Genworth (GNW) Investment Thesis: Part II Turnaround and Valuation

In Genworth (GNW) Investment Thesis: Part I we discussed what led to the collapse in the share price and why it is still trading at a huge discount to intrinsic value. The central question: is this deep discount justified or is it a value investing opportunity created by past worries, fear and excessive pessimism? To answer the question, we focus on the troubled segments, the macroeconomic challenges, and management’s actions.

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. A turnaround is underway but still largely overlooked.

Typical monetary policy recessions are caused by increased interest rates to reduce inflation and they last about 6-18 months. This recession is different. It came about because of the unsustainable levels of private and public (government) debt. Known as a balance sheet recession caused by bad debts, falling asset prices and bank losses; the cure is debt deleveraging and that can take many years to accomplish. It is likely these conditions will continue and we’ll experience a slower than typical U.S. recovery but it will come. Macroeconomic conditions, home prices and unemployment are stabilizing.

Mortgage Insurance:

Mortgage Delinquency and Foreclosure Outlook: Economists are encouraged from a variety of signs that the housing recovery is finally here including three months of increases in the S&P/Case-Shiller home price index; increase in the sale of existing homes and home construction; and an increase in the price of new home sales. Mortgage interest rates will likely remain at record lows as the Federal Reserve continues to purchase $40 billion in mortgages for the foreseeable future.

Mortgage delinquencies at GNW, a precursor of foreclosures and insurance claims, by aging category continue to trend downward while reserves per delinquency strengthen. This is shown below in the “Primary Delinquencies” chart. New delinquencies at GNW continue to trend lower as shown in the “New Delinquency Slowing” chart and the GNW U.S. Mtg. Primary Delinquency Rate chart below.

New delinquencies at GNW continue to trend lower shown in the “New Delinquency Slowing” chart.  New delinquency are also declining from the worst years, 2005-2008, where the bad business was adopted through poor underwriting practices as shown in the “2005-2008 Books Peaked” chart below.  Chart Sources: Genworth’s Australia Mortgage Insurance & U.S. Mortgage Insurance

Combined Ratio Outlook: Drilling down a little deeper we find that GNW’s U.S. mortgage insurance business loss ratio (the combined ratio ex expense ratio) shows losses are continuing to decline. Significant improvement is seen in 2012 compared to 2011 as U.S. mortgage insurance losses improve and will be soon reflected in the combined ratio reflected in charts below. Analysts forecast GNW’s U.S. mortgage business to return to profit sometime in 2013.

Genworth’s mortgage insurance revenues in 2011 were 68% from international operations and 32% from the U.S. operations. Speculation that GNW’s international mortgage was the next shoe to drop is just wrong as the larger international business segment has remained profitable thanks to better banking governance primarily in Canada and Australia. Canada and Australia represent 95% of the international mortgage insurance business with the remaining 5% primarily in Europe. Combining GNW’s maligned U.S. and International mortgage insurance business into one unit shows global results to be profitable for the first nine months of 2012.

Source: Genworth 3Q12 10Q

Capital Adequacy Outlook: Genworth announced during the 2Q12 earnings release that Genworth Mortgage Insurance Corp (GEMICO), its primary mortgage insurance company was granted an 18-month extension to its capital waiver enabling it to continue writing new insurance as illustrated in the chart below.

This is important because it enables the company to write profitable new insurance with favorable rates.  As discussed in the 3Q12 conference call: Considering these improving macroeconomic fundamentals, the continuation of government programs, loan modifications, the continued burn-through of the unprofitable books of business and the growth of new books with a 20% plus ROE, we expect U.S. MI to return to profitability during 2013.”

Regulation Outlook: The full scope of the Dodd-Frank Act on the mortgage insurance businesses remain unclear as it works its way through several federal regulating agencies.  Estimating the outcome is impossible and in my view un-necessary. Considering a few important aspects of the Act, it could be a significant boost for mortgage insurers:

Mortgage securitizers retain an economic interest in a portion of the credit risk and it will be costly: Qualifying Residential Mortgage (QRM) would exempt banks from retaining 5% of the risk. The size of the down payment required for a QRM is an important issue being defined by regulators.

The cost of the risk retention rule will reduce credit availability for credit worthy borrowers unless provisions for either private mortgage insurance or further government mortgage insurance is made. Analyzing nearly 20 million mortgages made between 2000 and 2008, the Center for Community Capital and the Center for Responsible Lending report that QRM mortgages requiring a 10% down payment would lock 40% of all creditworthy borrowers out of the market. A 20% down payment would exclude 60% of creditworthy borrowers.

Without private mortgage insurers lenders will direct homebuyers with less than a 20% down payment to the FHA. The FHA currently provides 100% government insurance of the loan amount vs. 20-25% by private mortgage insurers. The FHA already exposes taxpayers to potential liability of $1.25 trillion as of 3Q12 and without private mortgage insurance the QRM significantly increases that potential exposure.

Given the choice of 1) locking out 40-60% of credit worthy buyers from an already depressed housing market; 2) requiring the federal government to commit more tax payer money to housing with record deficits already in place, or 3) continuing the decades long role of private mortgage insurers putting their own capital at risk, in the first loss position to insure the mortgages. At the risk of over simplifying; is there really a question here?

The other provisions of the Act are to exclude loans with non-traditional features and require adherence to strict, objective underwriting standards. These provisions require good underwriting standards a major contributor to insurer’s profitability.

The Dodd-Frank Act directs regulators to consider mortgage insurance as one of various risk mitigants that might qualify a loan for exemption from securitization risk retention requirements. This additional regulatory recognition may spur additional demand for mortgage insurers.

Competition Outlook: GNW operates in a consolidating mortgage insurance industry where prices are firming, underwriting standards improving (with the help of regulation), and competition shrinking; all positive signs for the company. They now compete with five private mortgage insurers and the federal government (FHA).

Competitors include: CMG Mortgage Insurance Company, Essent Guaranty, Mortgage Guaranty Insurance Corporation (MGIC), United Guaranty Corporation (subsidiary of AIG), and Radian (RDN). In 2011 two other private mortgage insurers PMI Group Inc. (PMI) and Republic Mortgage Insurance Company (RMIC) existed. RMIC went into runoff and in early 2012 was placed under the supervision of the insurance department of its domiciliary state. PMI ceased writing new mortgage insurance in 2011 and PMI’s parent company filed a voluntary petition for relief under Chapter 11 of the U.S. Bankruptcy Code. The FHA’s future role in mortgage insurance will likely come under further scrutiny during federal budget negotiations.

The Wall Street Journal reported on November 16, 2012: “The Federal Housing Administration’s projected losses hit $16.3 billion at the end of September, according to an independent annual audit to be released Friday, a much larger figure than had been forecast earlier. The report suggests the FHA will require taxpayer funding for the first time in its 78 years, though that won’t be decided until early next year. Housing officials said late Thursday they would announce a series of steps on Friday to raise revenue and avert such a milestone. Those steps are likely to raise the cost of FHA-backed mortgages
for future borrowers.”

Long-term care insurance:

Genworth’s largest product line is long-term care insurance and GNW is the industry leader with about 38% U.S. market share. The concerns expressed around the viability of the long term care industry and Genworth in particular is old news. Long term care rates must rise to meet changing demographics and spiraling cost or insurers simply stop selling policies. The chart below shows GNW’s ability to maintain a profitable LTC business in the face of the challenges.

As an example of GNW proactively addressing LTC issues; during the 2Q12 earnings release GNW announced that the LTC premium rate increases of 18% to manage losses on older issued policies were substantially implemented. The company received approvals for price increases in 45 states, representing approximately 80 percent of the targeted premiums.

They announced that later in the month they would file a new round of rate increases:

  1. To achieve average premium increases in excess of 50% over the next 5 years.
  2. Seek approval for premium rate increases for policyholders in the earliest series of
    the new generation policies that are falling short of returns due to lower interest rates, higher claims due to an unfavorable business mix and lower lapse rates than expected.
  3. Stay ahead of this block of business with our in-force premium rating strategy, and
    we’ll therefore request an average premium rate increase in excess of 25% over the next  5 years.
  4. That early intervention is important to managing the long-term performance of this
    business.
  5. Subject to regulatory approvals the increases will generate approximately $200 – $300
    million of additional annual premium when implemented.

Effective July, the company introduced changes to its individual long term care product to strengthen profitability and reduce risk including:

  1. Certain lifetime benefits coverage and limited pay options will no longer be available.
  2. Underwriting was tightened, first year commissions lowered, certain discounts reduced or eliminated effectively increasing prices by more than 20 percent on the products impacted.

The company began filing a new product scheduled for early 2013 release, which will include new concepts such as:

  1. Gender distinct pricing for single applicants.
  2. Blood and lab underwriting requirements for all applicants.
  3. As of July 27, 2012, the new product has been filed in 38 states and has approval from seven states.
  4. Offsetting these changes will be increases in sales of the current product before it is replaced by the new product.

When question whether the rate increases will impact sales, management responded in part “…reason for the rate increases was really related to the strategic review and a desire to really dramatically improve business performance….we frankly look at the older block and see the losses….we felt we need to take more — much more significant
action… big driver was really the economics and the drive to improve business performance.”
 A reassuring focus on improving earnings.

Low interest rates hurting investment returns will self-cure. Eventually the cycle will return and historic low interest rates will rise helping to increase the investment returns and the earnings power of the business.

Holding Company:

Management: During the 3Q12 conference call, Martin Klein acting Chief Executive Officer and CFO reported the board to be actively engaged in the CEO search process and has made good progress. Credit to the company without a CEO as progress is being made and management is responsive to requests for more disclosure, especially on the strategic plan, more on this later.

Financial Flexibility:

  1. The GNW holding company debt that matured in 2009-2011 was refinanced and paid. Financing is in place for debt maturities prior to 2014.
  2. GNW liquidity is viewed as strong by Fitch credit rating and management has indicated its intent to hold a cash buffer of 2x annual debt service in holding company cash. It exceeded its goal at the end of 3Q12.
  3. Following a similar block transaction 1Q12; Genworth Life plans to complete a second block transaction in 4Q12 generating in excess of $100 million of after tax capital benefits.
  4. The Australian mortgage insurance IPO was postponed to late 2013. Although delayed, the 40 % offering of the company is expected to raise almost $2 billion.

Commenting on liquidity during the 3Q12 conference call, Klein reported “At the end of the third quarter, cash and liquid securities at the holding company totaled about $1.4 billion…and after reflecting upcoming payments the holding company has about $1 billion in cash and liquid securities in line with our target of 2x debt service coverage… as well as an additional buffer of approximately $350 million for stress scenarios that might impact the dividend sources to the holding company over the next 18 months.”  

Fitch views: “GNW’s financial flexibility as being hindered by the company’s low stock price that trades at a significant discount to book value and high spreads in the credit default swap market. Additionally, both of GNW’s revolving credit facilities matured in 2012 and neither facility was replaced.”

Strategic Review: During the 3Q12 earnings report the company provided needed clarity on its Vision & Strategy. Addressing criticism of past management’s diversification into non-core areas the essence of the strategic plan is shedding these assets and focusing on core operations with a priority to “rebuild value for shareholders”.

Source: Genworth Vision & Strategy

Core businesses are: the Global Mortgage Insurer and; U.S. Life Insurer focused on Life, LTC, and Fixed Annuities. Non-core businesses are: International protection where management announced plans to increase value for potential sale and Wealth Management. On 10/12/12 Reuters reported on the prospective sale of Wealth Management: “Genworth is working with Goldman Sachs & Co (GS.N) as the banker for the deal, said one of the sources, who estimated that if the two businesses were sold together they could be valued at about $400 million.”

Valuation:

It is believed GNW is a good investment opportunity as company specific and macroeconomic conditions improve but timing is uncertain. Because there are many aspects to this investment and a CEO is yet to be hired the risks are high. However, it seems the deep discount provides a reasonable margin of safety.

Net Asset Value (NAV):

Net Asset Value or book value refers to the sum of all of a company’s assets minus its liabilities. It is reflected on the balance sheet as shareholders’ equity. Because the assets and liabilities exist today and can be measured with better precision than future earnings it tends to be a more reliable indication of value.

Net Tangible Value (NTV):

Net Tangible Value is a more conservative measure of the worth of a company because it does not include value for intangible assets such as goodwill.  The NTV of Genworth is calculated by taking a firm’s total assets and subtracting the value of intangible assets including present value of profits ($488 million), goodwill ($1218 million) and deferred acquisition costs ($5020 million) that would have no value on liquidation. Liabilities for policy and contract claims were also increased to reflect a contingency of 50% ($1244 million) for U.S. mortgage potential under-reserve, although all future losses should already be reserved. The NTV reflects the orderly liquidation value of the company, believed to be a conservative view.

Insurer’s shares are typically valued at a multiple of book value. The multiple depends on the type of insurer and the insurers return on equity. Adjusting for these factors, Genworth had a pre-crises average return on equity of about 8% implying a book value multiple of about 1.0X. During the past 10 years, 5 year pre-crises and 5 years during the crises the average return on equity was about 4% implying a book value multiple of about 0.6X. Given the severity of the recent crisis, I’m assuming this macro environment is not likely to recur anytime soon, and this should represent a pessimistic case.

This brings us to the first intrinsic value estimate range and the liquidation value for GNW:

Earnings Power Value (EPV):

Earnings Power Value is an estimate of the company’s value calculated from free cash flow from ongoing operations with no credit given for cash flows anticipated from future growth. EPV for GNW looks at the insurers recent 10 year cycle. EPV at the bottom of the cycle (now) indicates an EPV of $12/share; mid cycle EPV of $22/share, and top of the cycle (over the next 5 years perhaps) at $32/share.

Valuation:

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 as discussed in Part I.

Our Investment Thesis: The Reasons to Consider this Investment:

There are a lot of moving parts, both at the company and macroeconomic level. Continued  uncertainties are holding GNW’s share price at 15% of stated book value. The company will likely continue selling at a discount pending further resolution of the many issues that need to be monitored. However, it seems turnaround is underway on both a macro and micro level but largely overlooked by the investment community. Lingering pessimism and misperceptions create a buying opportunity that may last until the improvements are widely recognized. These improvements include:

  1. The U.S. housing recovery is underway and GNW’s domestic mortgage insurance will survive.
  2. Unlike mono-line domestic mortgage insurers, GNW has other resources to fund the recovery.
  3. Competitive and structural changes in U.S. mortgage insurance will lead to increased industry profitability.
  4. GNW’s international mortgage insurance business is profitable and improving.
  5. Long-term health care is profitable and growing concerns are aggressively being addressed.
  6. The financial crisis acted as a catalyst forcing needed management and strategic changes resulting in a more focused company.
  7. Shareholders have a vocal advocate with Highland Capital Management.
  8. Low investment returns will correct on future inevitable interest rate increases.
  9. Share buybacks provide an extremely attractive, alothough yet unused, opportunity to increase share price significantly.

We’re in good company. Seth Klarman has bought 15 million shares 2Q12. The Economist describes Baupost the $25 billion hedge fund and ninth-largest hedge fund in the world this way: Since 2007 its assets have more than tripled, as other funds have wobbled. Baupost has had only two negative years (in 1998 and 2008) since it launched in 1982,
and is among the five most successful funds in terms of lifetime returns…a particularly striking record given its risk aversion.
Highland Capital Management holds 25+ million shares and is acting as a strong advocate for shareholders. As always it’s nice to be in good company.

Risks:

  1. GNW is in the midst of a turnaround and in search of a new CEO. A strategic plan has been adopted by the board of directors but in the absence of a CEO there is uncertainty as to whether the current direction will continue.
  2. GNW’s results are influenced by macroeconomic conditions that are difficult to forecast and could significantly change financial performance of the company.
  3. Government regulations in the future may not be supportive of private mortgage insurers.
  4. This analysis assumes the housing market has bottomed in the U.S. and Australia or Canada’s housing markets will not deteriorate significantly. There is no guaranty this is the case.
  5. Long-term care insurance profitability requires program modifications and rate increases subject to regulatory approvals. There is no assurance that approval will be obtained.
  6. Further, estimating health care costs years in advance is difficult and rising costs could negatively impact results.
  7. GNW is subject to various regulatory reviews in a number of jurisdictions, any of which could result in cash flow reductions and other adverse changes.
  8. As a global company GNW is exposed to foreign exchange risk, interest rate risk, global economic conditions and other material impacts that could adversely affect the business.

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.

Copyright © 2012 Provalum LLC. All Rights Reserved.

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