After last year’s spin-off of Prudential (PRU), Jackson Financial (NYSE:JXN) has been actively increasing its brand awareness among investors as it continues its quest to expand its shareholder base to boost its valuation. Although it is a ticker chart spanning just 14 months, the company has been in business for over 60 years, partly as a division of PRU, during which time it has become the industry leader in the annuity market, thanks to its unrivaled distribution network of independent financial advisors familiar with its brand.
Because of this novelty as a standalone company, relatively small market cap, lack of coverage and news flow, the company remains under scrutiny. Nevertheless, the quality of governance, market leadership and risk approach remain unchanged. These factors combined to create an attractive investment opportunity at a low price that will turn into double-digit gains as the stock market becomes familiar with the Jackson name.
Our Buy rating reflects JXN’s leading position in the fixed annuity market and its significant share of the variable annuity market, enabled by its robust distribution and market channels supported by a solid back-office infrastructure.
The majority of JXN’s income comes from management fees associated with its annuity products. This rule has remained relatively flat over the years, with minor fluctuations due to changes in the average value of annuity accounts, mainly due to changes in interest rates. JXN must invest heavily in debt instruments to pay its annuity obligations, the value of which is sensitive to interest rate changes. Nevertheless, fluctuations in bond prices are on average less unpredictable than movements in stock markets, and this consistency helps smooth out substantial fluctuations in JXN’s fee income.
JXN needs to hold large derivative positions that are essential to maintain its capital base while catering to consumers with a higher risk tolerance. These financial derivative instruments enable JXN to offer annuities with varying risk characteristics (including equity exposure), expanding the product offering and attracting new consumers.
Changes in the fair value of these derivatives are recorded in the income line, supporting the volatility of last year’s earnings as equity markets plummeted from last year’s highs. Despite upward and downward fluctuations in hedging instruments, the impact on cash flow is limited.
The chart below shows JXN’s revenue by segment, with relatively flat fee income and much more volatile net earnings on derivatives due to last year’s market sell-off.
As a safeguard against losses, financial institutions are required to keep a certain amount of cash and other high-value assets on hand. These liquidity requirements vary depending on the type of institution and the nature of its activities. Given the current market turmoil, management is confident that the company has sufficient liquidity to meet regulatory capital and liquidity requirements. Most of JXN’s assets are invested primarily in high-quality corporate bonds, government securities and mortgage-backed securities, enhancing risk-based capital coverage. Most of its obligations are contractual obligations to its policyholders and beneficiaries.
In recent quarters, we have seen prices of both stocks and bonds fall, putting pressure on the balance sheets of financial institutions, including JXN, whose capital was impacted by unrealized capital losses, negating hedge gains.
While higher interest rates negatively impact GAAP earnings in the short term through higher unrealized losses, the higher interest rates are expected to have a positive effect in the long term by increasing interest income on its debt investments. Higher interest rates also increase the attractiveness of annuity products. So far, we see a limited impact on the company’s operating cash flows, as losses are limited to non-cash fair value measurements.
Dividend and valuation
Dividends and buybacks show management’s confidence in its ability to preserve its capital while providing a good return to shareholders. However, rating agencies are concerned that management’s commitment to returning money to investors could hinder its ability to maintain an adequate capital buffer in case something unexpected happens, for example an unforeseen adverse event affecting liquidity . Every financial institution has to walk this thin line, and the way management returns capital to investors is not at all alarming. Share buybacks and dividends make up only a fraction of the company’s operating cash flows, as shown in the table below.
So the 6% dividend yield is not because the company pays out a lot of money, but because the stock is undervalued. The forward non-GAAP P/E ratio (adjusted for non-cash amortization of derivatives) is currently 2.3%, 77% below the industry median. The current market capitalization is a fraction of the tangible book value. The shares are so undervalued that small share buyback budgets make a huge difference in the number of shares. Since going public, the company bought 12.5% of the total number of shares outstanding, with just $500 million. Last year, the company even generated enough cash to buy back all of its shares. I think this market price undervaluation will keep growth in the double digits for years to come.
JXN celebrated its first year as an independent company last September. Still, its legacy goes back to the 1960s before it was acquired by Prudential, where it thrived as an industry leader in annuity insurance. This allowed JXN to get off the ground with no disruption to its insurance business or operations and no redundancy of old insurance policies despite market disruptions. The dividend payment and share repurchase are just a continuation of the governance policy that was put in place when it was still a grant from Prudential.
The high returns are not the result of a high payout ratio, but rather an undervalued stock. As JXN builds its name as a standalone company, I expect capital gains over the next 2-3 years with its strong fundamental growth and increasing dividend payout.