Genworth (GNW) Investment Thesis: Part I What went wrong?

Genworth Financial, Inc. (GNW):

Genworth Financial, Inc. (GNW) provides insurance and financial management in the United States and internationally including fixed annuity products, life and long-term care insurance; payment protection; and mortgage insurance to insure residential mortgage loans. With more than 15 million customers in 25 countries the company was spun off from General Electric, Inc. in 2004 and is headquartered in Richmond, Virginia. GNW has the following operating segments:

U.S. Life Insurance (59.3% of 2011 revenue):life insurance (19.7%), long-term care insurance (29.0%) and fixed annuity products (10.5%).

International Protection (9.9% of 2011 revenue): provides payment protection (lifestyle protection) in European countries due to accident, illness, involuntary unemployment, disability or death.

Wealth Management (4.4% of 2011 revenue): includes managed accounts, advisor
and financial planning services.

International Mortgage Insurance (14.6% of 2011 revenue): a leading provider
of mortgage insurance in Canada, Australia, Mexico and European countries. The products insure individually underwritten residential mortgage loans known as “flow mortgage insurance” and mortgage insurance on a bulk basis for the sale of mortgages to capital markets and for lenders.

U.S. Mortgage Insurance (7.0% of 2011 revenue) United States mortgage insurance insuring individually underwritten residential mortgage loans and mortgage insurance on a bulk basis.

Corporate and Runoff (5.0% of 2011 revenue)Corporate includes debt financing at the holding company level, unallocated corporate income and expenses, eliminations of inter-segment transactions and the results of other non-core businesses that are managed outside of the operating segments. Runoff includes the results of non-strategic products no longer actively sold.

What Went Wrong?

After the spinoff from General Electric, GNW continued to build its global presence in life, long term care and mortgage insurance and expanded into a range of financial services businesses. The share price was penalized for mispriced products in Long-term care insurance and large incurred and pending losses in mortgage insurance from the housing market downturn. Macroeconomic concerns and management miss steps further eroded confidence in the company.

Mortgage insurance:

The 20% down payment is the primary barrier for most to buying a home. That barrier has historically been overcome with the use of private mortgage insurance (MI). Mortgage insurance enables borrowers to buy homes with less than a 20% down payment because mortgage insurance takes the first loss after the borrower if defaults occur. A survey by the National Association of Realtors estimated half of all home purchases in 2010 were first time buyers and 86% of these buyers made down payments below 20%.

Mortgage Delinquency and Foreclosure: Mortgage insurers in the U.S. faced a huge challenge in the housing market meltdown. They guarantee the most risky residential mortgages, those with less than a 20% down payment, and are placed in the first loss position if the mortgage defaults. Some mortgages written during the 2005-2008 housing boom were “non-traditional” products from which insurers experienced large losses in addition to the losses on traditional MI products. Mortgage delinquencies and foreclosures continue to occur well above historic levels leading to concerns of more mortgage insurance claims.

It takes about one year between the initial delinquency on a mortgage and foreclosure when the mortgage insurer pays out on the claim. So the fear lingers that the worst may yet be to come. The chart below shows U.S. mortgage delinquencies through 3Q12. Source: Mortgage Bankers Association

Combined Ratio: A measure of the profitability of insurance companies is the combined ratio. It is the sum of the expenses incurred for writing insurance and the losses incurred once claims are made divided by the revenue or premiums received. The results are expressed as a percentage.

So if expenses and losses exceed premiums the combined ratio is greater than 100%. The company is paying out more than it is receiving and operating at a loss.  If the ratio is less than 100% the company is receiving more than it pays out and is operating at a profit. The combined ratio must be considered over a long period of time in the mortgage insurance industry where premiums may be accumulated for many years (about 7 years on average in the U.S.) before claims are paid out. The charts below show the mortgage insurance industry and Genworth’s combined ratio.

Exhibit 4 Source: Mortgage Insurance Companies of America (MICA)

Exhibit 4 illustrates the cyclical nature of the mortgage insurance business. A major housing market downturn occurred in the early 1980s and was followed by the 2005-2008 downturns. Between these two declines there were 16 years of profitable mortgage insurance operations (less than 100% combined ratio). The recent industry losses began subsiding in 2008 and at GNW in 2010. The decline in the combined ratio reflect the start of improvement in delinquencies and foreclosures.

Capital Adequacy: A problem is accessing capital adequacy for the mortgage insurers. Reserves are established on a historical premium to claim basis and the basis became irrelevant in the unprecedented severe housing market downturn. Also, state regulators limit statutory risk to capital at 25:1 for mortgage insurers. Above that limit states have the authority to stop the mortgage insurer from writing new insurance and can take control of the company. The mortgage insurers now depend on continued regulatory and counterparty forbearance to write new business.  GNW along with industry peers are operating under questions about reserve adequacy and concerns over the continuation of risk to capital waivers.

New Regulation: The Dodd-Frank Act contains provisions impacting mortgage insurers. The Act mandates significant rule making by several regulatory agencies to implement the far reaching provisions. The full scope of the Act and its impact on mortgage insurance businesses remain uncertain at this time.

The Act requires:

  1. Mortgage securitizers retain an economic interest in a portion of the credit risk for any asset (mortgage) that they transfer, sell, or convey to a third party.
  2. Exclude loans with non-traditional features such as negative amortization loans.
  3. Require following objective underwriting standards, including; maximum loan to value (LTV) of 80% on a home purchase, maximum debt-to-income ratios and borrower credit history restrictions.

Competition: The National Association of Realtors estimates that 75% of all buyers financed 80% or more of their home purchase in 2010 while the availability of mortgages declined especially for low down payment loans. To avoid further housing market declines the federal government directed the Federal Housing Authority (FHA) to step up loan insurance to avoid further obstacles to the market recovery. Increased government activity in the market raised further concerns about the future role and viability of the private mortgage insurers in the face of increased government competition.

Long-term care insurance:

GNW’s largest product line is long-term care insurance (LTC) at 29.0% revenue. GNW is the industry leader with about 38% U.S. market share and almost three times the next largest. Long-term care insurance sells policies to help pay for nursing-home, assisted-living and home care costs.  Estimating the costs of claims from policy holders years in advance is risky as people live longer and care costs soar. GNW continues to sell LTC policies but has experienced increased stress in two important areas of LTC insurance.

Underwriting losses: Underwriting losses occur when the assumptions for pricing insurance products are incorrect and premiums are insufficient to offset insurance claims. Miscalculations and optimism prompted carriers to offer policies at lower prices expecting to make money on fewer claims and getting higher returns on their investments. LTC insurance has proven very difficult to price with higher than expected claim costs due to:

  1. Persistence or lapse rate as Genworth expected 5 percent of its policyholders to stop
    paying premiums and give up the policy each year. Only about 1 percent did, that resulted in more policy holders making claims for care.
  2. Life Expectancy is increasing for individuals buying the coverage. That resulted in policy holders claims lasting longer.
  3. Increased Coverage as insurance policies broadened to cover assisted-living residences and in-home care where claims last longer. Some still ended up in nursing homes increasing the costs further to the insurer.
  4. Soaring Costs as the cost of care is expensive and expected to rise with a year in a nursing home easily topping $80,000, according to some reports. The graphs below illustrate the increasing daily rates by type of care rising at more than twice the rate of inflation.

Source: Prudential Long Term Care Cost Research Report 2010

Interest rates: Insurers also seek to profit by managing their investment portfolio
for investment income and gains until claims must be paid.  Forty percent to sixty percent of the money insurers accumulate to cover future claims comes from investment returns, according to the American Association for Long-Term Care Insurance. Recent historically low interest rates have resulted in lower yielding investments returns further hurting LTC results.

Holding Company:

Management: Chief Executive Officer Michael Fraizer’s resignation was announced May 1, 2012 after shares plunged more than 80 percent since the end of 2006. Chief Financial Officer Martin Klein was named acting CEO. Fraizer was criticized for shelving plans in April, 2012 for the initial public offering of the Australia mortgage insurance unit to raise capital due to elevated losses at the unit. The sale was intended to increase the company’s cash sought for share repurchases at the depressed prices.  Previously the CEO was  criticized for misjudging when results would rebound in the U.S. mortgage insurance operations.

Jonathon Jacobson of Highfields Capital Management LP, a major shareholder with about  6 percent of GNW was quoted by Bloomberg; “This has been a long time coming. Fraizer has been an impediment at the company to both operating and structural changes. We applaud the board for taking the step that they took today.”  

Financial Flexibility: Genworth’s low share price, continuing losses in the U.S. mortgage insurance business, capital waivers, the failed Australian IPO, low earnings in life insurance, and rising costs in the LTC segment raised multiple concerns about GNW’s ability to raise capital.

Strategic Review: GNW’s undertook a strategic review and announced it was complete, but perhaps waiting for a new CEO, it was slow to disclose the results. This created frustration for analysts and investors following the company. In times of stress transparency and open communication is needed to help alleviate fears. In the absence of transparency the concerns become fodder for negative media and analyst attention.

The Turnaround

The financial crisis and operating problems at GNW became catalysts for the company to start addressing needed changes. The board woke up, investors and analysts became vocal and improvements were initiated. The turnaround is underway, still needs work, but initial signs of progress largely overlooked.

Genworth Financial, Inc., Valuation Summary:

Genworth share price is about $5.50/share, trading at a huge 85% discount to book value. The discount came about as the company experienced significant problems during the financial crises and fearful investors fled. However, a fresh look Genworth’s business in the today’s environment indicates the worst may be over and a turnaround is underway.

There is still a lot of work to do but real progress is being made; external and internal conditions are improving. The ongoing fear is depressing the share price at levels representing the old news rather than new developments and promising data.

It is a question of timing; if we wait until progress becomes obvious to those not willing to analyze the data it will be reflected in a higher share price and we miss an opportunity. If we act too early we could have a long wait or worse error on the valuation and lose capital. I believe in the former and have made an investment in Genworth with the intention of increasing it as progress continues.

The share price plunge has the board of director’s attention (with the help of an attentive hedge fund) and a serious turnaround effort seems to be underway. Currently trading at a price to book (P/B) value of 0.15 and a forward price to earnings ratio (P/E) of 4.3, GNW has the potential to reach a valuation close to book value.

At a recent price of $5.50/share, and placing more weight on the intrinsic value estimates of about $22.00/share a 300% improvement in share price is expected and up to the mid $30/share in a 3-5 year time frame:

Share Buybacks would be Accretive to Book Value:

GNW’s management is under pressure to buy back shares of common stock now trading significantly below tangible book value. No buybacks are assumed in this evaluation. However, should the low share price continue, it provides management with a very attractive use of capital. The table below shows that a $100 million share buyback would decrease book value by $100 million because cash declines by that amount, but increases per share book value by 1.14/share or about 3.2%. Eventually the market share price will reflect improvements in book value per share.

To put this capital allocation opportunity into perspective it would take about $560 million in after tax earnings without share buybacks to have the same impact on book value as $100 million in share buybacks.  Warren Buffett, no slouch in capital allocation or the insurance industry wrote in Berkshire Hathaway’s 1984 annual report, “When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.” Let’s hope GNW’s management listens.

Part II covers the underlying turnaround thesis for the investment and valuation in detail.

Disclosures:

I am long GNW and may buy more shares in the near future.

The information contained herein is provided for informational purposes only, is not
comprehensive, does not contain important disclosures and risk factors associated with investments, and is subject to change without notice. The author is not responsible for the accuracy, completeness or lack thereof of information, nor has the author verified information from third parties which may be relied upon. The information does not take into account the particular investment objectives or financial circumstances of any specific person or organization which may view it. Nothing contained within may be considered an offer or a solicitation to purchase or sell any particular financial instrument. Any investment can be very risky and is not suitable for everyone. You should never enter into an investment unless you can afford to lose your entire investment. Always complete your own due diligence. Before making any investment, investors are advised to review such investment thoroughly and carefully with their financial, legal and tax advisors to determine whether it is suitable for them.

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