Description

Overview

I previously wrote up Athene in 2014 (then part of AAA). I thought the situation then was highly asymmetric given the company was trading at ~5.7x my estimate of normalized earnings. I’m writing ATH up again since the setup today is similarly skewed (trading <5x 2020 earnings). Athene has been written up extensively on VIC, so for basic business background and history, please refer to the previous posts. In a nutshell, Athene is a net spread business (similar to a bank) that takes cheap, long-term liabilities (~10yr wtd avg life) and invests them in high quality credit assets, generating investment spread. Athene’s investment yield is currently ~4.65%, and after the cost of crediting (~1.70% of invested assets), amortization of policy acquisition cost premium (~1.35% of invested assets), and platform opex (~0.35% of invested assets), ATH generates an after-tax ROA of ~1.25-1.35% (or “Adjusted Operating Spread”). Athene operates with a modest amount of leverage (~11-13x assets/equity, similar to a regional bank), and generates a mid-to-high teens ROE (~15%+).  94% of ATH’s assets are investment-grade NAIC 1 and NIAC 2. Note that ATH has a ~5% asset allocation to “alternatives” (which is pretty similar to peers).

Investment thesis

Athene’s has massively de-rated since its IPO in 2016, despite achieving or out-executing all of the pre-IPO goals, growing book value (BV) at a high-teens CAGR (NTM P/E down from ~10x to <5x today). Whether the fears be rate-driven or credit-driven – pessimism (as highlighted by pcm983’s post in 2017) has pushed the stock down to a valuation level that is irrational, and in my opinion, unsustainable due to the reflexivity of capital return at a significant discount to book value. Put simply, a company that does a ~15% through-cycle ROE trading at 0.8x book value will generate a “buy-and-hold” ~20% IRR (not to mention its share repurchases are book value accretive). I lay this math out in the Appendix. I think investors with a 3-5 year time horizon will be very pleased with an entry price at current levels.

Today, Athene is trading at ~5.5x 2019 earnings of $7.30 (which they’ve effectively guided to), and ~4.8x my 2020 estimate of ~$8.50. Adjusted BVPS was $45.60 at year-end 2018, and the company is accreting book value at ~$1.70/qtr, which means ATH will have ~$49.00 of BVPS by 6/30/19. That implies the stock is trading at ~0.8x BV today (and ~0.7x statutory BV ~$56 by 6/30/19). This valuation disconnect seems crazy with the market near all-time highs and credit spreads indicating no recession in sight. While many financials have sold off dramatically in-light of the recent decline in interest rates, the worst of the carnage has been reserved for the most rate-sensitive companies (i.e. some banks are not duration-matched and would see earnings cut ~40%+ if Fed Funds went back to 0-50bps). Athene is roughly duration matched, so while lower rates could pull portfolio yields down over time, the industry will adjust pricing on new business to continue to target the low teens returns (which equate to mid-teens returns for ATH given its Bermuda tax advantage).

Athene does have some rate exposure - for each 25bps parallel shift in rates, their operating income moves by +/- 25-30mm. So even if you take rates back to zero, you're talking about a ~10-15% impact on earnings. For a company trading at <5x 2020, I think that's more than baked into the share price. I'm not saying ATH can't get cheaper. Obviously if the US slumps into a recession the company could trade at an even steeper discount to BV. But for investors with a long-term view who aren't trying to time the cycle, I think ATH represents a very compelling risk/reward - one in which you're getting paid ~5% per quarter to hang out. Furthermore, when ATH emerges on the other side of a US recession, I think the multiple it trades at will be significantly higher given today's corporate credit concerns will very likely prove to have been overstated. Over time, I think ATH's cost of equity will migrate to something closer to ~10-12% from today's ~15-20%. If ATH were valued at a paltry 7.5x 2020 earnings (or 1.2x P/BV at YE 2019), shares would be worth $64.00 (+57%). You don't need to believe this though, since just buying and holding it here will produce a ~20% IRR if the company just maintains its crappy 5.5x valuation.

The situation with Athene today is reminiscent of when Warren Buffett bought Wells Fargo in 1990 at 5x earnings (you can read his letter here). I think this is an interesting analogy, since both Athene and Wells (at the time) generated attractive through-cycle ROEs, both traded at a discount to BV because of credit fears, and both were led by incredibly capable management teams. In the case of Wells, Buffett basically said (I'm paraphrasing): who cares about the credit risk - since even if a recession wipes earnings for a year, you set the business up in a recovery at 5x earnings:

Of course, ownership of a bank - or about any other business - is far from riskless.. Consider some mathematics: Wells Fargo currently earns well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank's loans - not just its real estate loans - were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even. A year like that - which we consider only a low-level possibility, not a likelihood - would not distress us. In fact, at Berkshire we would love to acquire businesses or invest in capital projects that produced no return for a year, but that could then be expected to earn 20% on growing equity. Nevertheless, fears of a California real estate disaster similar to that experienced in New England caused the price of Wells Fargo stock to fall almost 50% within a few months during 1990. Even though we had bought some shares at the prices prevailing before the fall, we welcomed the decline because it allowed us to pick up many more shares at the new, panic prices.

Athene has run recession sensitivities, and based on its modeled scenario (which is roughly an average of the last 3 recessions), earnings for one year are nearly wiped out. That also assumes all of the losses are pulled forward into a single year (which won’t happen). ATH’s recession sensitivity scenario implies a ~120bps total loss rate in a recession vs. ~100bps for a peer portfolio (with the difference entirely explained by a higher allocation toward RMBS securities). Note that insurance industry credit losses peaked around ~60bps in 2008 (but again, Athene’s analysis is “cumulative” which would be roughly comparable to the ~110bps the industry experienced in ’08 and ’09).

Why the opportunity exists?

Athene, and life insurers in general, seem to be ground zero for corporate credit worries – investors are convinced they’ve been stretching to pick up yield in a rate-starved macro environment. While on the margin, that’s true (e.g. there are higher allocations to the BBB and more structured securities than historically), the share prices of life insurers, and Athene in particular, far more than reflect any real or perceived increase in credit risk. In addition, Athene has been managing its credit portfolio in recent years to shift exposures to more macro-resilient industries (e.g. utilities) and higher rated tranches of structured securities.

“Shadow banking” has been a hot topic in recent years, and investors are clearly spooked by the amount of credit formation that has occurred outside of the formal banking system this cycle. There are good reasons for this shift however: onerous bank regulations post crisis, both quantitative (e.g. stressed losses in CCAR) and qualitative (e.g. leveraged loan guidance) have discouraged banks from competing aggressively on loan terms and dramatically increased their cost of capital. Large banks are effectively bound by their stressed losses which force them to hold irrationally large capital cushions relative to historical loss experience, making other funding structures (such as CLOs) much cheaper/more efficient for issuers. While it’s true LSTA data shows that aggregate corporate leverage has risen and covenant protections have weakened post-crisis, the rise in aggregate corporate leverage levels can be justified by the lower cost of debt service today (which isn’t about to change with Japan and German 10-yrs now negative yielding). With the 10-yr around ~2.4-2.5%, corporate debt burdens will remain highly manageable. While you can always find a dumb deal being done (e.g. Grant’s loves to call these out), they are the exception, not the rule. In addition, Apollo/Athene have consistently called out the frothiest parts of the credit market and the company is staying away from assets that don’t offer attractive risk/reward or downside protection. Lastly, while there’s been a ton of press about the inverted yield curve signaling recession, I think that risk is more than priced into shares (as the recession sensitivity shows). Additionally, a recession would provide a very attractive capital deployment opportunity for Apollo/Athene as credit spreads widen (ATH has ~$3bn of dry powder available - $1bn of excess equity capital and $2bn of debt capacity, which could support ~$40bn of incremental assets). Frankly, I’m not even sure how accurate of a predictor the inverted curve will prove this cycle given the near record negative term premium (close to its Brexit lows, driven by Europe/Japan’s negative yielding bonds).

Athene vs. regional banks: irrational pessimism

Athene has been very candid about staying away from the highly competitive asset classes where they are not finding value today (e.g. leveraged loans). Increasingly, ATH’s competitive advantage will come in the form of direct origination of credit assets (as opposed to buying out-of-favor assets which was the strategy historically). Currently, direct origination accounts for ~5-10% of ATH’s portfolio, but the company is targeting ~33% over time as they continue to build out differentiated capabilities with Apollo. Today, Athene sources direct originations from four Apollo-managed platforms:

-MidCap: a middle-market corporate lending platform originating senior secured loans (~$19bn of commitments across different sectors). ATH has an equity stake in MidCap within its “alternatives” portfolio

-AmeriHome: a mortgage originator and servicer, which allows them to hold MSRs. ATH has an equity stake in AmeriHome within its “alternatives” portfolio

-Merx: aircraft leasing platform managed by Apollo, targeting low DD% return

-Triple-net leases: Apollo is in the process of building out this platform which will permit Athene to acquire triple-net real estate assets to add to its “alternatives” portfolio

This quote from Jim Belardi (CEO) at Athene’s investor day succinctly lays out the strategy:

We also, in addition to credit risk, underwrite with Apollo liquidity and complexity risk as long as we're paid adequately for it. Before we buy any asset, we engage in significant stress testing on all sorts of metrics, see how it performs in a crisis… Apollo has a variety of direct origination sources that we can pivot among as well as we have a dynamic asset allocation process within Athene to lean in on – and Apollo to lean in on cheap assets, back off on rich assets. We've never stretched for yield. We rely on core fundamental underwriting and our business model allows us not to have to stretch for yield on the asset side.

Direct origination is becoming more and more important. It's clear to us that's where the emphasis needs to be. It's a new paradigm, insurers can't continue what they've done in the past, it's not generating enough alpha. So, here we show some of our direct origination capabilities, compared to various indices. In the levered loan indices, and you see in our MidCap asset originator outperforming significantly. And down the road the CMBS Index, Apollo's commercial real estate debt outperforming; in the U.S. Corporate Index, Apollo's foray into insurance-linked securities, significant outperformance; and in aircraft, through Merx at Apollo done better than the Index. Value-add exists we believe in direct origination in less trafficked areas where we can underwrite complexity and illiquidity without sacrificing any credit quality or risk metrics. We've benefited significantly from Apollo's investment in direct origination.

These directly originated assets have significantly higher yields than comparable indices:

While Athene underwrites to (and generates) a mid-teens ROE (~15%), similar to most regional banks, it trades at ~0.8x P/BV while regional banks trade at anywhere from ~1.5-2.0x+ TBV.

While there are many who point out Athene is an “unproven” business model within insurance since it allocates a portion of its portfolio to unconventional assets like illiquid corporate credits, I’d point out that banks hold large portfolios of “illiquid credits” (i.e. loans) with arguably inferior liabilities (short-term deposits). Call me crazy, but I just don’t find it scandalous for a company with long-term (~10yr duration) liabilities to invest a portion of its portfolio into illiquid, higher yielding instruments.

I think the comparison to regional banks is instructive since the essence of the business models are similar, yet ATH trades at a material discount to BV while banks trade at significant premiums. They both “borrow” from the public (banks from depositors, and life insurers from policyholders) and invest in a portfolio of credit assets. The idea that Athene is somehow “riskier” because it invests a portion of its portfolio in “illiquid” assets is sort of funny to me because that’s exactly what banks do. Athene is levered ~12x (assets/equity), which is similar to most banks. While regional bank P/BV multiples are much higher than Athene, I’d argue Athene has a more durable competitive moat given less competition within the insurance space (e.g. there’s no goliath like JPM or BAC gobbling up share of consumer deposits by investing $10bn/yr in technology). Additionally, Athene’s relationship with Apollo allows them to source assets much more broadly than a regional bank which is generally confined to its footprint.

I’m not trying to suggest shorting regional banks against Athene (although that trade will probably generate spread), I simply want to point out the irrational pessimism infecting Athene relative to other financials.

Risk on Athene’s balance sheet

The “alternatives” allocation gets a lot of airtime, but it’s much safer than perceived (with 85% of the allocation to credit, real assets and strategic investments such as MidCap and AmeriHome). There’s only a 15% allocation to private equity or hedge funds. ~15% of the ~5% alternative allocation as % of total assets = ~75bps of total invested assets allocated to “risky” alternatives, or ~9% of equity assuming current leverage levels of ~12.5x assets/equity. Looking at this a different way, given ATH already trades at a significant discount to both GAAP and statutory book value, you’re getting the “risky alternatives” (and more) for free.

There’s also been a lot of noise around Athene’s CLO exposure, but I think the perceived risk is wildly disproportionate to the actual risk as suggested by the data. 95% of ATH’s CLO exposure is investment grade (BBB or higher), up from 83% in 2016 (as you can see, ATH has been upgrading its credit exposure). If you conservatively assume leveraged loan loss severity this cycle of 40% (vs. historical severity of ~20-30%), you would need a default rate ~3x that of the financial crisis to see even the first dollar of loss impairment on a typical BBB CLO! In other words, the BBB tranche generally has ~15pts of credit protection in the waterfall (meaning you’d need to see a default rate of ~35% before the BBB tranche became impaired –assuming a punitive 40% loss severity). A recession where we’re witnessing that level of carnage would require a severe global financial crisis, one that is highly unlikely anytime soon given the significant banking-system deleveraging, Volker rule, derivative central clearing mandates, etc. that have taken place post crisis). Note that ATH does have a ~30bps position in BB-rated CLOs, but even to impair that, you’d need roughly ~2x the defaults of the financial crisis to see a first dollar impairment there.

Between ATH’s non-investment grade CLO exposure and “equity-like” alternatives exposure, you’re looking at approximately ~1% of invested assets (or ~12% of equity) exposed to “high risk” assets. Again, given the discount to book value, you’re getting these things (and more!) for “free”.

Athene’s structural advantage

Athene’s Bermuda structure gives it a sustainable competitive advantage vs. its US-domiciled peers. In the early days after tax reform passed, Athene appeared to be a relative tax reform loser since the company initially guided to a higher effective rate (~14-15% vs. ~9% inclusive of excise-tax previously). The company has since restructured operations to achieve an all-in rate similar to where it was before tax reform (guiding to a ~9-10% all-in tax rate on a go-forward basis). That said, peers’ tax rates have come down, but still not the level where Athene is today (competitors are generally at ~15-22%). This implies if peers are originating new business at a ~12.5% underwritten ROE, ATH should be able to do a ~14% ROE (and that’s before any investment yield or scale advantages which historically have given ATH’s ROE an even greater edge). ATH has generated a ~40bps higher net investment yield than the industry over the last few years, so even if you assume going forward it’s ~10-20bps, that would add another ~100-200bps ROE outperformance. Hence ATH’s mid-teens ROE target feels very sustainable. Keep in mind that annuities (like financial services generally) are highly competitive, and that industry ROEs are bounded by the industry’s cost of equity. While this caps the “upside” from higher interest rates or tax reform (since the benefit is passed onto customers as the book rolls over), the “downside” from lower rates is also mitigated since competitors adjust pricing/terms to achieve their internal ROE targets.

Apollo/Athene relationship

While there’s been much written about potential APO-ATH conflicts both in the investment community and in the press, I think it’s massively overblown. ATH just recently re-cut the fee arrangement to better align incentives (paying more for “high alpha” products like direct originations and less for more plain-vanilla product). A recent FT article pointed out that the ~40bps fee rate is higher than the ~15-25bps fee rate that would be considered closer to “market” for an outsourced investment capability. But as an ATH investor, I’m very happy paying Apollo a 10-20bps premium for significant cross-asset expertise, help with deal structuring/sourcing, and industry-leading direct origination capabilities.

On a related note, management’s incentive plan (crafted by Apollo) is very thoughtful and encourages profitable growth. The annual cash incentive (roughly ~50% of total comp) is structured with 40% based on an operating income target, and 20% on expense targets, organic growth, and underwritten IRR, respectively. The company also grants long-term RSUs awards (roughly ~25% of total comp), of which 50% are performance based (equally weighted on ROE and operating income targets). Salary makes up the remaining ~25% of management comp. Lastly, senior management owns a ton of stock.. Jim Belardi  owns ~$200mm, Bill Wheeler owns ~$65mm and Grant Kvalheim owns ~$90mm. They are very unlikely to do anything so stupid as to jeopardize their largest personal investment.

Appendix: Illustrative buy-and-hold IRR math:

Catalyst

I think continued share repurchase (ATH initiated its first repurchase in Q4’18) will be a catalyst that keeps the stock from trading at too steep a discount to BV. It’s going to be hard for ATH to continue de-rating at the same magnitude the company has over the previous three years since it would imply ATH would trade at a silly P/E and book value multiple (if ~5x isn’t silly enough). Obviously if we hit a severe recession ATH could trade to an even deeper discount to book value, but the risk/reward today for this stock seems wildly asymmetric when compared to the market broadly (or financial company peers).