Genworth Financial / Genworth MI Canada S&P note

A credit rating note on Genworth Financial (NYSE: GNW) and impact on Genworth MI Canada (TSX: MIC):

Oct 11 - Standard & Poor's Ratings Services said today that its 'AA-'
financial strength rating and 'A-' issuer credit rating on Genworth Financial
Mortgage Insurance Co. Canada and Genworth MI Canada Inc., respectively
(collectively referred to as Genworth Canada), and the stable outlook on these
ratings are unaffected by the recent downgrade of their ultimate parent and
majority shareholder, Genworth Financial Inc. (GNW) to BBB-/Negative/A-3
from BBB/Negative/A-2. The ratings on the Genworth U.S. life insurance companies
were also affected by these actions (for details see "Genworth Financial Inc.
Downgraded To 'BBB-'; Outlook Negative", published Oct 11, 2012, on
RatingsDirect on the Global Credit Portal). 

Although Genworth Canada is part of the GNW group, we consider there to be 
negligible links between the creditworthiness of GNW and Genworth Canada. We 
consider Genworth Canada to be non-strategically important to GNW. 
Accordingly, we attribute no support to the stand-alone credit rating on 
Genworth Canada from GNW. We are cognizant of the influence GNW has on its 
Canadian operations as a majority shareholder but, in our view, Genworth 
Canada has some protection against financial deterioration at the group level, 
aided by prudential supervision by the Office of the Superintendent of 
Financial Institutions, presence of independent directors on the boards of 
both the Canadian operating company and publicly listed holding company, and 
senior management/boards' recognition of the necessity of a financially strong 
entity in order to operate in the Canadian market, considering that the main 
competitor and largest player, Canada Mortgage and Housing Corp. 
(AAA/Stable/A-1+), is a highly rated federal government-owned entity. In the 
normal course of business, we expect Genworth Canada to return capital 
including payout of dividends. However, if the level of return of excess 
capital, in our view, hinders the company's very strong capitalization, the 
ratings could come under pressure.

The “non-strategic” nature of Genworth’s 57% investment in MIC would make it ripe for some sort of takeover bid if Genworth was going to fetch a reasonable price for MIC.

Misconceptions on Canadian mortgages

There have been quite a few media articles about how the recent rule changes has kneecapped the Canadian real estate market. It should be pointed out that these rule changes were strictly in the context of having CMHC (a federal crown corporation, so if they fail, then the public picks up the bill) insure such mortgages.

It does not include private lenders or insurers (such as Genworth (TSX: MIC)). So private lenders and insurers are free to make bone-headed decisions, such as providing zero-down financing and prime minus 1% rates to 450-rated credits if they deem it to be in their best interests.

Since the major chartered banks are really only interested in arbitraging their mortgage portfolio risk by getting CMHC to pick up the downside, they have been much more reluctant to give mortgages outside of the 25-year amortization, 5% down payment guidelines. The two major private lenders in the Canadian market are Equitable Group (TSX: ETC) and Home Capital Group (TSX: HCG) which have to make their own decisions with respect to giving out mortgages.

The share prices of both of these companies should be leading indicators with respect to the Canadian real estate market as a whole. The analogies in the USA, such as Novastar Financial, have long since gone insolvent for well-documented reasons. The semi-equivalent of CMHC, Freddic Mac and Fannie Mae are still publicly traded, but will not likely be returning capital to shareholders ever unless if the US government decides to make their obligations disappear.

I would be cautious of the Canadian private lenders without trying to thoroughly examining their loan portfolios. Doing this is not an easy job, even on the inside. They are producing disproportionately large earnings per share strictly through the usage of leverage, which in itself is not a bad thing, but you don’t know how secure those assets are. In the case of Equitable, one sees a company that has about $10 billion in mortgages outstanding, about $5.3 billion of it has been securitized (wrapping them up in happy packages, insuring them, and then selling to market) – the only problem of the securitized assets is that your net interest margins on them are piddling low – 0.49% in the last quarter, compared to the very relevant 2% more you get with the non-securitized assets.

ETC’s book value per common share is $27.46 (at June 30, 2012) and is currently trading at $31.49, so there is a premium assigned to their operations.

Canadian short-term interest rate projections

BAX Futures are as follows:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 12 OC 0.000 0.000 98.820 0.000 0
+ 12 NO 0.000 0.000 98.780 0.000 0
+ 12 DE 98.730 98.735 98.745 -0.015 10452
+ 13 MR 98.710 98.720 98.750 -0.030 27000
+ 13 JN 98.680 98.690 98.730 -0.050 32803
+ 13 SE 98.650 98.660 98.690 -0.040 19232
+ 13 DE 98.610 98.620 98.660 -0.040 11758
+ 14 MR 98.570 98.580 98.610 -0.030 1998
+ 14 JN 98.520 98.540 98.560 -0.020 1257
+ 14 SE 98.470 98.480 98.500 -0.020 613
+ 14 DE 98.410 98.430 98.430 -0.010 525
+ 15 MR 98.340 98.360 98.370 -0.010 123
+ 15 JN 98.280 98.300 98.310 -0.010 50
+ 15 SE 98.210 98.230 98.240 -0.020 50

The market is pricing in the anticipation that rates may increase a quarter point in 2013 but nothing yet substantive.  In particular, the September 2015 projection of a 1.5% target rate is an interesting bet from a risk/reward perspective.  Three-month corporate paper is at 1.16% and has been this for quite some time.

The Dell and PC hardware value trap

I noticed recently that Dell (Nasdaq: DELL) slipped below $10/share. They’re now at $9.5/share or roughly a market capitalization of 16 billion (if you net out the cash and debt, the enterprise value is about $12 billion). This is on $3 billion income for the trailing 12 months, so something is completely out of whack – the market is either nuts, or they’re betting that Dell’s net income is going to drop significantly in the future. The latter is more likely to be the case.

I still don’t see anything worth investing in unless if you have a good sense of salvage or residual cash flow analysis. Dell is facing a compounding problem of being in a low margin industry that is not only shrinking, but is facing longer lifespan cycles and technological shifting.

In other words, they don’t have a proprietary tablet to be selling for ultra-large margins like some other fruity-named company.

Intel (Nasdaq: INTC) has an escape route – their processors can be used elsewhere and can command market pricing. They’ll take collateral damage, but will do relatively better. However, since the consumer end is still a significant portion of their market, I will also continue to lump them in the value trap category. Their anti-trust shield, AMD (NYSE: AMD), should also struggle. Considering that embedded chip makers such as ARM (Nasdaq: ARMH) are stronger competition to Intel, it makes you wonder if AMD is at all relevant any more and will get taken out by Intel finally.

This is similar to the fate that graphic chip designers were all finally consolidated into Nvidia (Nasdaq: NVDA) – which in itself might get munched by Intel. Its as good a time as any for consolidation in this entire PC sector.

Finally, it is always easy to point out share buybacks are a mistake when your stock is richly priced, but in Dell’s case, they have cumulatively spent $32.1 billion of cash on repurchasing 1.2 billion shares of stock – an average price of $26.79 per share. If from day zero they banked this cash and simply traded at a market cap of their net cash value (not even the higher book value), they would be trading at $11.93/share today. If they traded at the premium above book value as they are trading today, they would be at $15.26/share. Quite a bit of value destruction went on with those share buybacks.