Greenlight Capital - Brighthouse Financial Inc.

Summary

• This remains one of the most perplexing investments we have ever made.
• Although the shares “recovered” 29% in 2019, the underlying value of the business also improved, so much so that the shares are arguably cheaper now than they were a year ago.
• BHF shares could double from here and still be absurdly cheap.

The following segment was excerpted from this fund letter.

Brighthouse Financial (NASDAQ:BHF) - Long

4.0x P/E on 2020 consensus adjusted earnings, 31% of book value

This remains one of the most perplexing investments we have ever made. Although the shares "recovered" 29% in 2019, the underlying value of the business also improved, so much so that the shares are arguably cheaper now than they were a year ago.

BHF's main business is variable annuities. Customers deposit funds into segregated accounts, which are then invested in equity and fixed income funds, and pay BHF fees in exchange for minimum performance guarantees. The biggest risk BHF takes (and must hedge) is that equity markets underperform and the company has to make good on these minimum guarantees. When markets do poorly, policies can become "upside down," meaning the guaranteed policy benefits exceed the value of the assets in the separate accounts. Policies written with assumptions that are too optimistic cause trouble for variable annuity writers, as was the case from 1998 to 2011 when the S&P 500 index was essentially unchanged.

In 2019, the S&P 500 returned 31.5%, bringing its return since 2011 to 203%, or almost 15% annualized. Separate account returns have been vastly exceeding the underwriting assumptions, making it very unlikely that many variable annuity policies are presently upside down. We posit, if the policies are performing this well, why should the business have any discount to book value?

In nearly every analyst report (1 buy, 9 holds, 4 sells), potential investors are given stern reminders that BHF is "sensitive" to equity markets. Analysts seem to be ignoring (or in a couple cases underplaying) that this sensitivity goes both ways. Since none of the analysts have delved into what happens to BHF in a strong stock market, it's no surprise that they don't recommend the stock.

BHF's annual report provides certain sensitivities showing intermediate-term cash flows from the variable annuities segment based on hypothetical capital markets scenarios. We estimate that the 31.5% gain for the S&P 500 incrementally added at least $2 billion to BHF's distributable cash flow over the next four years. BHF's entire market capitalization is only $4.2 billion. The company will release new sensitivity tables next month.

In 2018, the company announced that it would return $1.5 billion to shareholders by the end of 2021. At that time, management was clear that its targets were sensitive (in both directions) to capital markets. As a result, we believe there is an excellent chance BHF will exceed its capital return targets. Even at current levels, the company is buying back stock at a rate of over 1% of the company each month. Given the discount to book value, the buyback alone is causing book value per share to grow by 10% per year, in addition to the company's earnings.

The bears' latest bugaboo is that around 2022, BHF will be subject to a change in accounting, which could lead to a "sizable" non-cash charge and reduction of book value. We note that the shares already trade at only 31% of book value and that any write-down would actually have a positive impact on future earnings. We estimate that every $10 per share write-down will improve annual earnings by $0.65 per share. By our estimates, even with a $3 billion charge, book value per share is likely to grow at a double digit rate over the next 5 years and adjusted earnings per share is likely to grow even faster than book value per share.

BHF shares could double from here and still be absurdly cheap.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.