Brighthouse Financial is trading at material discount to its book value per share as the market questions its strategy to enhance its return on equity in coming years, and we’re not high on its risk/reward potential as a notable portion of its bottom-line performance is beyond the control of management. Quad/Graphics sports a lofty dividend yield, but we’re less than enthused about its long-term prospects as it looks to consolidation in a declining industry for growth.
By Kris Rosemann
We’re Not Interested In Brighthouse Despite It Trading at a Discount to Book
Image Source: Brighthouse Financial Investor Presentation
Hedge fund manager David Einhorn is a big fan of Brighthouse Financial (BHF) thanks in part to its hedging with an options-based strategy rather than a futures-based strategy, and he points to the company reporting hedging profit and loss on the income statement as setting it up for success over the long haul, even if it may result in reported quarterly GAAP losses. Einhorn is also a fan of the company’s plan to take an increasing amount of equity risk in the years ahead, which is expected to reduce the cost of its hedging strategy by moving the options it purchases further out of the money. In essence, Einhorn’s bull case rests on the idea that an improved equity hedging cost will ultimately result in improved earnings and returns on equity.
Brighthouse is one of the largest providers of annuity and life insurance products in the US with approximately 2.5 million insurance policies and annuity contracts as of the end of 2018. The company was spun-off from MetLife (MET) on August 4, 2017, and MetLife divested the remaining 19.2% stake it held in Brighthouse in June 2018.
On a high level, we’re not too fond of the insurance business model, as underwriting profits can quickly be eroded by exogenous events, and returns on premiums (“float”) are still based on investments that are tied to market activity. An investor, for example, may instead prefer to identify his or her own investments that meet his/her circumstances and criteria than rely on an insurer’s investment committee for such diligence. Please read our full opinion of the structure of the Insurance industry, which we view as largely commoditized, meaning that its products are largely undifferentiated or can be replicated by rivals quickly, at the following link:
Brighthouse’s operating entities receive strong financial strength ratings from the major rating agencies (A/A3/A+), indicating its solid asset quality and modest exposure to high risk assets such as below-investment grade securities and alternative investments. Its capital adequacy is high, as management works to maintain cash and liquid investments of at least two times annual fixed charges (interest expense) over time, but these strengths are partially offset by a concentration of legacy variable annuities and modest expected statutory capital generation due to elevated costs of hedging market sensitive liabilities. Its credit rating is in investment-grade territory (Baa3), a mark that reflects Moody’s typical notching for an insurance holding company relative to its operating subsidiaries.
The company recently raised its financial targets from those set at the time of its separation, and it now expects low double-digit growth in adjusted earnings per share annually (was mid-to-high single digit growth). Its adjusted return on equity, defined as total annual adjusted earnings on a four-quarter trailing basis, divided by the simple average of the most recent five quarters of total Brighthouse stockholders’ equity, excluding AOCI, target has been increased to ~11% by 2021 compared to its prior target of a stable ~8% adjusted return on equity over time. On a GAAP net income basis, its target return on equity, excluding accumulated other comprehensive income, is ~8%, and the company began shareholder capital distributions in the form of share repurchases in September 2018, well ahead of its previous target start date of 2020.
Brighthouse reported an adjusted return on equity of 6.9% for the fourth quarter of 2018, roughly in-line with that of the prior year period. Management pointed to challenging market conditions as a suppressor of earnings in the quarter as its separate account returns came in at -9.2% amid material equity return weakness in the quarter, and variable annuity separate account balances, which drive fee income, fell to $92 billion at the end of the year from $104 billion at the end of the third quarter of 2018. The company expects investment income and capital returns to be key drivers of adjusted earnings per share growth in 2019, and a decline in annual establishment costs, or investments in technology and infrastructure, should help its bottom line as well. This decline in establishment costs is expected to continue into 2020, and management is targeting $150 million in annual run-rate corporate expense reduction by the end of 2020.
At the end of 2020, Brighthouse’s book value per common share sat at $122.67, implying a price-to-book value of roughly 0.31x as of this writing. This denotes a material decline from our prior update on the company, “Analysis of Spark Energy (SPKE) and Brighthouse Financial (BHF),” potentially due to the market questioning the company’s ability to generate economic value in excess of its increased return on equity target (cost of capital). It should be noted that tangible book value per share is material lower ($74.03 at the end of 2018) after accounting for $5.7 billion in deferred policy acquisition costs and value of business acquired.
We don’t necessarily disagree with Einhorn’s logic in arriving at his upside expectations for the company, but it contains a degree of execution risk that we are not comfortable with as it relates to an insurance company. A key portion of an insurer’s income is generated from its investment portfolio, and these returns are largely out of the firm’s control. The market is questioning Brighthouse’s strategy in ultimately driving its return on equity higher, and the discrepancy in its return expectations on a GAAP and adjusted basis may be a contributing factor.
We’re not interested in shares at this juncture as Brighthouse contains material execution risk in improving its cost structure to ultimately achieve its ambitious return on equity improvements. The fact that a material portion of its bottom-line performance, and ultimately the attaining of its return on equity target, is beyond the control of management to a large degree only adds to the uncertainty surrounding the company. Our fair value estimate for shares currently sits in the mid-$40s, and we would require a larger margin of safety, along with materially improved technical considerations, before considering the company an attractive investment opportunity.
Quad/Graphics’ High Dividend Yield Is Not Attractive
Image Source: Quad/Graphics investor presentation
Quad/Graphics (QUAD) uses its data-driven, integrated marketing solutions platform to help clients reduce complexity, increase efficiency and enhance marketing spend effectiveness in multiple industries, including retail, publishing, and healthcare. As of early 2019, the Quadracci family (the company was founded by the late Harry V. Quadracci) holds ~72% of total voting control.
According to third-party estimates, the US advertising services industry is projected to grow at a compound annual rate of ~4% from 2018-2022, but the printing industry remains mired in secular decline. Quad believes its scale advantage gives it a leg up in this declining and highly fragmented space, and it has completed multiple acquisitions in recent quarters to take advantage of the opportunity to remove excess, inefficient capacity and reduce costs. We’re not enthused about the long-term growth potential of the space, and Quad acquiring less-than-healthy businesses to drive growth, most notably its recent agreement to acquire LSC Communications (LKSD) in an all-stock deal worth ~$1.3 billion, is not a sustainable growth plan, even if the move makes strategic sense in the current operating environment.
Quad may draw additional attention from income-oriented investors due to its large dividend yield, but this lofty yield is more a function of its beaten-down share price than anything. The company has not raised its quarterly payout since 2013. Free cash flow generation faced pressure in 2018 but averaged $223 million in the past three years, which is more than sufficient in covering annual run-rate cash dividend obligations of $63 million. Management expects free cash flow to come in at $145-$185 million in 2019 prior to $20-$30 million in LSC-related payments, compared to $164 million in 2018 and $258 million in 2017. At the end of 2018, Quad held $941 million in total debt compared to just under $70 million in cash and cash equivalents.
Quad’s leverage and poor secular outlook are reflected in its junk-territory credit rating (Ba2), and questions remain surrounding the company’s ability to retain sufficient scale and flexibility to offset the negative credit quality impact of LCS’ business, which carries lower margins and higher leverage. We’re not predicting a dividend cut at Quad in the near term thanks to its free cash flow coverage of dividend obligations and ample liquidity, but its debt load is reason for pause. We prefer companies that boast free cash flow coverage of dividend payments in addition to solid net cash positions on the balance sheet, the combination of which are not likely to be found in a company operating in an industry that is working to offset industry secular declines with consolidation. We think shares are roughly fairly valued at current levels.
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Kris Rosemann does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.