Brighthouse Financial: Ugly Duckling Spin-Off Doesn't Need Much To Turn Into A Beautiful Swan

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Antao
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Summary

  • Brighthouse Financial ticks all the boxes of a busted spin-off.
  • The stock trades at all-time lows.
  • Multiple ways to realize value.

Brighthouse Financial (NASDAQ:BHF) is the company comprising the former U.S. retail insurance business of Metlife (MET) which was spun off in August 2017 with the main objective of reducing regulatory headwinds for MET arising from a “too big to fail” label.

Busted Spin-Off = Forced Selling?

BHF has the makings of a busted spin-off, namely:

  • BHF seems to be the ugly duckling versus MET regarding future business prospects;
  • BHF’s business compares poorly versus peers - lower ROE, higher sensitivity to interest rates and the overall equity;
  • BHF has no plans to return capital to shareholders (via dividend or share repurchases) until 2020, versus MET’s ~3.5% dividend yield and ongoing share repurchase program; this should cause income-oriented investors (a big chunk of MET shareholder base) to promptly hit the Sell button upon distribution;
  • Small exchange ratio (11-to-1);
  • Big overhang on BHF stock caused by MET’s impending sale of its remaining ~20% position on BHF;
  • Little sell-side coverage;
  • Weaker-than-expected results on both quarters since inception as a public company.

As expected, BHF’s first months as a public company have not been pleasant to shareholders, with a drop of ~16% since their debut in August 7, 2017, and currently trading at all-time lows around $52.

Despite these initial headwinds, we do believe there is value to be obtained from ownership of BHF if one is to remain patient and rates continue to head higher as expected. But before we get to the reasons we like BHF, a little color on the business is warranted.

Business

BHS’s business is comprised of 4 segments:

1. Annuities (52% of sales)

The annuities business is growing in terms of sales at a reasonable mid-20% pace, driven primarily by the success of the Shield product. However, costs have been higher as well, more than compensating for the increase in sales.

On this front, it is very important to underline that BHF currently has $2.6 billion of assets above CTE95, which is a QoQ increase from $2.3 billion. This is important because management has set a goal of $3 billion as the level at which it expects to begin returning capital to shareholders.

Given that BHF’s assets above CTE95 are tied to the performance of equities, rates and volatility, we could reasonably expect that 1Q 2018 will bring a further bump to assets over CTE95, probably getting them very close to the $3 billion watermark.

2. Life (16% of sales)

Life insurance sales have been declining (both absolutely and relative to the overall mix) due to a change in strategy designed to convey simpler life insurance solutions. Results have also been hampered by unfavorable underwriting due to elevated mortality.

3. Run-off (26% of sales)

The Run-off segment is comprised of legacy businesses not actively being sold - most notably, the ULSG business. These will decline over time, hurting results but freeing up capital and improving returns along the way.

4. Corporate & Other (6% of sales)

This includes general excess capital not allocated to the other segments, results of part of MET’s ancillary international operations and ancillary U.S. B2C business, as well as interest and other general expenses. Results are immaterial to negative.

BHF is well-capitalized with liquid assets of $655 million, statutory total adjusted capital of $6.6 billion and a leverage ratio below management’s 25% target. The investment portfolio seems to be conservatively managed, with a 2017 year-end net investment income yield of 4.30%.

The company’s RBC ratio as of year-end 2017 is estimated by management to be over 600%, which translates to a ratio of over 500% in the context of the new tax environment with tax rates of 21% instead of 35%.

At the company level, BHF is guiding towards an 8% average ROE over time, down from 9% at the time of the spin-off due to a larger equity base. This compares unfavorably against peers in the low teens.

Valuation, always valuation

On the valuation front, things start to get interesting.

On December 31, 2017, BHF had a per share BV of $121 and a per share BV ex-AOCI of $110. That means the company is trading for a very attractive 0.43x and 0.47x multiple.

These multiples are attractive on their own, but even more so when we set them against a selection of peers. On average, comparable companies are trading for ~1x BV and ~1.2x BV ex-AOCI.

Granted, the discount versus the peer group is somewhat warranted, though, due to BHF’s lower ROE, no capital return policy, rough earnings profile and current higher-than-average sensibility to macro factors like interest rates, equity markets and volatility (although management is currently working to lower BHF’s exposure to these macro factors).

The discount, however, is only good for ~30-40% of the gap. The rest can be attributable to a mix of the market being excessively pessimistic about BHF’s future, lack of awareness, skepticism over execution and some forced selling arising from the dynamics of the spin-off. This means that if management is able to execute, BHF shareholders stand to earn a big return on investment enabled by:

  • BV and BV ex-AOCI growth;
  • Closing of the multiple gap, because of:
    • Better future prospects given the initial discount traditionally given to new companies because of operational uncertainty;
    • Freeing up capital sooner than expected, which could prompt the implementation of a capital return policy earlier than 2020, which in turn would attract a whole new shareholder base and cause a further multiple gap contraction.

Additionally, BHF could enjoy a double win on higher interest rates as profits increase and insurance company multiples re-rate.

Even if BV and BV ex-AOCI should stay unchanged, a re-rating to 0.7x BV / 0.8x BV ex-AOCI would cause BHF to trade at $85-90 per share, for a ~65% gain.

Risks

  • Worse-than-anticipated execution
  • An extended period of low interest rates
  • A steep / prolonged decline in equity markets
  • Insurance-related risks (i.e., underwriting, abnormally high mortality rates, etc.)
  • Regulatory
  • Incapability to institute a capital return policy to shareholders via dividends / buybacks

This article was written by

Antao profile picture
817 Followers
In 2014 João founded and currently manages Antão Capital, an investment fund focused on worldwide special situation and event-driven opportunities with an asymmetric risk/return profile, preferably with a near to medium term catalyst in place.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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