JXN - Jackson Financial: Undervalued And Underfollowed Market Leader

Summary

• Rising interest rates negatively impact GAAP earnings in the near term but improve profitability in the long term.
• The current valuation suggests that the market doesn't value JXN's underlying business fundamentals.
• Management's commitment to dividends and share buybacks will eventually help establish its name among investors.

Investment Thesis

After last year's spin-off from Prudential ( PRU ), Jackson Financial (JXN) has been actively expanding its name recognition among investors as it continues its quest to expand its shareholder base to boost its valuation. Although its ticker chart only spans 14 months, the company has been in operation for over 60 years, partly as a division of PRU, during which time it has become the industry leader in the annuities market, thanks to its unparalleled distribution network of independent financial advisors familiar with its brand.

Due to this novelty as a standalone company, relatively small market cap, lack of coverage, and news flow, the company remains underfollowed. Nonetheless, its governance quality, leading market position, and risk approach remain unchanged. These factors combined to create an attractive investment opportunity at a low price that will turn into double-digit gains as the stock market becomes familiar with the Jackson name.

Our buy recommendation reflects JXN's leading position in the fixed annuities market and its sizeable share in the market for variable annuities, powered by its robust distribution and market channels underpinned by a solid back office infrastructure.

Revenue Trends

The majority of JXN's earnings come from the management fees associated with its annuity products. This line item has remained relatively flat throughout the years, with minor fluctuations due to changes in the average value of annuity accounts, arising mainly due to changes in interest rates. JXN has to invest heavily in debt instruments to pay for its annuity obligations, whose value is sensitive to interest rate changes. Nevertheless, fluctuations in bond prices are, on average, less unpredictable than moves in equities markets, and this consistency helps to smooth out substantial fluctuations in JXN's fee revenue.

JXN needs to maintain large derivatives holdings essential to retain its capital base while catering to consumers with a higher tolerance for risk. These financial derivatives allow JXN to provide annuities with varying risk characteristics (including equity exposure), increasing its product offering and attracting new consumers.

Fair value changes of these derivatives are recorded in the revenue line, underpinning the revenue volatility picture of last year when equity markets tumbled from the previous year's highs. Despite upwards and downward swings in hedging instruments, the impact on cash flow is limited.

The graph below shows JXN's revenue by segment, demonstrating relatively flat Fee Income and much more volatile Net Gains on Derivatives driven by last year's market selloff.

Balance Sheet

As a safety measure against losses, financial institutions are required to keep a certain amount of cash and other quality assets on hand. These liquidity requirements vary depending on the type of institution and the nature of its business. With the present market turmoil in mind, management is confident that the company has enough cash to satisfy regulatory capital and liquidity requirements. Most of JXN's assets are invested primarily in high-quality corporate bonds, government securities, and mortgage-backed securities, enhancing its risk-based capital coverage. Most of its liabilities are contract liabilities to its policyholders and beneficiaries.

In recent quarters we saw both equity and bond prices go down, putting pressure on financial institutions' balance sheets, including JXN, whose capital was impacted by unrealized capital losses, offsetting its hedge gains.

Although higher interest rates negatively affect GAAP earnings in the short run through higher unrealized losses, the higher rates are expected to have a positive impact in the long run by increasing interest income on its debt investments. Higher interest rates also increase the attractiveness of annuity products. Until now, we see a limited impact on the company's operating cash flows, as losses remain limited to non-cash fair value measurements.

Dividend and Valuation

Dividends and buybacks show that management is confident in its ability to maintain its capital while providing shareholders with good returns. However, rating agencies have been concerned that management's commitment to returning money to investors may impede its capacity to maintain an adequate capital cushion in case something unexpected happens, e.g., an unforeseen adverse event impacting liquidity. Every financial institution has to walk this fine line, and the way management returns capital to investors is not at all troubling. Share repurchases and dividends are only a fraction of the company's operating cash flows, as shown in the table below.

Thus, the 6% dividend yield is not because the company pays out a lot of money but because the stock is undervalued. The forward non-GAAP P/E ratio (which adjusts for non-cash derivative write-offs) currently stands at 2.3%, 77% below the industry median. Its current market cap is a fraction of tangible book value. The shares are so undervalued that small share repurchases budgets are making a huge difference in share count. Since going public, the company bought 12.5% of the total shares outstanding, using merely $500 million. In fact, last year, the company generated enough cash to buy back all its shares. I think that this undervaluation of the market price will keep growth at double-digit rates for years to come.

Summary

JXN celebrated its first year as a standalone company last September. Still, its legacy goes back to the 1960s before being acquired by Prudential, where it prospered as a market leader in the annuity underwriting business. This allowed JXN to hit the ground running with no disruption in its insurance businesses or operations and no runoffs of legacy insurance policies despite market disruptions. Its dividend distribution and share buybacks are merely a continuation of its governance policy implemented when it was a subsidy of Prudential.

The high yield is not a result of a high payout ratio but instead of an undervalued stock. As JXN builds its name as a standalone company, I expect capital gains over the next 2-3 years with its strong fundamental growth and increasing dividend distribution.

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