuities reported sales growth that were in line with industry trends. Brighthouse Financial, for example, disclosed year-over-year annuity sales growth of 35% for Q1 23 on 8th May.

We can see this unfavorable product mix in the numbers, and JXN itself explained it the following way in its Q1 press release :

Variable annuity sales were down 46% compared to the first quarter of 2022, primarily due to the decline and volatility in equity markets and shifting consumer preferences in a higher interest rate environment.

Fixed annuities, by contrast, are rapidly growing albeit from a small base:

Fixed and fixed indexed annuity sales in the current quarter totaled $133 million, up from $23 million in the first quarter of 2022.

This goes to show that, for the time being, Jackson is not optimally positioned to take advantage of current customers´ preferences. We see growth in their fixed annuities segment, yet that is hardly enough to offset the drop in demand for Variable Annuities.

Weaker Earnings

If you read my first article on JXN stock or if you are generally familiar with the industry, you will know that GAAP earnings swing wildly for these kinds of businesses, and this is what happened this quarter. JXN recently screened at something like a 0.5 PE ratio, but the reality is that has been GAAP unprofitable for the last two quarters and lost ~$18 dollars per share on a GAAP basis in the recent quarter. I have outlined why I do not care too much about this number. It is an accounting peculiarity in this industry more than it is helpful in providing useful insight into current business conditions. Notwithstanding, Adjusted Earnings, which are favored by management as a proxy for the underlying economics, are down as well:

Adjusted operating earnings of $271 million, or $3.15 per diluted share, [are] down 28% from the first quarter of 2022 reflecting the decline in annuity account values and higher interest crediting rates on variable annuity fixed rate options in the first quarter of 2023.

This statement can be broken down into two parts. The part about "higher interest crediting rates on variable annuity fixed rate options" refers to the fact that JXN has to pass on higher interest rates to certain policyholders now, largely driven by increases in interest rates as measured by the five-year treasury bill. While this was a headwind this quarter according to JXN, interest rates payable on these options are now near the cap of 3%, meaning even further increases in rates would not translate into higher obligations. In case of flat or easing interest rates, these expenses would come down again accordingly. The second part of the statement is about the decline in annuity account value, meaning that assets JXN administers on behalf of its client base have by and large decreased in value:

Total annuity account value of $219 billion decreased 10% from the first quarter of 2022, driven largely by lower equity markets over the 12-month period. Compared to fourth quarter 2022, total annuity account value increased 4% due primarily to higher equity markets in the current quarter.

Now this is unsurprising, considering that generally bond and equity markets have come under pressure following rate hikes starting in 2022. It also goes to show the Asset-Management component of Jackson, which earns asset-based fees in proportion to the wealth they steward for their customers. It is really JXN´s massive 200 dollar plus Asset-Management tail which creates ongoing profits and capital to allocate for management. As such, this component to me is much more an indication of "Operating Earnings", and I think it is way more useful to look at instead of focussing on short-term recorded derivative movements. This is also a rather stable figure in JXN´s case as opposed to their GAAP profits. Unsurprisingly, given the decline in account value, JXN recorded fee income of roughly $1.9 billion, a 5% decline year over year.

As we can see, momentarily, JXN´s business is in decline and the company is lagging behind on industry growth trends. This can be largely attributed to their strong focus on Variable Annuities, which are currently out of favor. As Mr. Market thinks notoriously short-term, and sometimes disregards valuation, I think it is understandable why the stock came down a great deal from its February highs. However, let me now present the other side of the argument and why I am still convinced of my original thesis on JXN stock in the long run.

The Good

Industry trends come and go

Consumer preferences are notoriously shaky in nature, and Variable Annuities have been a very successful model over the long-term even if they are not currently en vogue. After a truly rapid rise, interest rates may very well come down again, increasing the attractiveness of Variable Annuity features against the backdrop of a long-term rising stock market.

At this valuation level, however, I do not think much of that is priced into Jackson, and I do not think much of that needs to happen in order to make an exceptional return with the stock. This is still one of the cheapest stocks in the market. Book value comes in at $8.1 billion as of Q1, Adjusted Book Value as provided by management is $8.6 billion. Pick your number, but when compared to a $2.5 billion market cap (multiplying 86 million shares outstanding with a $29 share price), this is still an amazing disparity. Also, let us take the recent softer than expected Adjusted Earnings figure of $271 million, which is down 28% year-over-year, and let us assume this figure will never grow again in the future. If we extrapolate 271 in a quarter to a full year we still arrive at $1.084 billion in annualized operating earnings, which is significantly below the recent historical average (see my first analysis for details). Divided by the current market capitalization, we still arrive at an unheard of 43% earnings yield, or a 2.3 PE-ratio, whatever you prefer.

With regard to capital return, Jackson Financial has just reaffirmed its capital return guidance for the year of $450-550 million, after having raised the dividend the quarter before by nearly 13%. As such, the company is returning roughly a fifth of its market cap in 2023, which is extraordinary relative to the market as a whole. We can also see that these capital return targets are well-funded, given the level of Operating Earnings and Risk-Based Capital Ratio between 425-500%. Risk-based capital requirements are minimum capital requirements for financial institutions set by regulators, and for reference, it is currently 460-480% for Brighthouse Financial, and 380% for Lincoln National, as of Q1 . JXN also has significant liquidity of nearly $1 billion in cash at the holding company, adjusted for an upcoming debt repayment later in the year. The RBC-ratio for JXN is down year-over-year, but not by any worrisome amount.

All of this should signal to the market that this is a prudently managed business with a strong capital position and plenty of liquidity to return to shareholders. Also, in my eyes, the market is giving hardly any credit to JXN´s increasingly successful development of the RILA-type annuity pipeline, a category which is currently sporting double the sales it had last year at $530 million. It is a small base for a company with the dimensions of JXN, still it is a successful new product category and in the early innings of growth. Furthermore, the market does not seem to believe that JXN´s management is capable to change product offerings in order to capitalize on recent trends while this very topic was addressed by CEO Laura Prieskorn on the recent earnings call :

We continue to position our product portfolio for future growth, implementing several changes to our traditional VA product offerings over the first quarter. These changes capture the benefit of the higher interest rate environment, offer attractive value to financial professionals and clients and are aligned with our pricing and return requirements.

Given Jackson´s strong track record and their brand recognition among customers (if there is something like a brand in annuities), I am convinced that potential annuity buyers will be inclined to look at Jackson´s future offerings which are perhaps more in line with current industry trends. With such an expanded offering, JXN should be able to capitalize on what is still a very favorable secular development in US demographics. According to Prieskorn:

We are witnessing the greatest surge of new retirees our country has ever seen with more than 10,000 Americans turning 65 every day, a number that will increase to more than 12,000 each day at its peak in 2024. When you add recent market volatility to the mix, the need for protected retirement solutions is reaching historic highs.

Sentiment

I think a large part of the sell-off can probably be attributed to the scare in the financial markets emerging from the Regional Banking Crisis. JXN itself addressed this topic briefly in the recent earnings call, which I think is a good sign and speaks to a management that is conservative, aware of risks and forthcoming with its shareholder base:

This quarter, we're providing greater transparency into our investment portfolio given the regional bank crisis and emerging commercial real estate concerns. These additional disclosures provide key metrics that highlight credit quality across our fixed portfolio and commercial real estate assets. [...]

Given the increased focus on the potential for a near-term credit cycle, we expanded this section to provide greater transparency, specifically around our exposure to regional banks and commercial mortgages. Regional bank exposure is limited with only $135 million in smaller regional banks. We had zero exposure to Silicon Valley Bank, Signature Bank and First Republic Bank and we had no exposure to Credit Suisse AT1s at any point during the first quarter. Jackson's investment portfolio remains conservatively positioned with only 1% exposure to below investment grade securities on a statutory basis, excluding funds withheld assets.

Jackson Financial, as I have outlined in my first article, is a financial business and essentially "long Credit", if you will. That translates to a certain tail risk that is not zero in case of severe financial carnage, if it were to happen. However, this is one of the reasons why Jackson is hedged, something they have been very successful at historically. Also, we can see from management´s commentary that JXN really is not in the business of taking on huge risks in its investment portfolio. If you can picture an Armageddon-type scenario where we see large-scale investment grade bond failures, then yes, this probably is not the investment to be in. But then, you should probably only invest in Gold anyway. The main takeaway should be that JXN is an experienced provider of annuities with a long history of managing various credit cycles. The fact that they are actively anticipating tightening credit conditions indicates that they are prepared for such developments.

Considering current concerns around Financials, I think it is also worth noting that JXN as an annuity provider does not carry any significant "Duration Mismatch" risk. It has long-term assets, yes, but the obligations are long-term as well and the assets match the liabilities. In addition, there is really no "bank run risk" with an annuity provider. The whole concept of it and why the annuity business is working is that customers give up control of their assets over an extended time period in order to receive certain benefits. These contracts for the most part do not allow significant withdrawal from the asset base, and there would generally be a fine associated with it for the customer, hence disincentivizing him to withdraw money outside of an orderly plan. However, I do not think any of this is relevant as long as annuity customers as a group do not get into a huge panic about the financial system in general, and there are currently no signs of that whatsoever. People who buy annuities generally trust the system and believe that their annuities are safe, and responsible providers like JXN ensure exactly that.

Higher interest rates

In my first article, I outlined how rising interest rates should benefit JXN´s business, because they should earn more on their assets over time and annuities should generally be more attractive to customers. However, I also did state that this is not on a 1:1 basis and that it is a double-edged sword of some kind. I think we have seen this play out with Jackson, as the extreme rise in interest rates over a short period of time coupled with high uncertainty has undoubtedly hurt Jackson´s flagship products, namely Variable Annuities. In the short-term, this leads to JXN losing market share. Variable Annuities are generally more attractive when people expect long-term upside, mostly from Equity Markets, an expectation that is often present during bull markets. We can also see how higher interest rates imposed some additional costs on JXN with regard to certain policies, although this effect should even out in the long run.

As a result, also considering some commentary from JXN CFO Marcia Wadsten on the recent earnings call, I would revise my thesis that higher interest rates are good for JXN to the extent that it is more beneficial to Jackson if rates are stable and higher, but not too high. A stabilizing interest rate environment and decreasing uncertainty with regard to equity markets would serve as catalysts for customers´ interest in Variable Annuities, which would lead to a recovery in JXN´s core business.

Conclusion

Why I am still optimistic about JXN stock

I think with JXN stock trading down heavily after its Q1 earnings release, investors have another opportunity to add to a high-quality business at really nonsensical prices. The market may have digested short-term disappointments from the recent data and JXN´s suboptimally positioned product mix in a shifting consumer preference environment. However, I think it is rather likely that these current headwinds are temporary and I see no long-term impediment to JXN´s ability to provide valuable retirement services to a growing US client base, which should be reflected in higher AUM, Operating Earnings and fees over time.

I still believe this is a severely underappreciated stock. It is without a doubt a volatile business, and I question whether it is a fruitful exercise to project what next quarter´s GAAP earnings will look like. However, if we look at the business long-term, I think the business trajectory looks just fine. An expanded product offering and also the recovery of the Variable Annuity which is uniquely disadvantageous at the moment should help JXN reach its long-term goals.

Until then, the company can keep buying back boatloads of stock at very cheap prices in the open market. I am really happy about the fact that JXN is such a serial acquirer of shares, because this will amplify the eventual recovery. As Warren Buffett has reminded us recently at the annual Berkshire Hathaway meeting, buybacks at the right price are a great thing, because it increases our interest in good businesses as a shareholder, free of cost. Additionally, you are getting paid to wait with JXN through a generous dividend that is a very high yield in and of itself. As I said, I am very content with the share repurchases, but think about it: If they decided to do all their Capital Return through dividends, this stock would yield almost 20%, effectively. I am convinced that if JXN were to screen with a 20% yield, more market participants would evaluate the business. But make no mistake, this is what you are getting from the company, just not purely in form of a dividend.

With these closing remarks, I will conclude that I am still very comfortable with my stake in JXN. I have added to my position after the recent sell-off and I re-iterate my strong buy rating based on a valuation that I regard as far too cheap.

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