2023-10-17 16:47:12 ET
Summary
- Variable annuities, which offer stock market participation, may become more favorable in an environment of loose money and higher inflation.
- Jackson Financial has generally been #1 or #2 in overall U.S. annuity sales over the last 10 years. It stands to benefit from a secular tailwind of retiring Baby Boomers.
- I explain why Jackson is not really trading for an extremely low valuation multiple and how investors can derive a realistic multiple.
- Jackson is trading with an estimated forward-looking capital returns yield of 18% to 20%. I see 40% upside in Jackson on capital returns alone. This is a significant value opportunity.
The Secular Tailwind for Variable Annuities
This is less apparent to the typical Seeking Alpha reader but the majority of people saving for retirement are better off with annuities. They don’t know anything about stocks and are driven by their emotions to sell when they should buy and then buy when they should sell. This simple reality that I have seen firsthand, time and time again, gives me confidence in the future of annuity sales, especially as the large Baby Boomer generation is now in its primary retirement phase.
The Life Insurance Marketing and Research Association (LIMRA) noted the following:
" The average age of an annuity buyer is in their early 60s with the majority purchased between ages 55–70. According to Oxford Economics, the U.S. population aged 65 or over is expected to grow by more than 8.3 million from 2022 to 2027. "
Annuity sales should generally have a tailwind looking out the remainder of the decade.
My longer term view of the investment landscape is one of financial repression where the Federal Reserve will have to monetize the U.S. Government’s reckless spending and unfunded liabilities. This environment will be characterized by loose money and higher inflation which will be bad for bonds and okay for stocks generally. I suspect that this environment will eventually favor variable over fixed annuity sales because variable annuities generally offer holders a measure of stock market participation. A 1997 National Bureau of Economic Research (NBER) paper titled, The History of Annuities in the United States , noted the following:
"Variable annuities, by design, address the risk of purchasing power erosion that is associated with fixed nominal annuities. Unlike fixed annuities that promise a constant nominal payout, variable annuities provide an opportunity to select a payout that bears a fixed relation to the value of an asset portfolio. If these assets tend to rise in value with the nominal price level, then the payout on the variable annuity will adjust to mitigate, at least in part, the effects of inflation. Because variable annuities are defined in part by the securities that back them, they are more complex contracts than fixed annuities. In spite of their complexity, however, they have become one of the most rapidly growing annuity products in recent years."
Variable annuities have the potential to provide investors with secure income and a measure of inflation protection.
Jackson Financial
This brings me to Jackson Financial ( JXN ), the largest variable annuity company in the U.S. Over the last 10 years, Jackson has generally been #1 or #2 in the U.S. annually in overall annuity sales (fixed, indexed, and variable). This strong run as a market leader fortified Jackson’s deep distribution network and reputation for strong customer service. This fact should not be minimized. It means that Jackson has the wherewithal to sell any kind of annuity successfully that the marketplace demands.
Jackson’s annuities are sold by financial professionals to mostly retail customers (~85%) but it is also increasingly getting into the institutional business where its annuities are included in Defined Contribution, employer sponsored retirement plans (e.g., 401k, 403b, etc.). This latter market is one that I love due to the fact that Defined Benefit pension plans are now all but dinosaurs and the vast majority of Americans will increasingly have to rely on Defined Contribution plans to build their own pension plans. Add to this, Social Security is becoming increasingly unreliable longer term. (I personally will never retire if it means that I have to rely on Social Security at all for income.) These products allow 401k participants to transform their plans into personal Defined Benefit plans. Jackson's institutional business is not going to move the needle on earnings at this point but it is worth watching over time and perhaps an organic growth opportunity.
Jackson makes its money primarily from fee income on annuities and income from its investment portfolio which backs its policy and contract liabilities. It employs derivatives to hedge the economic liability associated with market movements impacting its variable annuity policyholder benefits and to also protect its statutory capital (similar to banks, insurance companies are required to hold a certain level of risk based capital). It does not use derivatives to hedge against market movements that impact its GAAP liabilities. In other words, Jackson uses derivatives to hedge against negative market movements that would impact its ability to pay policyholder benefits and to avoid having to raise excessive amounts of capital. It does not hedge against market movements that cause its GAAP earnings to swing wildly (which they do). Said even more simply, Jackson hedges against real capital risks and does not attempt to smooth out its reported earnings. Such activity leads to a recent earnings history like this:
Here you can see that over the last 2 years, quarterly earnings have fluctuated between $2.52 and $7.48 which is a huge range.
Jackson reports what it calls “Adjusted Operating Earnings” which is an estimate of its core business earnings excluding the changes in its derivative investments. Over the last 3 years, Adjusted Operating Earnings per share were $27.81, $25.38, and $16.27. Jackson currently trades for ~$40 per share so on the surface we have a stock with a price to core operating earnings ratio in the 1.5 to 2.5 range. Since being spun off by Prudential ( PRU ), the stock has consistently traded in this range, as shown on the following weekly log chart:
What is going on here? Why does this stock look so cheap on the surface?
What it comes down to is that there is a hidden hedging cost to maintaining capital stability and this is difficult to glean from the financial statements. Here is one way to go about determining what Jackson is really earning for shareholders. For 2021 and 2022 combined, Jackson had a net cash increase (end of the Cash Flow Statement) of $2.3 billion. If I add back the cash they used to repurchase shares and pay dividends (capital returns to shareholders), I get $3.05 billion. However, Jackson took in $2.3 billion of cash through net increases in its amount of long-term debt outstanding so if I back this out I am left with $768 million of actual net cash generation— the exact amount they paid to shareholders through capital returns . This $768 million or $384 million per year is the number that we should be looking at on a per share basis to gauge what Jackson is really earning for shareholders. This translates to an average of $4.24 per share putting Jackson currently at about 9.6 times average 2021-22 real earnings. The armchair analysis on various financial websites saying that the stock is trading for 1 or 2 times earnings is not really accurate.
Looking out 12 months, and using my target multiple of 8 for the stock under a Moderately Bearish outlook (not really bearish but playing it safer with a lower multiple target due to the opaqueness of the hedging costs), I get a target price of $56 which represents 40% upside. The forward dividend yield is also 7.2%.
My outlook assumes no operating earnings growth at all and that the company can simply continue paying out $500 million of capital returns each year ($300 share repurchases / $200 dividends). What actually happens under this scenario is that share count reduction drives annual earnings growth of 13%+. At a constant valuation of 8 times capital returns per share, the stock would almost triple over the next 10 years.
$500 million of annual capital returns is $5 billion over a decade (and ~1.5 times the current market cap). Here I would like to point out that Jackson’s 2021 Analyst Day Presentation mentioned that the company, when it was part of Prudential, paid out $4.2 billion of shareholder dividends from 2011 to 2020 (i.e., $420 million per year on average). Moreover, Jackson has been on this pace since it went public, as the following slide from a recent earnings presentation reveals:
The patient investor who rides out the volatility should do very well from capital returns alone. However, there is also the potential that hedging costs will decrease. Higher interest rates decrease the amount of hedging that Jackson has to do as the following slide details:
Higher interest rates reduce the present value of Jackson’s long-term policyholder liabilities and this is a positive contribution to its capital position.
Higher volatility increases hedging costs. Stock market and interest rate volatility skyrocketed in recent years as the Fed took Fed Funds from 0% to 5.5% in a little over a year and the stock market had a significant decline.
Hedging costs could come down in a new higher interest rate regime with less volatility. This could represent additional upside but I’m not counting on it.
Interesting Potential Kicker
Jackson's latest quarterly earnings call included the following interesting Q&A between analyst Tom Gallagher from Evercore ISI and Jackson CFO, Marcia Wadsten:
Tom Gallagher
And then my follow up is just on the discussion with the Michigan regulator. I just want to get a sense for what are you -- I assume it's some kind of negotiation, but what is your wishlist? Because I look at the positive GAAP reserves, meaning it's a net asset now, I think, it's several billion. You have a non-admitted asset in a DTA that I think you said was 2 billion. Would the wishlist be to get all of that added back to TAC? Because if you did, I would assume your RBC might double or something like that. What's kind of a realistic outcome and what are you aiming to accomplish? Like, is it to fully align the economics where you can, where the movement in reserves looks more like GAAP, or do you think it's going to be some lesser version of that?
Marcia Wadsten
Tom, I think our -- rather than a wishlist in terms of what form it takes, I'll just sort of start with what is our aim here. So we are looking for a solution that allows for better alignment between the movement in our liabilities and our assets. And the key reason for that is sort of two outcomes and thinking of these as important benefits on a go forward basis. First is that that would allow us to make sure that our hedging is actually much more focused on the economic risk and that we're having to do less non-economic hedging against the framework element within the statutory framework being the cash surrender value floor. So I think that would create the opportunity for more efficient hedging, which is a great outcome in terms of the ability to use a lesser amount or spend a lesser amount of the fees we collect for that purpose. And then the second benefit going forward is that we're looking for something that we think will allow for the economics of our business to be more clearly recognized and reflected in our financial results, so that we just have more intuitive results for anyone who's looking from the outside and trying to understand how things are moving and why they're moving in the directions that they are. So that's really our goal is looking for an opportunity to not have this sort of artificial floor in the reserves in a way that creates all of this sort of noise and understanding the results as well as creates the need for some non-economic hedging spend. And the paths to get there probably are many and those are the things that we're kind of in discussion with at this point .
To translate all this, Jackson has been having discussions with its State of Michigan regulator about how current regulations require it to carry more capital than it actually needs to and also requires it to do more non-economic hedging. The tone of this conversation implied that some sort of positive outcome is likely. This could mean the following to some extent:
- Potentially more excess capital available to ultimately leak out to shareholders.
- The stock is currently trading at about .85 times its latest reported Statutory Total Adjusted Capital of $3.8 billion so if Tom is right the stock could theoretically double.
- Reduced hedging costs.
- The real valuation of the stock would be more transparent to the investment community which would likely lead to a higher long-term multiple range.
To be clear, I'm not baking any of this into my outlook, but I love to have some upside surprises in my back pocket.
Key Risk
Look closely at the price chart of JXN and you will notice a correlation with the broader equity market due to the nature of its core product, variable annuities, being invested in equity funds. A material decline in the broader U.S. stock market eats into Jackson's capital position, however, it does hedge against this. There is a risk that its hedging program fails to offset this risk enough. The greater or key risk is that a deep and extended downturn in stock prices leads to a significant slowdown in variable annuity sales which impacts Jackson's free cash flow available for capital returns to shareholders— core to my bullish case.
Strategic Conclusion
I recently heard an interview with someone who used to work with legendary investor, Stan Druckenmiller. He said Stan’s great talent is to determine the one thing that will move a stock or asset. (This is essentially the same approach that I have always taken.) Capital returns is the thing that I think we need to focus on with Jackson. The 2024 forward shareholder yield is currently 18% assuming the company repeats its mid-range 2023 capital return guidance in 2024. Given the pace of share reduction, this climbs to 20% in 2025 if the share price does not rise. I see significant upside from capital returns alone and massive upside if annuity sales accelerate.
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Jackson Attractive On Capital Returns