Genworth Financial (GNW) Reports 4Q12 Results

Genworth Financial (GNW) reported 4Q12 earnings on February 5, 2013 [Source]. Genworth continues to be a work in progress. Our investment thesis [Source] identified many moving parts that need addressed to restore investor confidence. The 4Q12 report on a quarter to quarter basis is characterized as mixed from an operating perspective. From a longer term value perspective, as our investment thesis plays out over a 3-5 year time frame, the results are also a mix of accomplishments and more work to be done. Our thesis remains on track and there is nothing to discourage us from anticipating outsized returns for our patience over time.

The company experienced significant problems during the financial crises around the mortgage insurance business layered on top of ongoing poor performance in the life insurance and long term care. Fearful investors fled. In our investment thesis our look at GNW’s business indicated the worst was over and a turnaround underway. Today’s 4Q12 earnings report supports this.  The improvement in the mortgage insurance business is starting to be recognized as evidenced by about a 65% share price increase since late November 2012.

The needed operationaGNW Photo Lighthousel improvements were recognized by the recently hired CEO, Tom McInerney, who remarked in the conference call; “My focus will be to improve operating performance, generate more cash and capital from the businesses and increase return on equity.”  Issues that were previously the primary sources of concern; credit rating downgrades, mortgage insurance contagion, housing market stability, and company leadership are fixed, improved or viewed less significant.

At the company and macroeconomic level significant progress is being made on many fronts.  After the news release in part below we’ll discuss 4Q12 results and progress with our investment thesis to track progress.

Press Release, Genworth Financial Announces Fourth Quarter 2012 Results:

  1. Operating Performance Includes Benefit Of $78 Million From New Government Guarantee In Canada
  2. U.S. Mortgage Insurance Recovery Continues
  3. Capital Benefit To U.S. Life Companies Of $175 Million From Second Life Block Transaction
  4. Transfer Of Mortgage Insurance Europe Entities To U.S. Mortgage Insurance Completed

RICHMOND, Va., Feb. 5, 2013 /PRNewswire/ — Genworth Financial, Inc. (NYSE: GNW) today reported results for the fourth quarter of 2012. The company reported net income (1) of $166 million, or $0.34 per diluted share, compared with net income of $142 million, or $0.29 per diluted share, in the fourth quarter of 2011. Net operating income(2) for the fourth quarter of 2012 was $167 million, or $0.34 per diluted share, compared with net operating income of $124 million, or $0.25 per diluted share, in the fourth quarter of 2011. Current quarter net income and net operating income included a favorable adjustment of $78 million associated with the finalization of the new Government Guarantee framework in Canada.

“U.S. mortgage insurance continued its recovery in the fourth quarter, and the company achieved a number of its strategic goals to improve financial flexibility highlighted by the comprehensive U.S. capital plan announced in January,” said Tom McInerney, President and CEO.  “However, results in the U.S. Life Insurance Division were mixed, and I am disappointed in our long term care results.  We are focused on executing our plans to rebuild shareholder value.”

GNW 4Q12 Consolidated Net Income

Net investment gains, net of tax and other adjustments, were $1 million in the quarter and in the prior year. Total impairments, net of tax, were $14 million in the current quarter and $70 million for the year ended December 31, 2012. In the fourth quarter of 2011, a non-cash impairment charge of $19 million after-tax was recorded in Corporate and Other activities to write-off all of the goodwill associated with the reverse mortgage business.

Beginning in the fourth quarter of 2012, the company changed its financial presentation for divisions to align with the strategy announced in October 2012. The company will continue to operate through three divisions: U.S. Life Insurance, Global Mortgage Insurance and Corporate and Other. Under these divisions, there are six operating business segments. The U.S. Life Insurance Division comprises the U.S. Life Insurance segment, which includes life insurance, long term care insurance (LTC) and fixed annuities. The Global Mortgage Insurance Division includes the International Mortgage Insurance and U.S. Mortgage Insurance segments. The Corporate and Other Division comprises the International Protection segment, which includes the lifestyle protection insurance business, the Wealth Management segment, the Runoff segment, which primarily includes our variable annuity, variable life insurance, institutional, corporate-owned life insurance and Medicare supplement insurance products, and Corporate and Other activities. There were no changes to the financial presentation for the segments.

Net operating income (loss) results are summarized in the table below:

GNW 4Q12 Net Operating Income

Net operating income (loss) excludes net investment gains (losses), goodwill impairments, gains (losses) on the sale of businesses and other adjustments, net of taxes. A reconciliation of net operating income (loss) of segments and Corporate and Other activities to net income (loss) is included at the end of this press release.

Unless specifically noted in the discussion of results for the International Protection and International Mortgage Insurance segments, references to percentage changes exclude the impact of foreign exchange. Percentage changes, which include the impact of foreign exchange, are found in a table at the end of this press release. The impact of foreign exchange on net operating income in the fourth quarter of 2012 was a $4 million favorable impact versus the prior year and a $1 million favorable impact versus the prior quarter.

How do these results compare to what we thought would occur in our investment thesis [Source]?

Our investment thesis is that a turnaround is underway on both a macro and micro level but largely overlooked by the investment community. The nine improvements we listed and results to date are:

1. The U.S. housing recovery is underway and GNW’s domestic mortgage insurance will survive. Following national trends, GNW’s U.S. Mortgage Insurance leading indicator of new mortgage loan delinquency payments continue to decline as the “bad books” from the housing bubble continues to decline as reported by GNW [Source].

GNW 4Q12 Mortgage Delinquency Graph2. Unlike mono-line domestic mortgage insurers, GNW has other resources to fund the recovery. This is covered in the Genworth (GNW) Announces Resourceful Capital Plan post on 1/16/13 [Source]where the company implemented a restructuring plan that utilizes the international assets of the company to address rating agency concerns and preserve the still to be recognized value for existing shareholders.

3. Competitive and structural changes in U.S. mortgage insurance will lead to increased industry profitability. Although not an explicit part of our valuation, but a huge potential upside option, the U.S. government is pulling back from the mortgage insurance business. In a response to a question from Mark Palmer, BTIG, LLC Research Division CEO Thomas McInerney responded in part this way:

“Yes, great question..we’re talking about the FHA, which is the government’s mortgage insurance arm. And just from a trend perspective.. we’re really coming out of 2012 at a fairly high penetration rate, 8% overall. That’s starting from a point going into the year that was about 5%. Our refinance penetration, which is usually lower than our purchase penetration, has almost doubled… And our purchase penetration, which is really the bread and butter of our business, exited the year as an industry at almost 17%, sort of back to pre-go-go year type levels…So you see the government raising prices on the FHA’s business…getting more restrictive in underwriting policies… that business is beginning to flow back into our markets. We hear it from our customers. You can see it in our production… compare that to where we were on a prior year basis, we’re up over 50%. So the market is getting bigger, it’s a market we think is an attractive market to play in, and we continue to be very disciplined in our pricing approach to going after that business.”

4. GNW’s international mortgage insurance business is profitable and improving [Source].

GNW 4Q12 Global Mortgage Insurance Summary

 

5. Long-term health care is profitable and growing concerns are aggressively being addressed. There is still a lot of work to be done in Long-term health care but it has been getting management’s attention. In this earnings release Tom McInerney, President and CEO said “However, results in the U.S. Life Insurance Division were mixed, and I am disappointed in our long term care results.  We are focused on executing our plans to rebuild shareholder value.”

Later in the release the company reported: In the third quarter of 2012, the company began to request … premium rate increases with the goal of achieving an average premium increase in excess of 50 percent on the older generation policies and an average premium increase in excess of 25 percent on an earlier series of new generation policies over the next five years…Subject to regulatory approval, this premium rate increase would generate approximately $200 to $300 million of additional annual premiums when fully implemented. As of December 31, 2012, this round of rate action has been filed in 49 states and has approvals representing approximately 20 percent of the targeted premium increase.

6. The financial crisis acted as a catalyst forcing needed management and strategic changes resulting in a more focused company. This has largely been accomplished through shareholder activism and the board of director responding by hiring Tom McInerney an insurance industry veteran as President and CEO followed by the announced planned divestitures of the Wealth Management and Life Style insurance segments.

7. Shareholders have a vocal advocate with Highland Capital Management. Highland Capital Management and Seth Klarman’s Baopost Group continue to be significant shareholders.

8. Low investment returns will correct on future inevitable interest rate increases.  This continues to be a significant headwind for all insurers. The prevailing historically low interest rates are not sustainable, however timing for a recovery is impossible to predict. The largest impact is in the U.S. Life Insurance segment, particularly long-term care and universal life insurance. Hedging of interest rate risk exposure helps mitigate the impact significantly. The impact, assuming current rates prevail, was presented by management in the slide below [Source].

GNW 4Q12 Low Rate Impact Chart

9. Share buybacks provide an extremely attractive, although yet unused, opportunity to increase share price significantly. No progress to date. However cash from divestitures of Wealth Management, Life Style Insurance or an IPO of the Australian Mortgage insurance business would provide funds for this high potential return capital allocation.

The turnaround is underway on both a macro and micro level. Lingering pessimism and misperceptions create a continued buying opportunity with the share price around $9.00 or about $11.00 below our $22.00 estimate of intrinsic value yielding about a 60% margin of safety.

Long: GNW

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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