Value Investors Club - ATHENE HOLDING LTD (ATH) PDF

12/6/2019 Value Investors Club / ATHENE HOLDING LTD (ATH)
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ATHENE HOLDING LTD ATH

March 31, 2019 - 9:42pm EST by sas7 (/member/sas7/43334)
2019 2020
Price: 40.80 EPS $7.30 $8.50
Shares Out. (in M): 194 P/E 5.6x 4.8x
Market Cap (in $M): 7,900 P/FCF n/a n/a
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT n/a n/a
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).

https://www.valueinvestorsclub.com/idea/ATHENE_HOLDING_LTD/2008198635 1/12
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 re exivity of capital return at a signi cant 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 nancials 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 signi cantly 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 (http://www.berkshirehathaway.com/letters/1990.html)).
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 re ect 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 e cient 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 justi ed 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 nd 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 nding 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 signi cantly 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 signi cant 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 nancial crisis to see
even the rst 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 nancial crisis,
one that is highly unlikely anytime soon given the signi cant 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 nancial crisis to see a rst 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 nancial 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 bene t 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 con icts 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
signi cant 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 pro table 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:

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.
Catalyst
I think continued share repurchase (ATH initiated its rst 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 nancial
company peers).
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