Genworth Financial (GNW) Update and 3Q13 Results

Genworth Financial (GNW) reported 3Q13 earnings on October 29 [Source] and held their earnings conference call the following morning. Results are good and the prospects for continued improvement are encouraging.

The stock traded down after headlines like Bloomberg’s “Genworth’s Profit Surges as U.S. Mortgage-Unit Results Improve” and Associated Press “Genworth Financial profits more than triple”. The drop was likely due to Genworth’s reported operating profit of $0.24/share missing the $0.26/share estimate by the 10 analysts that follow the company according to Bloomberg.

What Mr. Market ignored was the $0.08/share in one time charges in part from retiring higher interest debt early, a benefit to the company. Without the non-recurring expenses operating profit was actually $0.32/share beating the average of analyst estimates. This is a reminder of difference in investing as an owner of a company follow the underlying fundamentals of the business as opposed to owning a piece of paper, the stock, and following the random daily fluctuations in the stock price whether justified or not.

In our thesis Genworth is viewed as a turnaround investment. Successful turnarounds usually have two levels of recovery. The first recovery occurs after value investors realize excessive fear drove the share price far below the underlying value of the company even with the bad news considered. GNW has recovered from this excessive pessimism and uncertainty to produce a 160% gain in our portfolio.

An encouraging take away from the 3Q13 earnings release and conference call is GNW’s ongoing operations improvements. GNW is now entering the second level of the recovery where mainstream investors recognize it as a future contender that will demonstrate improvement in operating results. As traditional investors began to consider the company as a safe investment they drive share price closer to the intrinsic value. Genworth is showing sustainable operations improvement and management’s focus promises continued improvement and investment gains for us over the next 2-3 years.

“Genworth is moving forward and rebuilding shareholder value through solid operating performance from our divisions, the increasing impact of long term care rate actions and continued achievement of key milestones,” said Tom McInerney, President and CEO. “We have increased our cash balance, established a new credit line, and addressed our near term debt maturities, which have strengthened our balance sheet and increased financial flexibility.”

Investment Thesis:

In our investment thesis [Source] Genworth’s turnaround focused on the two poorly performing core business areas; U.S. mortgage insurance and long term care (LTC) insurance. Management also identified the sale of non-core businesses and debt reduction as high priorities. Progress is being made on all four fronts:

Mortgage Insurance:

The thesis proposed the U.S. housing recovery was underway and GNW’s domestic mortgage insurance business would not only survive but could thrive over time. This is due to competitive and structural changes in the U.S. private mortgage insurance leading to increased industry profitability. GNW’s international mortgage insurance business was profitable and improving.

Updating key metrics with four recent quarters of data we see mortgage delinquencies continue to decline indicating a future reduction in future mortgage insurance claims. The U.S. mortgage loss ratio remains below 100% showing profitable policies are being sold. When insurance expenses and losses exceed premiums the combined (loss) ratio is greater than 100% and the company is paying out more than it is receiving and incurring an operating loss.  If the ratio is less than 100% the company is receiving more than it pays out and is incurring an operating profit.

GNW 3Q13 Delinquency and Loss Graph

Mortgage insurance policies originated during the years 2005 through 2008 used poor underwriting practices and “creative” financing that contributed to the housing crises These are slowly being burned off. During the conference call management explained; “Our total flow delinquencies fell by 24% from the prior year, with new delinquencies up 8% sequentially from normal seasonal variation, and down 19% year-over-year, reflecting the continued burn-through of the 2005 to 2008 books, as well as the new, better-performing books becoming a larger portion of the overall portfolio, now at 41% of risk in force.”

Private mortgage insurance is a cyclical business now benefiting as the housing market recovers, underwriting standards improve and borrower financial strength. This cyclical improvement is complimented with structural changes in the private mortgage insurance industry with fewer private competitors and a reduced role of the U.S. Government sponsored entities (FHA) that were “public” competitors. Mortgage insurance is now more profitable resulting in Genworth’s U.S. mortgage insurance division returning to profitability in 2013. During the conference call management commenting on 2014 offered; “U.S. [mortgage insurance] should be the driver of this growth, with earnings significantly better than in 2013.”

Management expects this segment to produce returns in excess of 15% per year. None the less an area that needs close attention is the quarterly sequential rising loss ratio in the U.S. mortgage segment and managements conference call comments indicating GNW’s anticipative reaction to competitive pricing pressure in the U.S. mortgage market.

A kind reminder of the nemesis of many insurers is the reluctance to walk away from unprofitable businesses. Warren Buffett explains on page 11 of the 2010 Berkshire Hathaway Letter to Shareholders, underline added for emphasis [Source]:

At bottom, a sound insurance operation requires four disciplines: (1) An understanding of all exposures that might cause a policy to incur losses; (2) A conservative evaluation of the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) The setting of a premium that will deliver a profit, on average, after both prospective loss costs and operating expenses are covered; and (4) The willingness to walk away if the appropriate premium can’t be obtained.

Many insurers pass the first three tests and flunk the fourth. The urgings of Wall Street, pressures from the agency force and brokers, or simply a refusal by a testosterone-driven CEO to accept shrinking volumes has led too many insurers to write business at inadequate prices. “The other guy is doing it so we must as well” spells trouble in any business, but none more so than insurance.

GNW 3Q13 NIW and Income

Long Term Care:

The thesis further proposed Genworth’s largest product line, long-term care insurance (LTC) where GNW is the industry leader would remain viable as competitors left the market and GNW addressed changing demographics and spiraling costs. The chart below shows GNW’s ability to maintain a profitable LTC business in the face of these challenges.

GNW 3Q13 LTC Rev and Income

GNW has been able to achieve rate increases with state insurance agencies for older policy long-term care exposures. They are targeting $200-300 million in rate increases when fully implemented in 2017. Patrick Kelleger, EVP of U.S. Life Insurance commented during the conference call; “…the $155 million to $160 million of already approved premium rate increases, a large — very large percentage of that is going to come in over the course of the next year or 15 months as we receive approvals. However, I would also say that some of those rate increases are phased in over a period of years…. it’s really going to play out over the next several years. At the end of that point in time, we would expect to be seeing all of the individual policyholder decisions around level of benefits to be made, and the continuing impact will be the $200 million to $300 million of annual premium rate increases which will have been achieved over that 2-, 3-, maybe 4-year time frame.”

CEO Thomas McInerney addressed concerns around LTC during the conference call in part: “…[some] suggested we may need to take a significant reserve charge…I want to point out 4 significant differences between Genworth and some of the companies that have taken charges.

  • … we have $1.4 billion in after-tax hedge gains that reside in accumulated other comprehensive income on the balance sheet, and this amount will be amortized into income over time… the $1.4 billion contributes margin to our long-term care reserves.
  • …Genworth is achieving significant premium rate increases on the older policies to bring the policies closer to breakeven, and the per annum increases on these policies also add significant margin on our reserve testing.
  • Three, Genworth has written a significant amount of new business over the last several years, with better underwriting and higher prices. And profits from newer blocks of business more than offset losses or low returns on the older blocks.
  • … Genworth has implemented tighter underwriting standards, which has benefited our risk profile. All these actions and our new strategic approach put us in a position to take advantage of the opportunity in long-term care insurance.

Management commented in the conference call that returns in excess of 15% are also expected from this segment. The company will provide more details regarding the long-term care business at an investor update in December. The presentation will cover the details and analysis of long-term care balance sheet, including the reserve review. We remain encouraged on managements focus on this large opportunity for GNW and look forward to more details in December.

Other Initiatives:

  • The sale of the Wealth Management business closed in the third quarter with proceeds and other cash on hand now dedicated to paying down the 2014 debt maturity.
  • GNW issued $400 million in new debt and redeemed the outstanding 2015 maturities in September addressing all our debt maturities until December 2016.
  • GNW entered into a new 3-year credit facility of $300 million, which will allow us to reduce the amount of cash needed to maintain at the holding company.
  • The company announced it is on track for achieving the 2013 subsidiary dividend goal, with payment of dividends to the holding company totaling approximately $330 million year-to-date, including $100 million from the U.S. life companies and $173 million from International Mortgage Insurance.
  • The IPO of up to 40% of the Australia Mortgage Insurance business will allow GNW to reduce risk and rebalance capital among the major Mortgage Insurance platforms.
  • The company announced the elimination of approximately 400 positions and reduced information technology expenditures estimated to save up to $90 million in annual expenses.

Share Buybacks:

This is one area where our thesis missed the mark. Management chose to focus on debt reduction as a priority over resuming a dividend or our preference of buying back GNW’s shares selling at a fraction of value. However, it is hard to argue with the results and resumption of the dividend or share buybacks remain a future option for further improvement.

In response to an analyst question on the dividend, CEO McInerney commented; “We have a lot more to do. And as we’ve said, I think we still have a priority, Marty and I, to look at the leverage and also the fixed charge coverage ratio, which is important. And we’d like to see improvement there. As we continue to make progress in the turnaround, we’ll look for — and in generating more capital, we’ll look for opportunities to return capital to shareholders, including reinstating the dividend and/or share buybacks over time.”

Our thesis remains on track.

3Q13 Press Release [SourceGenworth Financial Announces Third Quarter 2013 Results:

  • Net Income Improves From Prior Year To $108 Million
  • Long Term Care Insurance Rate Actions Improve Earnings
  • Company Addresses Near Term Debt Maturities And Establishes Credit Line

Richmond, VA (October 29, 2013) – Genworth Financial, Inc. (NYSE: GNW) today reported results for the third quarter of 2013. The company reported net income1 of $108 million, or $0.22 per diluted share, compared with net income of $35 million, or $0.07 per diluted share, in the third quarter of 2012. Net operating income2 for the third quarter of 2013 was $119 million, or $0.24 per diluted share, compared with net operating income of $111 million, or $0.22 per diluted share, in the third quarter of 2012.

GNW 3Q13 Income

Net income for the quarter was negatively impacted by two charges in Corporate and Other activities consisting of $20 million from the make-whole expense related to the redemption of the company’s 2015 senior notes and an adjustment of $20 million, including $18 million from a correction of prior periods, related to non-deductible stock compensation expense resulting from cancellations.

Net investment losses, net of tax and other adjustments, were $13 million in the quarter compared to net investment losses of $2 million in the prior year. Total investment impairments, net of tax, were $3 million in the current quarter and $19 million in the prior year. The prior year included an after-tax goodwill impairment of all of the goodwill related to the International Protection segment of $86 million.

In August 2013, the company closed the sale of its wealth management business. During the quarter, the company recognized $2 million of income from discontinued operations, comprising $4 million of income and a true-up to the loss on sale of $2 million. Net proceeds of approximately $360 million, together with cash on hand at Genworth Holdings, Inc., will be used to address the company’s remaining 2014 debt at maturity or before.

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

GNW 3Q13 NOI

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

Unless specifically noted in the discussion of results for the International Mortgage Insurance and International Protection 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 third quarter of 2013 was an unfavorable impact of $7 million versus the prior quarter and prior year.

3Q13 Summary U.S. Life Insurance:

GNW 3Q13 US Life

U.S. Life Insurance Division: net operating income was $111 million, compared with $79 million in the prior quarter and $86 million a year ago. These results include the following:

Life Insurance:

  • Life insurance net operating income was $54 million, compared with $27 million in the prior quarter and $22 million in the prior year.
  • Life insurance mortality experience was favorable versus pricing expectations, the prior quarter and prior year because of lower frequency and severity.
  • Life insurance sales were flat versus the prior quarter and down $26 million versus the prior year when the company discontinued sales of its term universal life insurance product and began to transition to new term and universal life insurance product offerings.

Long Term Care Insurance:

  • Long term care insurance net operating income was $41 million, compared with $26 million in the prior quarter and $45 million in the prior year.
  • Results benefitted from premium increases and reduced benefits of $14 million versus the prior quarter and $26 million versus the prior year related to the premium increases approved and implemented to date.
  • The reported loss ratio for the current quarter was approximately 64 percent, three points lower than the prior quarter and one point higher than the prior year. Individual
  • Sales are expected to trend down in the near term due to the cessation of sales of AARP branded products in the retail channel and the introduction of higher priced products in additional states. The company continues to utilize reinsurance in LTC as part of its capital optimization strategies.
  • The company filed for LTC premium rate increases with the goal of achieving approximately $200 to $300 million of additional annual premiums when fully implemented by 2017.
  • As of September 30, 2013, the company has received approvals representing approximately $155 to $160 million of the targeted premium increase.
  • In September 2013, the company announced that it began filing for LTC premium rate increases on certain policies sold between 2003 and 2012; the requested range between six and thirteen percent on more than $800 million in annualized in force premiums.
  • These policies have generated positive operating earnings to date; the rate increases are primarily intended to return the projected lifetime loss ratios to the original priced-for loss ratios.

Fixed Annuities:

  • Net operating income was $16 million, compared with $26 million in the prior quarter and $19 million in the prior year.
  • Results included lower limited partnership and bond call performance vs. the prior quarter and spread compression versus both the prior quarter and prior year.
  • Mortality was unfavorable versus the prior quarter.
  • Sales in the quarter totaled $760 million, up sequentially benefitting from competitively priced products in the rising interest rate environment while still meeting or exceeding targeted returns.

Global Mortgage Insurance Division:

GNW 3Q13 Global Mtg

Global Mortgage Insurance Division had net operating income of $87 million, compared with net operating income of $102 million in the prior quarter and $57 million a year ago.

International Mortgage Insurance Segment:

  • Reported International Mortgage Insurance segment net operating earnings were $90 million, compared with $89 million in the prior quarter and $94 million a year ago.
  • In Canada, flow new insurance written (NIW) was up 30 percent4 sequentially and down 15 percent4 year over year. In addition, in the current quarter, the company completed $3.9 billion of bulk transactions, consisting of low loan-to-value prime loans. In Australia, flow NIW was up two percent4 sequentially and up one percent4 year over year.
  • The Canadian and Australian businesses continue to maintain sound capital positions.
  • Dividends of $173 million, including proceeds relating to Genworth MI Canada Inc.’s share repurchase program, were paid to the holding company year-to-date through September 30, 2013.

Canada Mortgage Insurance:

  • Canada reported net operating earnings of $41 million versus $43 million in the prior quarter and $42 million in the prior year.
  • The loss ratio in the quarter was 22 percent, down three points from the prior quarter and down eight points from the prior year primarily from a favorable shift in the geographic mix of delinquencies.
  • Total delinquencies were flat sequentially as new delinquencies were offset by cures, processed claims, loss mitigation and improving economic conditions in most regions. Improvement in losses was more than offset by higher taxes versus the prior quarter and prior year and lower revenues versus the prior year.
  • Flow NIW was up 30 percent sequentially from normal seasonal variation and down 15 percent year over year primarily from a smaller origination market. In addition, the company completed several bulk transactions, consisting of low loan-to-value prime loans, of approximately $3.9 billion reflecting its selective participation in this market.
  • At quarter end, the Canada mortgage insurance business had a regulatory capital ratio of 218 percent, well in excess of regulatory requirements.
  • GAAP book value was $2.9 billion, of which $1.7 billion represented Genworth’s 57.4 percent ownership interest and was flat to the prior quarter.

Australia Mortgage Insurance:

  • Australia reported net operating earnings of $61 million versus $55 million in the prior quarter and $57 million in the prior year.
  • The loss ratio in the quarter was 31 percent, down four points sequentially and down 16 points from the prior year, and total delinquencies were down six percent sequentially from lower new delinquencies and higher cures.
  • Flow NIW was up two percent sequentially and up one percent year over year as low interest rates continued to improve affordability.
  • At quarter end, the Australia mortgage insurance business had a regulatory capital ratio of 135 percent, in excess of regulatory requirements.
  • The GAAP book value was $2.0 billion as of the end of the quarter, up $0.1 billion from the prior quarter.

Other Countries Mortgage Insurance:

Other Countries had a net operating loss of $12 million, compared to $9 million in the prior quarter and $5 million in the prior year as the business continues to be pressured from elevated losses, primarily in Ireland.

U.S. Mortgage Insurance Segment:

  • U.S. MI net operating loss was $3 million, compared with net operating income of $13 million in the prior quarter and a net operating loss of $37 million in the prior year.
  • Flow NIW increased two percent from the prior quarter and increased 36 percent over the prior year to $6.4 billion.
  • The risk-to-capital ratio for Genworth Mortgage Insurance Corporation (GMICO) is estimated at 23.2:1 and the combined risk-to-capital ratio is estimated at 22.4:1 as of September 30, 2013.

Corporate and Other Division:

Corporate and Other Division net operating loss was $79 million, compared with $48 million in the prior quarter and $32 million in the prior year.

GNW 3Q13 Corp and Other

International Protection Segment:

  • International Protection reported operating earnings of $4 million, compared with $1 million in the prior quarter and $8 million in the prior year.
  • The business continues to be impacted by the slow consumer lending environment in Europe, and high unemployment in Southern Europe continues to keep losses elevated while a favorable shift in mix of contracts with profit share and lower expenses favorably impacted results in the quarter.
  • At quarter end, the lifestyle protection business had a regulatory capital ratio of approximately 335 percent, well in excess of regulatory requirements. Dividends of $24 million were paid to the holding company through September 30, 2013.

Runoff Segment:

  • The Runoff segment’s net operating income was $25 million, compared with $6 million in the prior quarter and $9 million in the prior year.
  • Results in the current quarter reflected more favorable equity market conditions versus the prior quarter.

Corporate and Other:

  • Corporate and Other net operating loss was $108 million, compared with $55 million in the prior quarter and $49 million in the prior year.
  • Results in the current quarter included a $20 million make-whole expense related to the redemption of the company’s 2015 senior notes and an adjustment of $20 million, including $18 million from a correction of prior periods, related to non-deductible stock compensation expense resulting from cancellations.

Investment Portfolio Performance:

  • Net investment income decreased to $801 million, compared to $821 million in the prior quarter primarily from unfavorable foreign exchange and lower impact from prepayment speeds on structured securities as interest rates increase.
  • The reported yield for the current quarter was approximately 4.7 percent. The core yield2 was flat to the prior quarter at approximately 4.5 percent.
  • Net income in the quarter included $13 million of net investment losses, net of tax, DAC amortization and other items of $4 million primarily related to mark-to-market on derivatives.
  • Total investment impairments, net of tax, were $3 million in the current quarter and $19 million in the prior year.
  • Net unrealized investment gains were $1.1 billion, net of tax and other items, as of September 30, 2013 compared with $2.6 billion as of September 30, 2012 and $1.3 billion as of June 30, 2013 primarily driven by rising interest rates.
  • The fixed maturity securities portfolio had gross unrealized investment gains of $3.7 billion compared with $6.7 billion as of September 30, 2012 and gross unrealized investment losses of $1.0 billion compared with $0.8 billion as of September 30, 2012.

Holding Company:

  • Genworth’s holding company ended the quarter with approximately $1.3 billion of cash and liquid assets, up approximately $300 million compared to the prior quarter.
  • Approximately $360 million of net proceeds from the sale of the wealth management business and $45 million of dividends received from the operating companies, partially offset by approximately $50 million of debt interest payments and $50 million of net other expenses.
  • In September 2013, the company entered into a credit agreement that provides Genworth Holdings, Inc. with a three-year $300 million, multicurrency revolving credit facility, with a $100 million sublimit for letters of credit.
  • With the addition of the credit facility, the holding company cash and liquid asset balance target changed from two to one and a half times its annual debt service expense, plus a risk buffer of $350 million.
  • After deducting for the net proceeds from the sale of the wealth management business transaction and cash on hand at Genworth Holdings, Inc. that will be used to address the remaining $485 million 2014 debt at maturity or before, cash and highly liquid securities were approximately $830 million at the end of the quarter.
  • The holding company has no debt maturities until June 2014.

In summary the turnaround is underway as it enters the second phase. Lingering pessimism and misperceptions create a continued opportunity with the share price around $15.00 or about $7.00 below our $22.00 estimate of intrinsic value for about a 30% margin of safety.

Long: GNW

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