Description

Opportunity: American Equity (AEL) is transforming into a better version of Athene (ATH), Apollo’s (APO) cash cow and crown jewel, while providing 50%-85%+ of its market cap (~$2.5B) in special dividends and buybacks in annual installments over the next few years (possibly into perpetuity) plus ~100+% stock appreciation in today’s multi-century low interest rate environment; and if rates rise, then this stock could be a multibagger. This set-up makes AEL one of the most attractive asymmetric plays on the market today and another answer to capitalizing on rising rates*. Bruce Flatt (“Canada’s Warren Buffett” and CEO of Brookfield Asset Management (BAM)) acknowledges this opportunity by currently building a ~19.9% equity stake in AEL at an estimated ~44% higher average stock price of ~$39.71. This is after the new CEO, who is considered a star in this out-of-favor, complex and years-long-suffering industry, rejected a buyout offer (Sep and Oct 2020) from ATH and MassMutual at ~$36/share, representing a ~64% premium to ~$22 on the announcement day and still ~30% upside from today’s ~$27 price. AEL and consensus estimates both expect the company to grow revenues, EPS, ROE, and book values all well into the double digits on ~$57.0B of invested assets, yet AEL is currently valued at ~4.9x-6.4x and ~50%-60% ~12-24 month forward P/E and P/B excluding AOCI, respectively. AEL is a complicated and under the radar idea so much so that there are no previous write-ups on VIC or anything meaningful on the Internet to my knowledge (no write-ups on SumZero, few on Seeking Alpha with little substance, etc.) and as a result, the ADV (3 months) is ~1.4M shares and days of just ~400K-500K shares traded seem common.

*Previous, related write-ups: https://www.valueinvestorsclub.com/idea/US_10-Year_Treasury_Payer_Swaptions_/0756286433 and https://www.valueinvestorsclub.com/message/Stagflation_Is_Coming/166187.

AEL’s Business will be an Improved Version of ATH: For almost 20 years, AEL has been a top fixed index annuity (FIA) provider (a founding player), but it was slowly losing its edge to the new private equity (PE) backed sponsor model: as of 3Q, AEL was ranked #10 on a YTD basis versus #5 in FY19. AEL hired Anant Bhalla as President on 1/27/20 and promoted him to CEO on 3/1/20 in order to quickly transform AEL into a hybrid PE-backed FIA specialist with reinsurance capabilities and asset management offerings. APO can charge ATH higher fees than normal since they are dependent on each other; in comparison, AEL is creating an open architecture with multiple asset managers, which should lead to better aligned incentives and risk sharing, and therefore lower fees.

Key Points from the Many Moving Parts: The plan is to reconstruct AEL into a 50/50 traditional spread-driven (ROE model) and fee-based (ROA model) business over time. The deals with BAM on 10/18/20 (BAM recently took a majority stake in Oaktree) and Varde/Agam on 9/28/20 migrates ~26% of the portfolio ($15B) into a ROA model from 0% previously (over the NTM or less) and analysts expect ~40%+ by the end of 2022. Future reinsurance transactions and how AEL sets up its own reinsurance efforts for third-party capital will be done similar to the BAM partnership than Varde/Agam. By ceding $5B blocks of FA statutory liabilities, AEL releases ~6%-7% of required capital, or ~$320M-$350M, plus ~$250M-$750M in current unrealized capital gains. The latter cash will fund the business transformation and growth while the former monies will both immediately offset each deal’s dilution and return $250M-$300M to shareholders on an annual basis beginning this year, 2021 (most likely in 2H21). Given Bhalla constantly mentions returning capital to shareholders after dilution-cancelling-share-repurchases, the CFO literally says special dividends are on the table over the 3Q20 earnings call, and Bhalla’s shareholder-oriented mindset (he highlights “the cash return is north of 10% of our current market cap”), lead me to believe special dividends are likely. Mathematically, if you cede ~50% of a business for ~50% of equity and offset dilution, then only ~50% of shares are left for buybacks; however, 50%-72%+ in cash will be available, which is more than the remaining ~50%: put simply, mgmt will run out of shares to buy, so they are either taking AEL private over time or left with issuing special dividends. This may be conservative as Bhalla sees the annual returns continue into perpetuity on the “flywheel” he is creating and since he looks “to grow that number over time at probably a faster pace than just earnings growth,” then 50%-72%+ turns into ~71%-85%+ on today’s ~$2.5B market cap. It is only a matter of time before activist firms notice this downside protection, upside potential, or both and pressure AEL to issue special dividends, especially since Bhalla is trying to reinsure $10B of the $15B in 1H21. Also, AEL has a ~1.2% common dividend.

AEL is Both a Value and Growth Play:

Year                   Min (FY06-FY19) Max      FY20E            FY21E             FY22E             FY23E**            FY24E**

Revenues          $916M               $3.5B      $2.5B*****       $2.9B               $3.4B              $4.06B              $4.8B

EPS                   $1.23                 $5.97      $0.99               $4.30               $5.06               $5.95                $7.01

Fwd P/E             4.3x                   15.8x      NM                  6.4x                 5.5x                  4.6x                  3.9x    

PEG                   NM                     NM        NM                  NM                   0.31x               0.26x                 0.22x

P/B excl. AOCI  $10.90               $29.33   $38.62             $44.95             $53.43             $63.51               $75.49            

P/B incl. AOCI   NM                     NM        $61.05             $63.18             $71.37             $80.62               $91.07

ROE                  6.2%                  20.4%    NM                  9.8%***            9.7%***           aiming towards 15%+***

FCF                   NM                     NM        NM                ~$250-300M     $294-353M**** $346-415M****  $407-489M****

FCFE Yield        NM                     NM        NM                 10%-12%         12%-14%         14%-17%          16%-20% 

**Extrapolated with FY22E growth rates unless otherwise noted.

***FY21E and FY22E are consensus estimates versus mgmt’s goal: “Achieve 11-14% ROE over the next few years and long-term goal of 15%+ even in a low rate environment” (12/9/20), with mgmt expecting 11%+ in 2021.

****Assumes the same EPS growth even though mgmt wants to grow FCF at a faster pace than earnings. Additionally on 9/10/20, mgmt guided FCF at ~$100M-$200M and then upped it to ~$250M-$300M over the 3Q20 earnings call (10/30/20) and again on 12/9/20. The amount and quickness came at a shock as multiple analysts kept questioning it, such as this quote: “And just to be clear again, the $250M or $300M, you expect to get there within three years?”

*****Consensus may be mismodeling 4Q20E total revenues by as much as ~$389M-$889M, with their estimate at $611M versus new mgmt commentary on 12/9/20: “Projected Sales for 4Q20 of $1.0-1.5B vs. prior 4 quarter average of $0.7B.” 1) Adjusting 4Q20E revenue estimate by adding the midpoint, ~$639M, 2) assuming the same FY21E-FY24E revenue growth rates and net income margins, and 3) maintaining the same shares outstanding, yields:

Year                                              FY20E           FY21E          FY22E          FY23E**       FY24E**

Revenues                                      ~$3.2B         ~$3.7B        ~$4.3B        ~$5.1B        ~$6.0B

EPS                                              NM               ~$5.39        ~$5.61        ~$6.62        ~$7.81

Fwd P/E                                        NM               5.1x             4.9x            4.2x            3.5x

Strong Spread Management and Multibagger Potential on Rising Rates: Despite decades-long falling interest rates, AEL’s investment spread has been relatively resilient over the past 15 years and seems to have bottomed in 3Q20. Since 2005, AEL’s spread in aggregate has ranged from 237bps on the low end to 323bps on the higher end versus 242bps in 3Q20 even while yields dropped from 6+% to ~4% (mgmt is quickly reversing the recent dip below 4% to 4+%). Mgmt’s new future spread assumptions were lowered to 240-260bps (rising over 8 years) in 3Q from 245-275bps in 2Q and sentiment is poor with at least some analysts modeling at the low end: 240-242bps from 4Q20E to 4Q21E. Furthermore, AEL may have the most conservative 10-year US Treasury rate assumptions in the industry: “rising from~70bps as of 3Q20 to 190bps over 8 years and remain under 200bps going forward,” which is just 15bps/year! AEL stock could be a multibagger, “if rates merely mean revert back to recent levels of 2-3% (the 10-year was as high as ~3.2% in October 2018)…before 2020, ~1.4%/1.5% is around the all-time historic lows for the 10-year going back to 1790” (quoted here*). Relatively small hops in the 10-year starting in 2012 and 2016 resulted in 100%+ stock price increases, but at today’s significantly lower base, a jump back to those levels (2-3%) may have up to twice the magnitude impact on AEL’s stock (a doubling on a double would be as much as 400%).

Mgmt Aligned and Incentivized: The Board is incentivizing the new CEO and his team with one-time stock option awards “to encourage their focused and swift execution of the Company’s AEL 2.0 strategy without incenting undue risk taking.” They have a $37/share target, and the new CEO is eligible to receive ~$1.8M worth and ~$700K next year for a total of $2.5M (spread over two years only because of “the annual award limitation to any single individual during any single calendar year within the Company’s Amended and Restated Equity Incentive Plan”). In addition, on 11/19/20, he received “a one-time special achievement cash bonus of $1M” for his “exceptional” performance and “significant contributions to the accelerated achievement of Company near term and long-term objectives in 2020.”

KKR Implications from the BAM Deal Details: Since 4Q19 and as of 3Q20 filings, KKR has been building a ~4.6% stake in AEL equity, or roughly $100M, making KKR the 7^th largest holder. One could speculate that KKR is chatting with AEL regarding a similar partnership that AEL and BAM struck. BAM’s initial 9.9% equity stake was completed on 11/30/20 at $37/share, $1 higher than the aforementioned buyout offer, but the next 10% is valued at the greater of $37/share and book value excluding AOCI. Since Form A insurance regulatory approval will take ~4-6 months from filing, 2Q21 would be the most likely time for the second equity installment. Book value excluding AOCI is estimated to be ~$42.41 in 2Q21. Hence, ~$39.71 is the average of $37 and $42.41. Any delays would cause higher costs to BAM: 3Q21 and 4Q21 are estimated to be ~$43.51 and ~$45.81 (see table above for more). Future deals, whether they are with KKR or other money managers, could be done at these higher prices. Over the next several years, BAM intends to grow its insurance business to ~$100B-$200B in AUM: “Our investing skills are ideal for excelling in insurance – and with interest rates now at zero, the downside risk of acquiring insurance books is lower than ever.”

Risks: The primary risks are 1) AEL can be a volatile stock (especially in light of the 3Q call when mgmt warned there will be some noise as part of the portfolio migrates to fee-based streams) and it may fall before rising, which makes receiving special dividends one of the most, if not the most, important point of the thesis – downside protection – and 2) there are many moving convoluted parts that even sometimes seem to overwhelm insurance analysts and experts, so do your own due diligence. Additionally, 3) AEL operates in a highly competitive industry with larger players and with higher leverage than many of its peers (equity to total liabilities) although AEL experienced less volatility in its portfolio during the recent downturn than most of its peers, 4) book value could erode under fluctuating rates, credit spreads or equity markets, or diminishing asset quality, 5) derivative counter-party risk, and 6) a changing regulatory landscape.

Catalyst

Special dividends, buybacks, more partnerships resembling the BAM transaction, rising rates, industry sales continue to grow while AEL also grows its top and bottom line in the double digits, AEL maintains a low cost operating structure while remaining a leader (for instance, BAM and other partnerships could allow AEL to white label products), and sheer value. After 2020, anything could happen in 2021.