Market is predicting Genworth Financial’s merger with China Oceanwide will fail

The market is projecting that Genworth’s (NYSE: GNW) US$5.43/share cash merger with China Oceanwide will fail:

The issue revolves around the insurance unit that contains their long-term care insurance liabilities – the theory would be that the Genworth is unlikely to obtain state approvals without taking the full burden of the LTC division.

The salient part of a piece of nearly unreadable verbiage from the finalized merger proxy form is the following:

In addition, it is a condition to the obligations of Asia Pacific and Merger Sub to consummate the merger that certain affiliates of Genworth shall have received regulatory approval (or non-disapproval, in certain instances) from the Delaware Department of Insurance and the Virginia Bureau of Insurance to effect the U.S. Life Restructuring, including the unstacking and the following intercompany reinsurance and recapture transactions between GLAIC and GLIC: (i) a reinsurance transaction pursuant to which GLIC will reinsure certain long-term care insurance business from GLAIC (which we refer to as the “Long Term Care Reinsurance Transaction”); (ii) separate reinsurance transactions pursuant to which GLAIC will reinsure from GLIC (A) certain universal life insurance business and term life insurance business, (B) certain company-owned life insurance business and (C) certain single-premium deferred annuity business, single-premium immediate annuity business, structured settlement annuity business and fixed annuity business (which we refer to as the “Life Restructuring Reinsurance Transactions”); and (iii) a transaction pursuant to which GLIC will recapture from GLAIC certain single-premium deferred annuity business that is currently reinsured by GLAIC from GLIC (which we refer to as the “Recapture Transaction”). GLIC and GLAIC have received approvals for the Long Term Care Reinsurance Transaction from the Delaware Department of Insurance and the Virginia Bureau of Insurance and completed the transaction effective November 1, 2016. Genworth made regulatory filings with respect to the unstacking with the Delaware Department of Insurance on December 21, 2016 and the Virginia Bureau of Insurance on January 3, 2017. Genworth made regulatory filings with respect to the Life Restructuring Reinsurance Transactions and the Recapture Transaction with the Delaware Department of Insurance and the Virginia Bureau of Insurance on December 16, 2016. In addition, the merger agreement provides that Genworth, in consultation with China Oceanwide and applicable insurance regulators, may explore the feasibility of the transfer of GLAIC’s 34.5% ownership interest in GLICNY to GLIC and, if approval from such regulators is received, to pursue such transfer.

If, for whatever reason, you believe these applications will succeed, then there is a very easy method to turn $3.30/share into $5.43/share in less than six months. Won’t tell you what I think, but I’ve been digging.

Details of Genworth Financial merger

There are lots of juicy details of the merger proposal with Genworth Financial in their preliminary proxy filing. In particular there are some hints that Genworth MI in Canada will get sold off whether this merger is successful or not.

Despite all short-sellers and naysayers believing that the Canadian housing market is going to crap, Genworth MI continues to appreciate post-Trump and is still trading 10% below their book value. They’ll continue to be mystified when the stock will break through its all-time highs it reached back in November 2014:

Not coincidentally, that’s when I last sold shares. I will note the price has been adjusted multiple times due to their rather large dividend (currently $1.76/share), and whether the Genworth Financial merger is successful or not, it is quite probable that Genworth MI Canada will be sold for as much as can be sought for it, because doing so before the Canadian housing market collapses is the only smart thing to do.

In terms of valuation, one can make a good claim for over CAD$40/share.

The market is also not appreciating at all the notion that mortgage insurance rates will be headed higher in early 2017 due to capital changes. The last time mortgage insurance rates went higher, the stock went up about 10%.

They are also somewhat buoyed by the “good politics, bad policy” decision by the BC government to extend a 5-year interest-free loan, matching dollar-for-dollar on the first 5% of a downpayment (for an insured mortgage). It would be a poor decision for a prospective buyer in BC to not take advantage of this, but they would need to pay mortgage insurance to do so.

Genworth Financial / Long-Term Care Insurance

For those of you that are interested in why Genworth Financial (NYSE: GNW) is willing to be bought out at US$5.43/share when their book value is far, far higher should take notice of this following Wall Street Journal article about the woes of another long-term care insurance provider that went belly-up.

Putting a long story short, there is an accounting mismatch – the liabilities on the book are less than what the actual liabilities will be.

There has been a lot of incorrect analysis (especially on Seeking Alpha) on the actual value of the holding company. In general when one sees sloppy analysis that is regarded as consensus, there is a necessary, but not sufficient condition for an investment decision in the contrary.

Genworth Financial bought out

Imagine my initial surprise when I saw a news feed that Genworth had been bought out. Unfortunately for me, it was Genworth Financial (NYSE: GNW) and not Genworth MI (TSX: MIC).

Genworth Financial is being taken over by China Oceanwide Holdings, chaired by Lu Zhiqiang, who apparently has a networth of $5 billion.

In the press release, there are scant details. They mentioned the buyout price and the intention of the purchaser to inject $1.1 billion of capital into Genworth to offset an upcoming 2018 bond maturity and shore up the life insurance subsidiary, but the release also explicitly stated a key point:

China Oceanwide has no current intention or future obligation to contribute additional capital to support Genworth’s legacy LTC business.

The LTC (long-term care) insurance business is what got Genworth into trouble in the first place, and its valuation is the primary reason why the company’s stated book value is substantially higher than its market value.

The press release also declared that this is primarily a financial acquisition rather than a strategic one, with management and operations being intact.

One wonders how long this will last.

Since Genworth Financial controls 57% of Genworth MI, it leads to the question of what the implications for the mortgage insurance industry will be – and it is not entirely clear to me up-front what these implications may be. Will the government of Canada be comfortable of 1/3rd of their country’s mortgage insurance being operated by a Chinese-owned entity? What is the financial incentive for China Oceanwide’s dealings with the mortgage insurance arms of Genworth Financial (noting they also own a majority stake in Australia’s mortgage insurance division)?

One thought that immediately comes to mind is that if Genworth Financial is not capital-starved, they will no longer be looking at ways to milking their subsidiaries for capital. In particular, if Genworth MI decides to do a share repurchase, they might opt to concentrate on buying back the public float (currently trading at a huge discount to book value) instead of proportionately allocating 57% of their buyback to their own shares (in effect, giving the parent company a dividend). This would be an incremental plus for Genworth MI.

Finally, one wonders what risks may lie in the acquisition closing – while it is scheduled for mid-2017, this is not a slam dunk by any means. Genworth Financial announced significant charges relating to the modelling of the actual expense profile of their LTC business and it is not surprising that they decided to sell out at the relatively meager price they did – there’s probably worse to come in the future.

However, as far as Genworth MI is concerned, right now it is business as usual. There hasn’t been anything posted to the SEC yet that will give me any more colour, but I am eager to read it.

(Update, early Monday morning: Genworth 8-K with fine-print of agreement)

Yes, I’ve read the document. Am I the only person on the planet that reads this type of stuff at 4:00am in the morning with my french-press coffee? Also, do they purposefully design these legal documents to be as inconveniently formatted as possible, i.e. no carriage returns or tabs at all?

A lot of standard clauses here, but some pertaining to subsidiary companies (including Genworth MI), including:

(page 47): Section 6.1,

the Company will not and will not permit its Subsidiaries (subject to the terms of the provisos in the definition of “Subsidiary” in Article X) to:

(viii) reclassify, split, combine, subdivide or redeem, purchase or otherwise acquire, directly or indirectly, any of its capital stock or securities convertible or exchangeable into or exercisable for any shares of its capital stock (other than

(A) the withholding of shares to satisfy withholding Tax obligations

(1) in respect of Company Equity Awards outstanding as of the date of this Agreement in accordance with their terms and, as applicable, the Stock Plans, in each case in effect on the date of this Agreement or
(2) in respect of equity awards issued by, or stock-based employee benefit plans of, the Specified Entities in their respective Ordinary Course of Business and

(B) the repurchase of shares of capital stock of Genworth Australia or Genworth Canada by Genworth Australia or Genworth Canada, as applicable, pursuant to share repurchase programs in effect as of the date hereof (or renewals thereof on substantially similar terms) with respect to such entities in accordance with their terms);

(note: Genworth MI’s NCIB expires on May 4, 2017)

(page 53): (e) During the period from the date hereof to the Effective Time or earlier termination of this Agreement, except as set forth on Section 6.1(e) of the Company Disclosure Letter, or as required by applicable Law or the rules of any stock exchange, the Company shall not, and shall cause any of its Subsidiaries that are record or beneficial owners of any capital stock of or equity interest in Genworth Canada or any of its Subsidiaries not to, without Parent’s prior written consent (which consent, in the case of clauses (ii)(B) and (iii) below (and, to the extent applicable to either clause (ii)(B) or clause (iii) below, clause (iv) below) shall not be unreasonably withheld, conditioned or delayed):

or (z) any share repurchases that would not decrease the percentage of the outstanding voting stock of Genworth Canada owned by the Company and its Subsidiaries as of the date hereof)

(note: Hmmm… this does open the door for repurchases).

I’m still unsure of the final implication on Genworth MI other than the fact that if this merger proceeds that the parent company is going to lean less on their subsidiaries for capital.

De-leveraging

Leverage is great – only when everything is appreciating. Indeed, if things appreciate, the leverage ratio goes down since the loan-to-equity ratio goes lower. A simple example is taking a $100 portfolio, borrowing $100, which gives you a 50% loan-to-equity ratio. If your portfolio appreciates 10%, the loan-to-equity goes down to 45%, and suddenly you’re feeling more comfortable again.

This basically explains the real estate market – you buy a house, take a mortgage for 80% of the house value (paying 20% down), and when the real estate market goes up 40% (like it has in the Vancouver area), suddenly your loan-to-value ratio goes down to 57% – let’s suck more money out of the house and get that back to 75%! This means borrowing another 25% of your original house value.

This all works, until the underlying asset value falls and you have to pay back your loans. In the instance of an initial 80% loan-to-value, a price drop of 10% means the loan-to-value goes up to 89%.

The same dynamics go for portfolio management – leverage is painful in the down direction because your loan-to-equity ratio becomes more concentrated.

Clearly, the best time to de-leverage is when you’ve made your anticipated gains.

I’ve started to take some money off the table. Specifically, Genworth (NYSE: GNW) and most US insurers have gotten hot because of the probability of the federal reserve increasing interest rates again.

After raising cash, the most difficult part of investing is to wait. The easiest way to lose money is to do something with cash just because it is earning zero yield in the brokerage account.

Genworth MI

It is quite obvious by trading action over the past month that some institution is accumulating shares of Genworth MI (TSX: MIC) and is sweeping up the supply that is being applied at existing prices. I loaded up in shares during the second half of January and bought a very small position in some out-of-the-money options (the Canadian options market is illiquid, high-spread, expensive to trade in and generally junky, but there was somebody on the ask that was not the market maker and at a reasonable price, I hit his ask). Genworth MI is once again the largest component in my portfolio.

It is difficult to understand how something trading at a greater than 1/3rd discount to tangible book value and giving a greater than 7% cash yield, and trading at a P/E of 8 can continue to trade so low unless if it can be explained by general paranoia (which exists on Canadian housing).

Insiders (as of February 22) have reported purchases of common shares of Genworth MI. They are not huge but it is something.

The reports of the Canadian housing market’s demise is clearly over-blown except in very narrow sectors that have traditionally had resource commodity concentration (looking at Fort McMurray as the prime example).

The underlying entity is incredibly profitable. The only real risk is whether the parent entity (NYSE: GNW) will sell Genworth MI out, which is a real possibility.

Such a sale, if done presently, would likely be done under book (CAD$36.82 presently). A sale at 10% under book ($33.14/share) would still be a 25-30% premium over current trading prices. The company’s P/E would still be 8 at this point and an acquisition would be instantly accretive to some other financial company.

This take-out price does not reflect my true value that the company should be trading at, which I would judge at least at book value. The Canadian economy, and thus residential mortgages servicing abilities, is not the most robust so the premium to book would be modest before I started to sell shares again. I also apply a general discount to majority-controlled entities, but suffice to say my target price is north of CAD$36.28.

Genworth Financial’s issues I do not want to get into in depth, but they have a pending May 22, 2018 debt maturity (bonds are trading at 87 cents on the dollar at the moment) and a series of maturities 2 years later (June 15, 2020, trading at 68 cents) that the market is getting panicky about. This may cause them to sell out their equity holdings in the mortgage insurance firms they have taken public (Canada and Australia), but it is a decision I do not think they would want to make lightly.

Genworth MI – Q4-2013 review

The earnings release was about what I was expecting. There was a slight increase in the expense profile but this was due to some stock-related compensation expenses (cash flow statement has it at $11.2 million for the year) but this is due to the stock itself increasing in value.

For the year, net premiums written were $511 million, while revenues recognized were $572 million. These two will have to converge eventually. This has been the trend for the past few years now – revenues recognized was $621 million back in 2010. Premiums earned in 2014 should be around the $550 million level.

The $5.4 billion portfolio continues to remain dull (a good thing) with a 3.6% yield, 3.7 year duration.

The loss ratio continues to remain exceptionally low, at 22%. Management continues to focus on Quebec and the Toronto condominium market, which is correct.

The bottom-line operating EPS is $3.60/share. Looking at tangible book value, I get a value of $32.34/share with a diluted share count of 94.9 million shares.

Balance sheet-wise, the company continues to remain over-capitalized with 222% of its required regulatory minimum capital, and well above its 190% internal target. There are regulatory changes which I have outlined earlier that the company is awaiting for before deciding what to do with its excess capital. They bought back shares when the stock was trading lower, but now they are holding onto their cash instead of buying back shares (a smart decision).

The only item of any distinction in the financials is the following paragraph:

On December 20, 2013, the Company, through its indirect subsidiary PMI Canada, entered into a retrocession agreement with Merrill Lynch Reinsurance under which the Company assumed reinsurance risk for up to $30,000 Australian dollars if the losses on claims paid by Genworth Financial Mortgage Insurance Pty Limited, an Australian company (“Genworth Australia”) exceed $700,000 Australian dollars within any one year. The term of the agreement is 3 years. Genworth Australia has the right to terminate the reinsurance agreement after the first year of coverage.

Under the excess of loss reinsurance agreement, the Company is required to collateralize its reinsurance obligations by posting cash collateral equal to the maximum exposure under the agreement in favour of Merrill Lynch Reinsurance. As at December 31, 2013, the Company has posted $30,000 Australian dollars, equivalent to $28,482 Canadian dollars, under the agreement. The collateral is recorded as collateral receivable under reinsurance agreement on the Company’s condensed consolidated interim statement of financial position.

Re-measurement adjustments arising on translation of collateral receivable under the reinsurance agreement and any reinsurance receivable balances from Australian dollars to Canadian dollars are recognized in net investment gains.

This is functionally a bet by management that the Australian real estate market is not going to crater. While I am not thrilled that the company appears to be engaging in gambling outside of the Canadian sphere, I do note that the history of paid claims in Australia appears to be considerably below this:

2013 – AUD$185 million
2012 – AUD$287 million
2011 – AUD$112 million
2010 – AUD$171 million
2009 – AUD$173 million
2008 – AUD$146 million

It would appear that it would take a disaster for Australia’s paid claims to be above the AUD$700 million threshold, but if this was the case, then why did Genworth Australia make this agreement with a sub of Genworth Canada?

Reading between the lines on the conference call, it sounds like management is tinkering around with the idea of deploying their excess capital in reinsurance of mortgage insurers. This doesn’t sound like a bad idea, until it blows up, like it almost did for the parent Genworth (NYSE: GNW) entity.

In absence of any better investment alternatives and also in absence of any looming Canadian real estate crisis, Genworth MI is still in my portfolio as a large fraction. It is or more less a proxy for a bond fund at this point and I am comfortable with the relevant risks regarding the Canadian real estate market. I also believe the equity is in the middle of what I consider to be its fair value range. If they execute as they have in 2013, the stock should go up another 10% or so on the basis of increased book value alone.

The critical sensitivity continues to be the state of the Canadian economy. Our country is export-oriented, especially in the commodity sector. As long as this remains active, we are unlikely to see spikes in unemployment that would cause mortgage defaults. Interest rates are also projected to be low and this will not create an additional shock in the market.

Genworth Financial restructures US mortgage insurance assets

Genworth Financial (NYSE: GNW) is up about 9% today on news that it will be implementing a plan to re-arrange the capital structure behind its US mortgage insurance units in such a manner that will basically leave the parent company with less “blow-up” risk concerning that business. This is assuming they receive regulatory approval, but this announcement surely would not have been announced had it not been floated by regulators first.

The implication for its majority-owned Canadian mortgage insurance subsidiary (TSX: MIC) is that there will be no requirement for a fire-sale of the MIC asset to raise capital for GNW.

MIC is up approximately 35% from its lows in July and August when I started to accumulate shares and GNW is up about 80% from the $5 baseline it was sitting at for the past year before this recent run-up. I guess I should have put money into GNW in addition to MIC, but I couldn’t make heads or tails out of GNW’s statements to a firm enough clarity for my own satisfaction.

At this point I am awfully curious whether GNW is still shopping around their Canadian mortgage insurance subsidiary or whether they’re just going to keep their ownership stake and collect dividend cheques. Genworth owns 57% of MIC and this represents $65.3 million in dividend income for them – 13 cents a share.

Genworth MI books a one-time gain

Genworth MI Canada (TSX: MIC) made an announcement today that reflected changes to the underlying legislation, the Protection of Residential Mortgage or Hypothecary Insurance Act and the impact on its balance sheet.

It had been accruing a government guarantee fund that was funded through gross premiums that effectively functioned as a corporate equivalent of an RRSP, with the difference being that there was an exit fee of 1% for every year the funds were deposited into the fund. Any deposits in the fund were tax deductible, but any withdrawals would be taxable.

In the new regime, this fund is now going to be collapsed, but without the exit fee. Thus, the company is basically going to book the exit fee (after taxes) as a gain, which will amount to about $135 million or about $1.37/share.

In exchange, the company is now going to contribute 2.25% of gross premiums to the federal government (as an expense and not into a guarantee fund) and their minimum capital test amount will be going up to an internal level of 185% (required is 175%) from the present 145% (required is 120%).

The implication here is that the company will be making more money in the future (all things being equal; this does not account for the decreases in real estate transaction volume that will be decreasing the premiums written in the future) and the company will have a relatively large amount of capital freed up to examine other options, including dividends or share buybacks. Management was previously burnt by spending $160 million on June 30, 2011 on a share buyback at $26/share. In light of the fact the company is trading well under book value, it would not surprise me to see them consider another one, or they could give out another dividend.

Investors would be cautioned that MIC will likely do what is in the best interests of Genworth (NYSE: GNW) as they own 57.5% of the company.

Shares of MIC are up 3.6% at present.

Genworth and subsidiary unit

Genworth (NYSE: GNW) shares have risen by about 25% over the past month:

gnw

This is presumably due to their reduction of exposure to US mortgage insurance liability. They also recently hired a new CEO. I tried analyzing them earlier when doing my purchase of Genworth MI Canada (TSX: MIC) without coming to any conclusions that made me feel warm and fuzzy, but MIC is also has been a somewhat more muted recipient of positive price action:

mic.to

Despite all the doom and gloom concerning the Canadian real estate market, at this time I do not believe that this is going to affect mortgage insurance. Increases in unemployment and subsequent employment instability will likely be the precursor to mortgage-related claims. Indeed, delinquency rates at present are considerably lower.

MIC should be trading closer to tangible book value (roughly $28-29/share) which I believe is a more accurate reflection of its market value. At a certain point if Genworth manages to stabilize its financial picture, its options with respect to MIC start to increase. While the market continues to figure out this picture, investors can continue to clip dividends ($1.28/year annualized) from the shares while the company is likely to report earnings around the $3/share range. This recovery in MIC’s market value will likely continue to accelerate if the recovery in the US housing market continues.