It is no secret that very few tailwinds have assisted insurance companies and banks over the last five years. These businesses have endured the Great Recession, the European Crisis and record low interest-rates amongst many other challenges. Distress and frustration breeds opportunity, which is why we believe that many of the most attractive long-term investments can be found in the financial sector despite the industry's strong stock performance in 2012. MetLife (MET) is the largest U.S. life insurance business with a growing international business, and the stock trades a deep discount to book value reflecting a level of pessimism, which we believe to be too great offering the investor opportunity to make money.
MetLife provides a variety of insurance and financial services products in the United States including life, dental, disability, auto and homeowners insurance among many others. MetLife operates in over 50 countries and is the largest life insurer in Mexico while holding leading positions in Japan, Poland, Chile and Korea. The company attempts to allocate capital to the business lines and geographies that have the highest rates of return. This risk management culture has helped the company navigate the rough waters of the last 5 years, and the company's success in continuing to execute on this strategic objective will be vital to the success of MetLife over the next 5 years.
As of September 30, 2012 MetLife had a book value of $57.90 per diluted share and excluding AOCI book value was $47.32. The company has 1.071 billion diluted shares outstanding and with the stock selling at $31.84, the market capitalization is roughly $34.1 billion. While this discount to book value is certainly extreme a large part of the rationale is due to the considerable leverage employed by the company, which has over $846 billion in assets as of 9-30-2012. Market movements in either direction can have huge impacts on MetLife's shareholders' equity and given the environment of the last 5 years, investors' have reason to be cautious.
While I personally don't believe that this amount of leverage is attractive or necessary, it is important not to overlook some very strong decisions that MetLife's management has made. Firstly, in 2004 the company hedged its investment portfolio against lower interest rates and the company has continued this policy up until now, protecting the huge portfolio's yield much better than most of the competition. Secondly, MetLife raised equity capital outside of the TARP program, and this stronger financial position emerging from the Great Recession enabled the company to acquire the attractive Alico business from AIG (AIG) in 2010. MetLife was already very strong in Latin America but this acquisition gives the company a wonderful presence in the growing Asian markets. Currently MetLife has begun to position itself for higher interest rates over the intermediate to long-term.
Given Federal Reserve Chairman Ben Bernanke's incredibly aggressive low interest rate policies it is difficult for many market participants to envision what the U.S. will look like when rates increase. Unprepared insurance companies with high duration investment portfolios could face severe losses due to their bond portfolios, but because insurance companies are regularly taking in premiums which can be invested, the companies will also be generating higher investment income in the future. MetLife targets a return on equity of 14-16% in 2016 and assuming interest rates stay low, the company still feels confident on the low end of that estimate. This relatively high ROE in comparison with others is largely a function of a diversified business model and higher leverage.
While the higher leverage ratios are a reason for the stock to trade at a discount to book value in this environment, it is also important to understand that this will give the company additional earnings power leverage when rates do indeed rise. The company is taking steps to reduce the overall risk profile of the company by exiting its banking and mortgage operations, and reducing the amount of capital intensive variable annuity sales. The bank has been a source of real problems for MetLife stemming from problematic mortgages, and then the disastrous CCAR process earlier in 2012 when MetLife failed the test, which was really designed for banks as opposed to insurance companies. The company is close to finally divesting the bank deposits to General Electric (GE) but it is unclear what this will mean for the CCAR process next year, and whether or not the company will be able to return additional capital to shareholders. MetLife believes that reducing its exposure to the volatile variable annuity business will help increase free cash flow from 40% to 50% of earnings over time.
MetLife has a very strong brand internationally and a great presence in corporate life insurance. The company's customer base includes 90 of the Fortune 100 and these companies tend to be less price sensitive than individual consumers. The company capitalizes on this by selling ancillary products and services along with life insurance. Currently MetLife generates about 14% of earnings from emerging markets and the stated goal is to get that number up to 20% by 2016, with a target of $250MM of operating earnings in 2016. Alico will play a key role in this growth and MetLife was able to acquire the global giant at a very cheap price, as AIG had to sell as part of its efforts to pay back the U.S. government.
Recently management projected 2013 operating earnings to be between $5.5 billion to $5.9 billion, or $4.95-$5.35 per share. MetLife's net income figures are often skewed by volatile derivative positions that the company uses to hedge its massive investment portfolio. Non-U.S. business accounts for roughly 1/3rd of operating earnings in the 2013 plan, with Japan accounting for about half of that. Emerging markets account for approximately 40% of non-U.S. earnings, and over the long-term these earnings should grow faster than the rest of the company's geographic regions. Latin America's underlying earnings growth is weakened in 2013 because the company is planning on increasing the marketing spend in the region, which hopefully will aid future growth. MetLife has reasonable 425%-450% risk-based capital ratios in the United States, and a solvency margin ratio in Japan of 800-900%.
I believe MetLife offers an attractive risk/reward opportunity at current prices and despite a decent overall market the stock hovers fairly close to its 52 week lows. At less than 70% of book value and around 6 times earnings the company is priced for serious problems. If management can execute on its plan to get to a 14-16% ROE by 2016 the stock could increase materially closer to book value, which at that point would be considerably higher than today's figure. Currently management is not projecting share buybacks in 2013 but the plan is to buy back about $8 billion by 2016. This figure might be unrealistic unless the company seeks and gets approval to buy back some stock next year. Buybacks at current prices would be highly accretive and would boost both book value and earnings per share figures. The stock is prone to be volatile so it makes sense to dollar cost average into the position. A conservative way to play it would be to sell the January 2014 $32.00 puts for $4.80. This would generate a 17.6% return on the maximum risk assuming the stock trades above $32 at expiration, and at worst the investor would own the stock at $27.20. From that level it is very possible that the stock could double within 3 years.