As I have argued earlier, financials have been overly hit by both the market and regulators. If ever there were a time to purchase shares in the industry, it would be now. With depressed valuations and regulatory proposals that will never pass, many of these companies are more attractive than what political rhetoric and market commentary would suggest. A case in point is MetLife (MET).
MetLife has a real albatross on its hands known as the Federal Reserve. Recently, the Federal Reserve refused MetLife's capital allocation strategy that would have greatly benefited shareholder value. The life insurer was planning on increasing dividend distributions and resuming the share repurchasing program, but was met with opposition due to its capital position. In my view, MetLife is well capitalized with an RBC ratio above 8%, tremendous free cash flow generation in its businesses, and an increasingly safe portfolio.
One of the greatest highlights at the recent third quarter earnings call was the discussion over low interest rates. Should the 10-year US Treasury remain below 2%, MetLife will still produce strong profits for five years. This is so because approximately five years ago, the company purchased $18B worth of notational interest rate floors. This strategy makes the company open to market share increases, as struggling competitor failed to properly hedge against a low interest rate environment.
And on the macro side, the insurer is holding up well. At the recent third quarter earnings call, CEO Steven Kandarian noted:
[W]hile Europe remains unsettled, we believe our exposure is manageable, especially given the number of actions we have taken over the past year. Out of a general account asset pool of $493 billion, our exposure to peripheral Europe sovereign debt was $571 million on a book value basis as of September 30, down from $1.6 billion as of December 31, 2010. And our exposure at quarter end to European banks was $6.9 billion, down significantly from year end. In addition, our total $42 billion of European exposure, more than 90% is investment grade. We have provided greater detail on our exposure to Europe in the appendix to the presentation deck for our call at 9:05 a.m.
The important aspect to note is that MetLife has limited investment exposure in Europe, which will likely face macro stagnation. At the same time, the insurer is actually performing well globally. Its International business grew by 25% and was strengthened by the favorable integration of foreign-insurer ALICO, acquired earlier from AIG. This integration was also partially responsible for Moody's upgrade. Earlier doubt about returns here have likely subsided to more optimism, as management proves that is committed to building shareholder value more in the long term than in the short term.
In regards to de-risking its portfolio (a top concern for investors), MetLife has taken the optimal actions thus far. While the company will benefit from strong returns in the variable annuity market, its eventual adjustment of GMIB Max offering to a roll up-rate of 5.5% from 5% will go a long way in reducing the business' risk. While the disclosure of up to $275M in catastrophe losses, reconciliation claims, and contribution costs is unsettling, I believe that the fundamentals of MetLife are strong - it is, afterall, one of the most diversified life insurers.
MetLife is also seeking to sell its depository business and is working on regulatory approval. This segment represents a nominal part of revenue, yet subjects the company to unnecessary stress testing and federal red tape. Despite the obstacles, MetLife will go forward with its plans as it grows free cash flow generation elsewhere. Based on investment strategy and restructuring, I model ROE growing from 10.9% in 2010 to around 12.3% in 2012.
From a multiples perspective, the company also appears considerably undervalued. It trades at only 6.7x forward earnings and offers a dividend yield of 2%. Given the emotional hysteria over financials, investors stand to benefit from high risk-adjusted returns while the company is much less risky than what meets the eye. Consensus estimates for EPS are that it will grow by 11.9% to $4.90 and then by 11% and 9.9% in the next two years. Based on the actions taken by management and the integration of Alico (a lucrative catalyst), I find myself in agreement with the "strong buy" rating on the Street.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.