LNC - Poor Capital Management Leaves Lincoln National Negatively Positioned

2023-09-06 22:24:21 ET

Summary

• Lincoln National's shares have lost nearly half of their value over the past year and will be removed from the S&P 500 due to poor performance.
• The company's primary problem is higher than expected mortality in its life insurance segment, leading to significant losses.
• Lincoln has mismanaged its capital posture, spending $7 billion on buybacks at high prices, leaving it unable to repurchase shares at the current low price.

Shares of Lincoln National ( LNC ) have been a poor performer over the past year, losing nearly half of their value. Adding insult to injury on Friday , it was even announced the insurer would be removed from the S&P 500 as its poor performance has left it with just a ~$4.5 billion market cap. With this year’s poor performance, LNC has the dubious distinction of being one of just 14 members of the S&P 500 trading lower today than when Lehman Brothers filed for bankruptcy in 2008, a distinction it will lose when it officially exits the benchmark index. Given this crescendo of bad news, it is certainly worth asking whether this could be an opportunity to get into a beaten down stock. I do not believe it is.

During the company’s second quarter , it earned $2.02, ahead of consensus , but lower than last year’s $2.13 in adjusted earnings. Fortunately, this quarter did not have the series of one-time items that have battered the company over the past few years, like market risk accounting changes which drove a $5.37 loss in the first quarter . While the company is earning money, it is not generating capital in a way that enables it to return funds to shareholders via buybacks.

The primary problem Lincoln has faced has been higher than forecast mortality in its life insurance segment. When it writes a policy, it assumes policyholders will leave a certain length of time, actuarily. When someone dies sooner than expected, Lincoln has less time to earn investment returns on premiums paid and takes a loss. Since the COVID-19 pandemic, Lincoln has seen deaths occur sooner than expected.

As a consequence, in 2022 , the company, in its annual reassessment of its assumptions, had to take a $2 billion charge to account for this, resulting in a $13.10 per share loss last year. A concern for investors has to be that these assumptions are revisited once per year, in Q3 for Lincoln. On the company’s last earnings call , management stated that the life unit continues to be weighed down by worse than expected mortality. There is a risk that we could see another unfavorable one-time item in the next release.

The challenge is that these items have significantly weakened the company’s capital position. As I noted in my piece last October , the company began last year with a risk-based capital position of 427% that had fallen to 400% by the middle of the year, a level that led management to significantly scale back repurchases even as they said they were “ comfortable ” operating there. The re-evaluation of its life unit dragged down risk-based capital further to about 380%, even as the company issued $1 billion in preferred stock to rebuild capital.

A company that was aggressively repurchasing stock for years was now forced to issue preferred stock in two tranches at 9% and 9.25%, quite expensive funding, to sure up its capital base. This speaks to how much the company has mismanaged its capital posture in recent years. It is worth delving into its share repurchase history for a moment.

Lincoln is a prime example of a company with a value destructive buyback. In the past ten years, it has spent $7 billion on repurchases—that is about 150% of the company’s current market cap to reduce the share count by about 36%. It bought back about 1/3 of the company for a price that could buy the whole company today and have $2.5 billion left over. That is because much of these purchases were done when the stock was over $60.

Due to these buybacks alongside poor operating results, the company has had to essentially halt repurchases and instead issue preferred stock. As it spent so much money buying stock above $60, it lacks the resources to buy it at $25. Lincoln is a critical example of how not all buybacks add value for shareholders.

At the end of the second quarter, risk based capital did not improve , staying around 380%, below a level the company felt comfortable operating, as its dividend and new preferred stock dividend drain capital, alongside some credit loss from the failure of First Republic Bank.

This leaves the company in a position where in needs to bolster its capital. That is why in May it announced a reinsurance transaction with Fortitude Re for 40% of its life business. By having reinsurance, its capital requirements go down, but it also is paying out a reinsurance premium. In essence, LNC is trading earnings power for better capital. This transaction reduces annual earnings by about $130 million or $0.76 a share but will boost its RBC ratio by 15%.

That still leaves RBC a bit below 400%, a level where the company had to essentially halt its share repurchase, assuming there are no unfavorable reserve adjustments. To get to a 425% RBC ratio, the company will need about $700-800 million of additional capital, which it can get through retained earnings. With $7 of run-rate earnings power after the Fortitude transaction, assuming nothing further goes wrong, the company could generate about $1 billion in capital a year. But it has to pay out about $250 million to fund its dividend and $90 million to fund its new preferred dividend, leaving $650 million of potential retained earnings. Of course, if it grows its business by writing net new policies, it will need to hold more capital against them. Realistically, it will take until the end of 2024 to mid-2025 to get capital up enough so it can resume buybacks.

And that assumes nothing further goes wrong. Last October, I was hopeful LNC was a year away from starting its buyback up again. Now, nearly a year later, it is even further away.

Yes, the stock trades at a large discount to its $58 book value, excluding accumulated other comprehensive income. This discount exists because the company’s poor capital position leaves it unable to return capital to shareholders via buybacks for a prolonged period of time. Moreover, there is likely skepticism that this book value can be fully realized as there may be more reserve adjustments that lead to impairments like the one last year, reducing book value.

There is a deserved lack of trust for LNC’s management given past capital missteps and reserve adjustments. Moreover, the company needs to rebuild capital rather than buy back stock. LNC is a long-term “show-me story” that will take a couple of years to play out. With an inability to buy back stock, I see no catalysts for meaningful improvement in the share price, and I do not see evidence there is a reason to believe the business’s performance is set to improve. LNC shares are likely to be dead money for a prolonged period as a result, and I would invest elsewhere.

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