MetLife: Somewhat Risky, Despite an Attractive Price

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 |  Includes: HIG, MET, PRU
by: Tom Armistead

MetLife Inc. (NYSE:MET) just announced guidance for 2010 in a range of 4.00 to 4.40, which is somewhat above what the street had been expecting. Shares were up over 3% to 36.75 in early trading, while forward P/E, based on midpoint guidance of 4.20, is 8.75. This stock is cheap based on forward earnings, and is an attractive investment to investors who can become comfortable with the market's perception of the risk involved.

Equity market risk - In common with competitors Prudential (NYSE:PRU) and Hartford Financial Group (NYSE:HIG), MET has an exposure to the equity markets arising from guarantees provided on variable annuities.

When the markets tanked, the sector was hammered. MET hit a 52-week low of 11.37, nearly 70% below where it is trading today. Life insurers deal with these exposures by hedging; however, that can be expensive and from time to time hedges go awry, resulting in unexpected losses. In the wake of the difficulties, the companies are reducing the scope of the guarantees offered.

MET carries a beta of 1.9, suggesting it will move a lot faster than the S&P 500 in either direction. So, given the equity exposure created by the variable annuity guarantees, this stock is only suitable for those who have an optimistic view of the progress of the S&P 500. Historical volatility stands at 97.0%, vs. implied volatility of 40.1%. The market does not expect that MET will be as volatile in the future as it has been in the past.

Residential and commercial mortgage risk – insurance companies invest heavily in bonds, to include RMBS and CMBS. In addition, they frequently have exposure to CRE. These exposures are reflected in large mark to market losses, with much ongoing debate as to the extent to which these will eventually revert to amortized values. To get a handle on this risk, it is helpful to compare Book Value excluding All Other Comprehensive Income (BvexAOCI) to GAAP. Most insurance companies. provide this information in quarterly supplements on their websites.

MET – GAAP vs. NonGAAP Book Values

Q1 09

Q2 09

Q3 09

GAAP

25.75

30.85

39.36

BVexAOCI

44.53

42.86

42.09

Click to enlarge

GAAP book value has been increasing, and a continuation of the meet in the middle process would result in a book value of 40 to 41 by both metrics. The mark to market values were an over-reaction that has been correcting over time. But the process could reverse if the economic recovery is not as strong as expected.

Valuation – Applying a P/E of twelve to midpoint guidance, I get 4.20 X 12 = 50. Applying a P/B of 1.20 to a meet in the middle book value I get 49. This target could be met by the end of next year, implying a very nice 30% price appreciation. If MET were to revert to historical valuations based on 5 year average EPS a price in the 60-80 range would result. When things are going good, how quickly we forget.

Positives – Demographics in the US suggests strength in retirement products. Baby Boomers, badly burned in the stock market, will be attracted to the security of such guarantees as the Life Insurance Industry can safely grant. International/emerging markets constitute a growth opportunity as new middle classes become a market for financial security products.

Strategy – Selecting an entry point depends on the investor's view of the trajectory of the S&P 500 and the housing and CRE crises. Possibly the market will defer the long overdue correction until the 1st quarter of the new year, in which case the cautious investor can look at another quarter's earnings and guidance before making a commitment.

The use of LEAPs, the Jan11 25 or 30 calls, as a substitute for owning the stocks makes sense to me in this case. The thinking is, if the market tanks the downside risk is limited by the strike. Also, if implied volatility spikes, which is very likely in a difficult market, the increase of time value will provide some downside protection. The sale of out of the money calls, with shorter expirations, can be used very similar to writing covered calls, for income or as a way of funding the time cost of maintaining the LEAPs position.

Disclosure: Long MET, Long PRU, no position HIG