Description

Charlotte, NC-based Brighthouse Financial, Inc. (BHF) is among the U.S. market leaders of life insurance and annuities (#12 based on assets, to be exact).  The Company was spun-off from MetLife, Inc. (MET) in August 2017 for multiple reasons:

1. By lowering its domestic insurance exposure, MET is trying to avoid being designated as a non-bank systemically important financial institution and thus limit regulatory risk and potential capital restrictions.
2. MET wants to reduce its exposure to the new DoL fiduciary standards that applies to products like annuities and life insurance (and limit more regulatory risk, a headwind to sales, and incremental compliance expenses).
3. The spin may unlock value for MET’s non-U.S. businesses, hopefully galvanizing a higher valuation multiple.
4. The U.S. Retail business is too large and with limited returns on capital for somebody else to buy it. 
5. MET and BHF would also say that this sort of spin would be good for the spun-off forgotten step-child (BHF) as well, as BHF could focus better on its core business and generate a higher valuation over time as a stand-alone company.

On the surface, BHF appears to be a relatively unattractive asset.  The core business generates sub-par returns on capital, and, with interest rates bumping along the bottom, growth in the intermediate period ahead is likely to be anemic.  In addition, the core business is somewhat volatile and, compared to its peers, relatively more subject to the vicissitudes of the broader equity and fixed income markets.  And, as mentioned, the DoL fiduciary rule could hamper future sales and add incremental compliance costs.  All this is true. 

However, BHF offers compelling value.  In my view, BHF is an attractive asset and is likely to become more valuable over time.  Key reasons to invest in BHF include:

• At 50% of TBV and 56% of BV ex-AOCI, the stock is absolutely cheap.  Relative to other insurance companies, the stock is relatively cheap as well.
• Capable management (all experienced MET alums).
• Beneficiary of rising interest rates.
• The stock price has sold off significantly since the spin, as MET shareholders, many of which are income oriented and others of which may just not want to own a stub stock, puked out their BHF holdings.
• MET still owns 19.9% of the Company, and it announced on November 1 that it plans on divesting its BHF ownership through an exchange offer, thus driving the stock price lower. MET did an exchange offer in 2008 to dispose of its stake in Reinsurance Group of America (RGA), which it did at a 10% discount to the prevailing price of RGA at the time.  It is possible that MET may dispose of its BHF stake at a discount, which may put additional short-term pressure on the stock price but will dissipate over time.
• The Company is well capitalized and the investment portfolio appears to be conservatively managed.
• The Company is trying execute strategies to shift its business mix away from the more macro-sensitive product segments, while also building the potential for margin expansion through expense initiatives over time. 
• The Voya Financial (VOYA) investment thesis is similar to that of BHF, and the VOYA investor base, in theory, should be attracted to the BHF story now that the VOYA thesis is playing out as expected.

The Company

During Q1 2016, MET announced a plan to divest itself from the majority of its U.S. retail insurance business, largely for regulatory reasons.  However, it does appear that MET capital returns, higher revenue growth, and share price should be strengthened by the spin over the intermediate period ahead.    Like all spins, MET and BHF are somewhat different business models, and as a result of the separation, both companies can better focus on their own strategic priorities.  In the long term, that phenomenon should eventually attract new investors, resulting in higher valuations for both stocks.

Thus, Brighthouse Financial was incorporated in Delaware on August 1, 2016 in preparation for the separation.  Apparently, MET was unable to find a buyer for the BHF assets, and in Q4 2016, it made the decision to spin-off BHF to MET shareholders.  MET shareholders received 1 share of BHF for every 11 shares of MET that they owned.  BHF was officially spun-off on August 7, 2017, and MET retained a 19.9% position in BHF with the promise of divesting itself of its remaining position within 5 years.  Then, in early November 2017, MET announced that it planned to conduct an exchange offer with BHF shareholders with no date nor exchange ratio yet determined.

Since the spin, BHF shares have declined by more than 20%, driven by a number of factors:

• MET shareholders received a small number of BHF shares, which many deemed unworthy of attention, causing some investors to sell the stub shares immediately.
• MET long-term business prospects are relatively more attractive.   
• MET pays a 3%+ dividend and has an active share repurchase program.  Any shareholders that focuses on capital returns would likely sell their BHF holdings, as investors are unlikely to get any capital returns until 2020.
• The MET exchange offer details are not yet clear, and many investors are skittish of getting nicked in the short-term by an unattractive exchange ratio.
• The impact of the DoL fiduciary standards is not yet known, which impacts BHF much more than MET.
• Returns on capital for BHF appear to be sub-par compared to the peer group.
• Sell-side support for the stock has been lackluster at best.
• Given BHF’s suite of products, the stock price should be relatively more levered to equity returns and interest rates, which make the stock price more volatile in comparison to its peers.
• Comparatively, BHF is less of a self-help story as compared to other insurance spins (e.g., VOYA).

Brighthouse has two primary operating segments:  Annuities and Life Insurance: beyond that, it has a run-off segment, which consists of products which BHF has ceased selling and which are managed separately.  These run-off products appear to be reasonably well-funded.  The Annuities business sells a variety of annuity products, including variable, fixed, index-linked and income annuities.  The Life Insurance business focuses on universal life and term life insurance. 

In the U.S. Annuity marketplace, BHF boasts ~6% market share and is the #5 player in terms of in-force business, but its sales are materially lower (~3% market share and is the #13 player).  Variable annuities represented almost 70% of BHF’s total annuity sales in 2015; however, that proportion now stands at less than 50%.  Variable annuity sales for the industry have been in decline since 2011 with MET boasting $28 billion in variable annuity sales – now down to $2 billion.  That being said, the loss of two key distribution relationships (discussed later in this report) has exacerbated this decline.  Fixed annuities also peaked in 2011 at $1.5 billion, which has since declined to $600 million.  Of course, it cannot be forgotten that potential future disruption associated with the DOL fiduciary rule may add another headwind to future sales.

In 2013, BHF commenced an active campaign to de-risk its investment portfolio by focusing on its new flagship product, the Shield Level Selector.  This is a single premium deferred index-linked annuity product that provides the customer with a certain level of protection against equity index losses.  Sales of this product increased 67% sequentially and 15% YoY in Q3 2017.  Over a longer time period, sales of Shield Level Selector have grown from $161 million in 2013 to $1.7 billion in 2016, now representing 36% of BHF’s total annuity production.  Overall, it appears that overall operating earnings from the Annuities segment should grow at a low-to-mid-single digit pace over the intermediate period ahead, assuming that equity markets are reasonably amenable.

Similar to the Annuities segment, the Life Insurance business will likely face lackluster growth.  BHF ceased selling whole life and variable life insurance in Q1 2017 and is now focused on term life and universal life without secondary guarantees.  The products halted represented more than one-half of Life Insurance sales in 2016.  From a liability perspective of the in-force insurance, 49% is in variable life insurance, 19% in term insurance, 17% in universal life, and 16% in whole life.  BHF is the #12 player in the United States for individual life insurance and has 2.7% market share for insurance in-force.  However, market share has declined as Brighthouse has pulled back from marketing certain product lines; 2016 market share for new life insurance issued stands at 2.6% in 2016, down 150 bps YoY.

While management intends to introduce new products over time, such rollouts will undoubtedly take several years; however, the new products being marketed by BHF currently have a better risk profile and are less capital intensive than the legacy products.  Over time, the in-force book is likely to shrink due to a narrower product portfolio and the distribution disruptions.  And, it will take some time for the shift in new business mix to impact other overall profile of the existing in-force block.

Beyond its core business of Annuities and Life Insurance, BHF does maintain a run-off block, consisting of structured settlements, funding agreements, corporate/bank-owned life insurance policies, and legacy universal life with secondary guarantees (ULSG).  The ULSG block was a MET-sold suite of products, while the other products issued by certain insurance entities that were passed on to BHF from MET as part of the spin-off.  ULSG is the most significant component of the run-off segment (45% of reserves). 

With the combination of the ULSG products and the other products, I estimate that segment pre-tax earnings should be around $300 million in 2017.  From this year on forward, run-off earnings should decline, which will pressure EPS but should free up capital and improve overall returns.  These products are conservatively hedged, but, of course, they remain susceptible to negative earnings surprises and actuarial change surprises.  Given the long-dated nature of these liabilities, I would expect the run-off block to decline at a low-to-mid single digit pace per year.

The “Corporate” division encompasses company overhead, interest expense, and the results of certain legacy international and U.S. direct policies.  This division should generate losses from the foreseeable future, but the losses should moderate over time.  The anniversarying of the separation expenses should help to boost EPS in the years ahead.  Corporate losses in 2016 and 2017 as a result of preparing for the spin were quite material.

As previously touched upon, one of the operational issues that should be negatively impacting BHF is somewhat lackluster organic revenue growth, as the loss of key distribution partners should inhibit sales growth.  Since 2012, MET’s annuity flows have been negative, and results have weakened incrementally due to the distribution disruption.  In February 2016, Fidelity Investments, which represented nearly one quarter of MET’s variable annuity sales and over one-third of MET’s total annuity sales in 2015, made the decision to stop marketing MET products as a result of MET’s announcement of the spin. 

Beyond the Fidelity issue, annuity sales were pressured in 2016 by the sale of MET’s captive agency network, MetLife Private Client Group (MPCG), to Mass Mutual in July 2016.  MPCG was responsible for roughly one-quarter of MET annuity sales in 2015.  However, as part of the separation, MET/BHF entered into a distribution agreement with Mass Mutual.  Individual life sales associated with MPCG/Mass Mutual fell by 28% in 2016 and are down by more than 50% in 2017 YTD. 

But, not all of that can be attributed to distribution challenges; BHF dropped variable life, whole life and universal life with secondary guarantees from its individual life offerings in Q1 2017.   Management is introducing new products and expanding distribution to improve sales, including a new variant of the Shield Level product through Wells Fargo and an index annuity offering via Mass Mutual.  However, top line growth in both Annuities and Life are likely to remain weak for a while.

One of the aspects of management’s strategy is to focus on cost reduction initiatives.  While BHF will likely incur higher costs in the near-term due to the tax separation agreement with MET, as well as operational costs associated with operating as a stand-alone public company.  As these tax separation agreement costs wind down by the end of 2019, these operational costs should decline.  Beyond that, management is taking a phased approach to re-engineering processes and systems across all functional areas, which is expected to occur through 2020.  After that time, run-rate operating costs should be even lower.

BHF’s business mix is highly concentrated in volatile business lines like variable annuities and, in its run-off segment, products like universal life secondary guarantee (ULSG).  In 2016, roughly 55% of revenues were derived from annuities, while the run-off segment, which is predominantly made up of ULSG business, contributed another 26%.  While the Company is looking to change its new product mix through new product introductions, it will take time for dependence on such business lines to lower materially.  In the meantime, however, the business (especially the variable annuity book) is levered to both the equity markets and to long-term interest rates, as demonstrated below.  Again, note that ~66% of earnings come from variable annuities (sensitive to equities and interest rates), 11% from fixed annuities (sensitive to interest rates), and 11% from ULSG (sensitive to interest rates).  On an overall basis, a 10% move in the equity market positively impacts EPS by ~6%, and a 100 bps in long interest rates impacts EPS by ~4%.

At the time of the spin, management disclosed some specific operational targets:

• Achieve a 9% ROE over the intermediate period ahead.  However, at the first earnings call, the Company lowered that goal to “8%-ish” because it ended up with more equity than it expected that it would as a result of the spin.
• No capital returns promised until 2020.  At that time, management plans to return 50-70% of cash flows to shareholders through dividends and buybacks.

From what is easily discernible, the management team appears to be of reasonably high quality.  All six managers of the core management team held senior leadership positions at MET, with four of them at the U.S. Retail business and two of them at the mother company.  Incentive systems appear appropriate, although the Company is forced to offer incentives to employees who forfeited previously awarded compensation in the transition from MET to BHF.

BHF has reported one quarter since the spin-off.  During Q3 2017, reported earnings beat forecasts, but operating fundamentals were weak.  BHF reported an operating loss of $5.64/share, but much of the loss could be attributed to non-cash items related to the spin-off.  Book value was not impacted by this loss, as there was a non-cash offset that flowed through equity.  Excluding the unusual items, BHF earned $2.45 in the quarter, well above consensus estimates at $2.12.  The EPS upside was driven by strong margins in the Life business and favorably mortality.  Variable net flows were negative to the tune of $1.4 billion and are unlikely to change anytime soon.  Fixed annuity flows were also negative at $218 million.

As mentioned, VOYA has a very similar investment thesis as BHF.  VOYA was a spin-off from ING, the Dutch financial services giant; ING was forced to spin-off its insurance operations as a result of the deal that it reached with the Dutch government and the EC when ING desperately needed capital during the Financial Crisis.  VOYA has been independent for a few years now, but the stock price remained mired in the gutter due to the fact that it had this troublesome Closed Block Variable Annuity (CBVA).  As a result, the stock price was trading at a significant discount to BV and BV ex-AOCI for years.

On December 21, 2017, VOYA announced that it reached an agreement to sell its CBVA business, along with its fixed and fixed indexed annuity businesses to Apollo Global Management, Crestview Partners, and Reverence Capital Partners.  After this transaction is completed (sometime in the middle of 2018), VOYA will be out of the non-retirement focused annuity business.  After the transaction is completed. BV ex-AOCI for VOYA will increase to $47.38.  As a result of the transaction announcement, VOYA’s stock price rose above BV ex-AOCI for the first time in its publicly-traded history.

The VOYA investment thesis is playing out as expected.  Valuation is less attractive on a BV basis as compared to pre-transaction, and many deep value investors who have been in VOYA for the past few years may be looking to exit their positions.  However, it would be logical for such investors to start looking at BHF as a replacement candidate for VOYA.  

Balance Sheet 

Like all insurance companies, BHF uses its balance sheet as a key part of operations.  The credit rating is investment grade (Baa3/BBB+) with a stable/negative outlook.  The debt maturity schedule is very reasonable with essentially all of its debt maturing in 2027 and 2047, and liquidity is very good at $2.0 billion.  There are no dividend payments or buybacks; as mentioned, BHF will not be returning cash to shareholders until 2020, at which time the Company plans on distributing 50-70% of earnings to investors in the form of dividends and buybacks.  Once that occurs, that means that the Company will be returning cash to shareholders at roughly 8-11% of market capitalization per year.

At year-end 2016, the risk-based ratio (RBC) at BHF was 525% and was subsequently improved to 650% at the time of spin, well above sector averages, as set forth below.  This corresponds to capital reserves in the variable annuity book roughly $2.3 billion above the CTE 95 requirement, consistent with management’s goal of maintaining a $2-$3 billion cushion above CTE 95.  However, despite the aforementioned high RBC ratio, it seems like the cash levels are not yet sufficient for management, as they plan to keep building capital until 2020, indicating that actual capital flexibility is less than what is implied. 

It appears that they will not be returning cash to shareholders until the capital reserves are north of $3 billion.  Given that the business should be generating cash flows to the tune of $1 billion/year, one would think that BHF would get there by the end of 2018.  But, management does not believe that to be the case, thus implying that the hedging program may eat up a fair amount of that cash as they build capital.  Nevertheless, it seems logical to me, however, that the Company is more likely to initiate a capital return policy sooner rather than later than 2020, given the prodigious cash flows associated with this business even in the face of this hedging program.  It seem like management is setting the bar low.

BHF’s investment portfolio is highly diversified and boasts a conservative allocation.  Roughly 70% of its fixed income portfolio is rated single A or above, while investment grade instruments represent more than 95% of the portfolio (which is above that of its peers).  In terms of specific asset classes, BHF’s portfolio is relatively more weighted towards U.S. government bonds, RMBSs, and mortgage loans, and it is relatively less exposed to corporate securities than its peers.  Average portfolio duration is 8.9 years.

BHF’s structured security holdings are generally conservative, with about 96% of the $14 billion portfolio rated single A or higher.  The mortgage loan portfolio is well diversified and appears to have strong credit protection.  Like its peers, BHF also invests in alternative assets with roughly 2% of its general account ($1.6 billion) allocated to this class, largely in private equity/venture capital funds, with the balance to a variety of hedge fund strategies.

Following the spin-off from MET, the investment portfolio will be managed by MetLife Investment Advisors for a fee.  This arrangement has a term of 18 months; once that time period is over, management believes that they will save on fees as it utilizes other external managers or brings investment functions in-house.

Valuation

Looking at BHF’s peer group, the company that exhibits the most similarity to BHF is Lincoln National (NYSE:  LNC).  This comparison is apt because both companies generate the majority of their earnings from their respective annuities businesses.  It should be noted that LNC trades at 1.1x book value, 1.3x book value ex-AOCI, and 10.0x earnings – a significant premium as compared to BHF’s valuation multiples due to the facts that LNC’s ROE is 10-11% and that it has an active capital return policy.

Both of BHF’s core businesses are capital intensive businesses that have low relative returns due to the absolutely low level of interest rates.  Of course, with higher rates, all life insurance companies should re-rate to higher levels.  That being said, given BHF’s targeted ROE of ~8% over the intermediate period ahead, it is logical that the stock should trade a discount to the broader life insurance peers. As a frame of reference, Voya’s return on capital targets are 9.5% - 10.5% for annuities and 7.5% – 8.5% for its individual life business. 

Nevertheless, it seems to me that this discount is unreasonably high given the comparatively narrower ROE spread between BHF and its peers.  Given that BV ex-AOCI takes into account unrealized gains and losses on the balance sheet, it seems to be the most appropriate valuation metric for BHF.  I slapped a 30% discount on BV ex-AOCI to address the ROE differentials (~25%), which generates a valuation of $91.  At this valuation, the stock would be trading at 0.8x BV, 11.1x earnings, and 0.9x BV ex-AOCI – certainly, not a heroic valuation.  Peer median averages for this metrics are 1.17x BV, 12.9x forward earnings, and 1.3x BV ex-AOCI.

As previously mentioned, there are a number of reasons that have caused BHF to trade at such a low valuation, some of them temporary, some of them cyclical, and some of them based on regulatory issues.  It is logical at this point for BHF to trade at a discount to its peers.  However, assuming that the Company generates an ROE in the 8% range, there simply is no reason for it to trade at ~50% of book value.  Over time, it should work out most of its issues, and investors will reward it for overcoming them.  To be truthful, I believe that investors will recognize this gross valuation discount as being aberrational and unwarranted sooner rather than later.  I also think that the concerns over the MetLife exchange offer are already built into the stock price by now. 

While it is true that volatile equity markets and lower-for-longer interest rates should negatively impact earnings, stocks as cheap as BHF are few and far between in today’s government-juiced market.  Given the cash generative capability of this business, I also think that BHF will start returning cash to shareholders well before 2020, which will attract a whole new investor who is completely ignoring BHF at this time.  Like VOYA, BHF is likely to allocate resources from its capital intensive businesses into new, less capital intensive businesses (i.e., retirement, employee benefits) over time and raise its overall ROEs.  Other tools at BHF’s disposal to improve ROE include share repurchases, expense controls, and freeing up tied-up capital.  In a market full of overpriced securities, this stock certainly appears to have a bright future.

Risks

• An extended period of low interest rates would negatively impact the stock.  BHF derives about one-third of earnings from interest-sensitive products, and a 100 bps decrease in interest rates impacts annual EPS by roughly $0.22.

• The equity sensitive products associated with BHF’s book accounts for roughly two-thirds of earnings; a 10% decline in the equity markets would lower earnings by roughly 6% -- more than triple the impact that its peers would experience.

• Economic recession and lower stock/bond prices could impact credit quality in the investment portfolio.

• Underwriting risk.

• DoL standard could have a negative impact on the ongoing shift in product mix.

• Unlike Voya and many other life insurance companies, there may not be any buybacks or dividends until 2020.

• BHF faces varied operational challenges, including a below average return profile, volatile business lines, negative flows in annuities, and distribution challenges.

Disclosure

My firm has long positions in BHF and may choose to exit our position at any time.

Catalyst

• Improved ROE
• Acquisition
• Value will out