Description

We believe LNC is currently one of the best long opportunities in U.S. life insurance - inflecting fundamentals, good eps revisions, trading at an undemanding valuation, with potential for a meaningful narrative shift over the next 3-6 months as investors begin to reengage in what has been the most complex turnaround story in the sector.  LNC has been considered to be one of the lowest-quality and most opaque companies in life insurance because they have faced a litany of complex issues over the past two years which have impaired not only their capital position and earnings power, but also the credibility of their management team.  However, management has done a good job of fixing the most pressing issues and reshaping the business over the past year - and now, the resulting setup is that most of the heavy lifting has finally been completed and visibility into the business transformation is at its highest level in several years, while investor engagement still remains at a multiyear low.  Management has recently laid out a credible roadmap for the next three years, with 2026 targets which imply hsd% upside to consensus eps.  And there are many potential catalysts over the next 12-18 months which would drive further upside to eps and multiple, including the resumption of steady buybacks; further expense savings initiatives beyond their current program; optimization of their general account assets; establishment of an internal and/or external reinsurance structure to further strengthen their balance sheet; and better investor communications.  Valuation remains undemanding, and an 8.5x FCF multiple on our 2026 FCFps would imply 40% upside over time. 

For brief context, LNC has faced a perfect storm of issues around their reserves, capital, and earnings over the last two years - which, when combined with a reversal of investor confidence in the management team, led to a -75% decline in stock price between early 2022 and mid-2023.  The most egregious of these issues occurred during the 3Q22 print when the company surprised investors with a $2b GAAP reserve charge to reset their lapse rate assumptions for their secondary guarantee universal life (SGUL) block, which resulted in a substantial decline in their statutory capital position, as well as significant impairment to their earnings generation and capital return.  This reserve charge caused the management team to lose a significant amount of credibility with the market - especially since many investors had previously expressed skepticism around LNC’s lapse rate assumption but were allegedly led to believe that the SGUL reserves were adequate heading into the reserve review.  At the same time, LNC faced significant margin compression in their group benefits business because their claims system was poorly equipped to handle the spike in covid-related disability cases.  Furthermore, the volatility in equity markets during 2022 led to higher-than-anticipated hedge breakage costs within their variable annuity (VA) business, which presented additional headwinds to their statutory capital position and FCF generation.  LNC also announced a new CEO and CFO during this stretch, both of whom had been relatively unknown to investors prior to their appointments.  And to further complicate matters, LNC announced a complex risk transfer transaction with Carlyle’s Fortitude Re in 2023, which was seen as a positive milestone – but then the regulatory approval process was unexpectedly held up by the Bermudan authority for several months, which added a layer of binary deal risk to the stock.  So altogether, there was a confluence of issues which led most of the traditional investor base to disengage from what had become one of the lowest-quality and most opaque companies in the sector.

But the new management team has done a good job of fixing the most pressing issues, and now most of the heavy lifting have been put in the rearview mirror.  These fixes include - (1) LNC has fully rebuilt their capital position, which had been the top management priority over the past year.  LNC has added an impressive 50pts to their risk-based capital (RBC) ratio during this time, primarily through a combination of their risk transfer transaction plus the sale of a noncore business unit.  Their YE23 pro forma RBC now implies over $300m of excess capital above their minimum threshold.  (2) LNC completed an important risk transfer transaction with Fortitude Re, which reduced their SGUL risk in-force by 40% while simultaneously releasing capital and improving their ongoing FCF generation.  (3) LNC implemented a new VA hedging program in early 2023 to address the elevated hedge breakage that they had experienced in 2022.  The new program reduced the sensitivity of their capital position to down-market scenarios and has been successful so far - which has enabled higher-than-expected dividend capacity out of the legal entity which houses their VA rider risk. 

And (4) LNC has completed a series of organizational changes over the last two years, which have centered around (i) adding senior executives in the right positions to address problem areas such as claims, risk management, and expense efficiency; and (ii) aligning product design, distribution, and sales incentives to prioritize capital efficiency & profitability instead of revenue growth.  Over the past year, LNC has added a new CFO; a new Chief Risk Officer, who was formerly the Chief Actuary of MetLife; a new CFO of Retail Solutions, who was formerly the CFO of AIG’s Life & Retirement business; several new leaders in Group Benefits who, as we understand, have already made significant improvements in the handling and administration of disability cases; a new Head of Insurance Solutions, who is responsible for centralizing the development and management of all retail insurance products; and a new Head of Investor Relations.  Furthermore, LNC has implemented a series of positive organizational changes such as exiting commoditized distribution channels (i.e., online aggregators), which are low margin and inefficient from a capital perspective; emphasizing the sale of fixed and registered index-linked annuities, which provide capital diversification benefits for their variable annuity business; and changing their sales incentives to prioritize profitability and capital efficiency, rather than new sales volume.   

The result of these changes is that the market now has good visibility into the recovery in earnings power over the next few years.  Management has recently laid out credible segment-level earnings targets through 2026, which imply hsd% upside to consensus eps.  We believe that the execution of these targets should be reasonably straightforward because most of the plan and pieces have already been put in place, and the job from here is primarily centered around standard blocking and tackling. 

We also believe LNC has a multitude of levers which could drive further eps revisions and multiple re-rating, and these levers have not yet been fully contemplated in their guidance.  These levers include - (1) Additional expense savings initiatives.  Over the past six months, management has alluded several times to examining further expense opportunities above and beyond their current program.  Expense control remains a top management priority, and there should be additional opportunities to rationalize the cost base now that the company has pulled back on new sales growth.  We suspect LNC may formalize new cost savings targets this year based on some of their public commentary in 2023, and these targets would be incremental to their current guidance.  (2) Resumption of a steady buyback program.  LNC has not yet quantified how or when they intend to resume share buybacks, but our capital rollforward suggests that they can return to a steady $400m/yr buyback program by 2025, which is higher than the street has baked in.  The resumption of a consistent share buyback would be positive signaling because capital return is one of the most important metrics for life investors, given the skepticism around GAAP earnings. 

(3) Establishment of an affiliated Bermuda entity to unlock opportunities for internal reinsurance, which would improve capital efficiency and FCF generation.  LNC is currently in the process of obtaining their Bermuda license, which should be a straightforward process.  There is a clear path and precedent for setting up an affiliated Bermuda entity to reinsure stable liabilities which are noneconomic under the U.S. regulatory framework.  (4) Natural spread expansion in their Life business.  LNC has not yet benefitted from higher rates in their sizeable Life investment portfolio because they had set up a duration extension program near the trough of the rate cycle, which has since been a headwind to their portfolio yield.  As this program begins to run down, LNC will begin to see spread expansion at a time when most peers are seeing compression; and this dynamic will be a tailwind to their Life earnings. 

(5) Optimization of their general account assets, including potential investment management partnerships with external asset managers.  LNC has historically run a conservative credit portfolio; their investment yield is among the lowest in the peer group; and management has acknowledged that there is a large gap between their asset yields and the industry average, which they intend to bridge over time.  In the past, LNC has not been as focused on asset allocation, and their approach to portfolio construction has been relatively simplistic.  But there are many creative ways to structure insurance asset portfolios to achieve better risk-adjusted yields, and we believe LNC had explored some of these possibilities during their discussions with the various private equity-backed counterparties who were involved in the bidding process for their SGUL block.  Additionally, LNC would be an attractive partner for an external asset manager given the sizeable opportunity that an external partner would have to improve the investment yields within LNC's asset portfolio, combined with LNC's strong ability to source spread-based liabilities via their distribution network.  

(6) LNC can continue to reduce some of their hedge costs over time.  LNC had implemented new hedge overlays in parts of their Life block over the last few years to better insulate their capital position against market volatility.  These hedge structures are suboptimal from a cost perspective because they were designed to be immediately functional - and now that LNC has fully rebuilt their capital above their target threshold, they should have the flexibility to grind down their hedge spend over time.  (7) LNC is continuing to explore strategic alternatives across their portfolio, and there could be opportunities for additional external reinsurance transactions over the medium term.  And (8) LNC will continue to optimize their capital structure, including the eventual paydown or refinancing of their expensive preferred tranche.

Valuation remains undemanding, and an 8.5x FCF multiple on our 2026 FCFps of ~$5/sh would imply 40% upside over time.  Our FCFps estimate reflects 50% FCF conversion on $1.6b of 2026 adjusted earnings, which is consistent with the high-end of management's guidance range.  Our upside FCF multiple is consistent with the trading range for select peers.   Our downside case assumes 7.0x FCF (i.e., around where lower-end peers trade) on our 2026 FCFps of ~$4/sh, which is consistent with the low-end of their earnings guidance range. 

Finally, we believe the stock should benefit from an attractive catalyst path over the next 12 months. Management is beginning to reengage with investors after a long period of relative silence, during which they had been focused on righting the ship.  And now, management has a good story to tell investors who have largely passed over the stock as un-investable over the past year.  As a result, we expect LNC should benefit from a positive narrative shift as management rebuilds credibility, executes on their plan, and improves their investor communications.  We believe LNC is also set up to benefit from positive eps revisions, with many areas of potential optionality beyond the guidance - incremental expense saves, capital return, yield enhancement, internal and external reinsurance, and further optimization of both sides of the balance sheet. 

Catalyst

Better investor communications; eps revisions; and further management intiatives around expense control, capital return, yield uplift, internal / external reinsurance, and balance sheet optimization.