MetLife's Valuation Implies Strong Upside

|
About: MetLife, Inc. (MET)
by: Damon Verial
Summary

MetLife has a lot of novel information: recently announced earnings, a new CEO, and a 5% dividend increase.

I run both a sentiment analysis and an excess returns valuation on MetLife stock, finding bullish results for both.

I offer a strategy for trading MET in the up direction, but with downside protection and a net credit.

The price of $47 is a strong buy-in point, especially with regard to its excess returns valuation, its valuation trend, its dividend raise, and management’s rising optimism.

Back in 2015, I implied that I would give an annual valuation of MetLife (MET). I lapsed on this until a student asked me about this stock. I have since updated my valuation method, so let's take a look at MET's valuation in 2019.

Excess Returns Model

I should now explain the valuation method, which is based on Dr. Damodaran's excess returns model for financial firms. The mathematics are a bit complex, but the general idea is simple: Financial firms should be valuated by their abilities to produce excess returns relative to the market. Typical valuation methods, such as discounted cash flow models, fail in accuracy because of accounting differences; these firms do not produce products, but simply reinvest their capital.

This can help explain why EPS poorly predicts financial stock prices. For MET, EPS did actually have a strong correlation with the stock price, up to around 2012. Indeed, EPS and stock price are completely out of sync:

(Source: Damon Verial; data from ADVFN)

Instead, to calculate a valuation for MET, we look at the company's ability to invest its investors' capital relative to book value. I have run this calculation and will plot it against the stock price. Here are the results:

(Source: Damon Verial)

You can see that the current valuation places MET at 20% underpriced. However, MET has been consistently underpriced, according to this model, since most of post-2008, which is actually quite common, as per my analyses of other financial stocks (but not all). My conclusion is that the aftertaste of 2008 has kept downward pressure on the financial sector via a mechanism of investor bias toward this sector.

Using ERM Valuation Changes as a Predictor

So, we might not believe that MET will actually hit its excess returns valuation. However, the ERM value is a much more reliable predictor of MET's stock price than EPS, and thus its trend can be useful even if you disagree with the actual point estimates in the valuation. Thus, we look at the change of the valuation for hints as to whether MET will rise or fall:

(Source: Damon Verial)

This chart implies a buy signal sometime in late 2018/early 2019. Much of the fluctuation here stems from an inconsistent ROE. Indeed, this is normal for many financial companies, as well as for managed funds; outperformance begets underperformance, and vice versa:

(Source: Damon Verial; data from ADVFN)

As an aside: This is something all investors should keep in mind. Alpha can be produced by playing contrary to comfort. While we wish to buy low and sell high, doing so is uncomfortable because it implies buying during times of underperformance and selling when the company is doing well.

Sentiment Analysis

Right now MET is on the upswing, according to this valuation. But these fundamentals, while statistically useful, explain less than management sentiment. As the company recently reported earnings, we can look at the recent sentiment swing.

I ran financial lexical analysis on MET's earnings reports. Sentiment overall has been less than the market average, which could help explain underperformance versus the market. The most recent quarter's sentiment did show improvement; management sentiment score rose roughly 33% year over year and 66% quarter over quarter.

Let's analyze some of the statements flagged in my analysis to help us understand the reasons for increased optimism. This is the first earnings call with the new CEO, Michel Khalaf, who succeeds Steve Kandarian. The change of CEO itself could help explain part of the sentiment change.

Khalaf made a point to state that he enters the company receiving the benefits of Kandarian's work, namely a better balance sheet and increased free cash flow. Khalaf mentions MET is coming off a strong 2018, and he mentions that the first quarter of 2019 also looked strong. However, actual data on Q1 show that MET underperformed in Q1, partly because of the 5 basis point rate decline and partly because of the overemphasis on chasing the changes in the macro environment:

"We did have a slightly higher allocation to shorter-term assets during the quarter as we continue to look to shift out of certain assets that are more susceptible to a market downturn, and so we see this mostly as timing."

The effective tax rate was closer to the low side of guidance and sets the benchmark for 2019 at roughly 19%. MET's goal by 2020 is a pretax profit margin improvement of $800M, implying $600 would be passed on as earnings. The company has already seen a 140 basis point increase. As this rises, so does ROE, which can help bolster the ERM valuation next year.

Finally, a dividend increase of 4.8% was announced. With buybacks, this dividend increase equates to $900M being returned to shareholders. MET is one of the best dividend payers in this industry:

(Source: Simply Wall St.)

The dividends have risen for six consecutive years and should continue to rise, as they are already well covered by earnings to the tune of 3x. Currently, MET is returning 30% of its earnings to investors. MET remains one of the best dividend stocks in the insurance and financial sectors.

Buy the Dip

We might see a dip in the bank industry shortly, due to the fines on the industry from previous Forex rigging actions. MET, with its beta of 1.17 and its correlation of .74 with the finance market, will likely be pulled down a bit. Clearly, this would be unfair from a fundamental perspective, but it does represent a strong buy-in point, especially with regard to its ERM valuation, its valuation trend, its dividend raise, and management's rising optimism.

If you want to play MET in the up-direction with a net credit and downside protection, consider the following play:

  1. Buy 2x Jun21 $47.5 calls
  2. Sell 1x Jun21 $42.5 call
  3. Sell 1x Jun21 $47.5 put
  4. Buy 1x May24 $45.5 put

Happy trading.

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.