XLF - Lincoln National: Seriously Undervalued At Peak Pessimism

2023-06-16 07:30:58 ET

Summary

• Lincoln National investors were battered. However, it likely reached peak pessimism in May as dip buyers returned.
• LNC's valuation remains highly attractive despite the recent recovery. Given its valuation dislocation, I expect the market recovery to help bolster better buying sentiments.
• LNC's price action is also constructive, with the underperformance against its sector peers at the most extreme levels since 2008, creating an exceptional mean-reversion opportunity.
• High-conviction LNC investors should consider the market's highly pessimistic positioning as a welcome signal to add more positions.

Investors of insurance company Lincoln National Corporation (LNC) have been hammered so hard in recent months that even bystanders like me are starting to consider whether dip buyers would ever return.

Despite all that doom and gloom that LNC bears have called out, LNC staged a bottom in early May, as dip buyers returned after its Q1 earnings release , as its recovery continued through this week.

With LNC's momentum reaching overbought levels, some dip buyers could be tempted to cut some exposure and take profits. However, I assessed that such cutting all exposure could be premature, as LNC's valuation remains highly attractive.

As seen above, LNC is trading at levels discounted significantly from its 10Y average, with the valuation dislocation reaching extreme levels in May. Despite the recent recovery, LNC last traded at a forward-adjusted P/E of 3.3x, as it recovered from a low of 2.5x recently.

Moreover, its forward dividend yield of 7.6% is well above its 10Y average of 2.6%, suggesting that investors are still highly pessimistic about LNC's recovery.

The market's pessimism isn't without basis. The recent banking crisis, coupled with the significant debt securities on its balance sheet, are sufficient reasons for investors to be wary. Furthermore, Lincoln National reported a $9.6B loss in its available-for-sale or AFS securities in Q1, significantly hitting its book value, including Accumulated Other Comprehensive Income or AOCI.

Keen investors should recall that Lincoln National reported book value per share of $33.89 (including AOCI), down 59% YoY. Excluding AOCI, it fell by 12%. Also, Lincoln National was affected by market volatility and operating challenges relating to impacts to accounting on market risk benefits and other fair value changes.

But, with dip buyers returning after its post-earnings release, LNC Bulls could argue that the market is likely looking past these challenges, given LNC's attractive valuation.

Management is also confident about its ability to turn things around. It's still optimistic about improving its " capital position and long-term cash flow profile." Management highlighted that the company is still on track to achieve a 400% risk-based capital or RBC ratio following the recent "$28 billion block reinsurance transaction with Fortitude Re." It also stressed that it's on track to enhance its free cash flow or FCF generation in 2024, with a near-term midpoint target of $400M in FY23.

While management's commentary is constructive, investors still need to assess its progress over the next twelve months. It's possible that management could be too optimistic about the improvement over its operational challenges if these headwinds prove to be structural.

The company has a diversified business spanning group insurance, life insurance, annuities, and retirement services. The significant market gyration has caused earnings volatility in its annuities and retirement services business. However, despite broad macroeconomic concerns, I believe the impact is likely cyclical, with the market recovery already underway.

In addition, investors could also be concerned with the commercial real estate exposure in Lincoln National's portfolio, as the downcycle in that market remains dicey, particularly in office properties. However, the company assured investors that its office exposure "has been proactively reduced, with limited near-term maturities."

Moving forward, I expect investors to focus more on its life insurance business. The company reminded holders that it continues to face headwinds from "COVID-related impacts." Management added that "elevated mortality relative to pre-COVID periods remains a current headwind."

I assessed that the structural impediments on its life insurance business are valid. However, management is also not doing about it. CEO Ellen Cooper stressed that management acknowledges that "the legacy in-force business puts pressure on free cash flow and GAAP earnings." As such, the company is working on improving its new business, focusing on capital efficiency while optimizing the in-force business. However, it's still too early to tell whether the progress could mitigate the structural impact on its life insurance business.

That said, I believe LNC's price action has passed a critical inflection point, suggesting that investors have likely priced in the worst of these headwinds. It's similar to the battering in the banking industry in March/April as investors looked past the commercial real estate exposure and the Fed's unprecedented rate hikes. While the hikes have placed Lincoln's AFS portfolio under tremendous pressure, it's reasonable to expect that the Fed could be reticent to continue its rapid rate hikes over the next twelve months.

While the dot plot from the recent FOMC meeting telegraphed a potentially higher terminal rate in 2023, it doesn't necessarily suggest that the Fed will "definitely" do it. It's still dependent on whether the data necessitates further hikes. Also, the possibility of another hike or two indicates that the previous pace of hikes since 2022 is unlikely to be repeated.

As such, I assessed that's what recent dip buyers in LNC have likely priced in: the worst selloff in LNC is likely over. But does it show up in LNC's long-term price action?

To be clear, LNC/XLF has been in a long-term secular decline over the past five years, suggesting that investors have consistently rotated out of LNC toward its Financial sector ( XLF ) peers at critical resistance zones.

However, investors can reasonably expect a mean reversion when the underperformance in LNC/XLF reaches an extreme. The previous two extreme selloffs in 2008 (global financial crisis) and 2020 (COVID pandemic) saw LNC revert with a vengeance subsequently.

I believe the current underperformance arguably rivals the selloff in 2008. As such, I believe it presents a remarkable opportunity for high-conviction LNC investors to average down and add more exposure.

Furthermore, LNC/XLF's price action has been constructive over the past two months. With the market recovery underway, I expect investors to take profit and rotate from the AI hype while assessing well-battered opportunities to look at LNC, given its highly pessimistic positioning.

It's hard not to be bullish at these levels if you are an LNC investor.

Rating: Strong Buy.

Important note: Investors are reminded to do their own due diligence and not rely on the information provided as financial advice. The rating is also not intended to time a specific entry/exit at the point of writing, unless otherwise specified.

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