Jackson Financial: Increased Capital Should Support Further Upside (NYSE:JXN)

Shares of Jackson Financial (NYSE:JXN) have been a strong participant in the recent market rally, with the stock rising 25% since I recommended it as a “strong buy” three months ago. While I had provided a target price of $61, which still points to substantial upside; whenever shares move so much so quickly, it is worth re-evaluating to see if some profits should be taken. Based on new information, I am raising my price target and recommend staying long.

Since my last review of the company, we have received updated financial information. It has been strong. In the third quarter, Jackson earned $3.77 in adjusted EPS excluding special items, beating consensus by $0.24. Jackson is benefitting from strong sales as investors seek to lock in higher rates and equity market gains. Given this demand for annuities, Jackson is now earning a higher investment spread on its products.

As I discussed in September, shares have traded at a large discount to book value because its legacy variable annuity business is quite complex, requiring numerous derivative positions to hedge the risks. Given this complexity, there is always some concern about whether these hedges will work. However, with the equity market rallying and bonds now starting to stabilize, the concerns over downside hedges are less of a concern, which has definitely allowed shares to loft higher.

In the near term, I continue to expect shares to show a relatively high beta to the markets, given perception of this risk. Importantly, we are seeing the hedge program working well, which added $2.8 billion to GAAP income. As I noted in the past, hedges, derivatives, and markets should over long periods of time cancel out towards zero, though on a quarter-by-quarter basis, there can be volatility given timing differences. As you can see below, over the past 18 months, these have broadly cancelled out, resulting in a net gain of JXN of $700 million, from a $1.5 billion loss last quarter. This bounce back and convergence towards a long-term $0 is consistent with my view of Jackson being an effective hedger.

Beyond the near-term, the surest way for Jackson to earn a higher multiple is to continue to transition its book of business away from riskier legacy variable annuities. Given the long-dated nature of these contracts, it will take a long time, but the transition continues steadily. Last quarter, VA sales were broadly flat, continue to run near $2.5 billion, but with a shift toward those without lifetime guarantees, which are easier to hedge. As you can see below, non-lifetime VA’s are up to 48% from 41% last year.

In addition to improved composition within VA, registered index-linked annuity sales were $807 million. Overall, there were non-VA net flows of $822 million, which was up 29% from last year, as Jackson continues to grow this product. Meanwhile, retail VA outflows were $2.3 billion as older policies roll off more quickly than it sells new ones. All of this shifts its business to newer, less-risky products, which should provide steadier earnings. Its closed block reserves declined another $500 million to $21.4 billion, down 6% from last year, as these legacy policies also run-off.

With its sale mix and run-off proceeding as hoped, I would also note that there have been no unfavorable developments on its investment portfolio. As you can see below, Jackson has a diverse, high quality asset portfolio. Less than 2% of its fixed maturity portfolio is below investment grade. All securitized assets are investment grade. $1 billion is invested in collateralized loan obligations (CLO) but these are largely in the least-risky AAA and AA tranche. Because the majority of its portfolio was purchased when rates were lower, there is roughly a 12% loss on the portfolio, but given annuities were sold against them at the same prevailing interest rate, the economic impact of this loss is minimal.

I do think it is important to maintain a watchful eye on commercial real estate exposure, given the challenges facing that sector. This is especially true in office. Jackson has just $700 million of exposure here, less than 2% of its portfolio. There is just an average loan to value of 65% in its office portfolio, meaning valuations could fall materially before it faces a loss. Just 9% mature next year, giving operators plenty of time to refinance loans as needed, and all office loans are first-lien, further reducing the risk of loss.

Given the strong business performance, Jackson has been able to return significant capital to shareholders. $347 million has been returned to shareholders through September via dividends buybacks. This leaves the company on track to meets its $450-550 million target this year. These buybacks have led to a 3.6% share count reduction over the past year, and even with the sharp rally, JXN pays a 5% dividend.

A strong balance sheet underpins these payouts. Jackson has $1.4 billion in holding company liquidity, allowing it to pay down $600 million in debt while leaving substantial excess liquidity for ongoing capital returns. Further, risk based capital (RBC) is now above management’s 425-500% range thanks to the market recovery and strong hedge performance. With excess capital and less capital-intensive sale mix relative to its rolling off VAs, JXN is well positioned to dividend up excess capital to the holding company over the next year to further support shareholder returns.

When thinking about a price target, I would continue to largely discount its adjusted book value of $146. Markets will continue to view its book value associated with legacy variable annuities cautiously, and this disconnect is set to persist. It may diminish slowly as closed block reserves continue to decline, but this will be a long process.

I continue to view a capital return yield as the best way to value Jackson.

With a stronger capital position, we may see capital returns move up towards a $550 million run rate from the $500 million I previously estimated. At a 10% capital return yield, that can push shares to $67 from my $61 target previously, representing about 34% upside. In the meantime, investors are paid a 5% dividend.

Now, my one point of caution is that if we do see the S&P 500 take a tumble, JXN shares will likely decline in sympathy, though given another good quarter of hedging, shares should be able to retain much of their gains. If you are bearish on stocks in general, there may be a better opportunity to get into JXN. But given it standalone valuation, I see the upside as being worth the broad market risk, and I continue to view shares as a strong buy.