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.

Financial crisis #2

The perverted effects of having a negative yield curve is finally hitting the financial markets. In particular, this is hitting the banking sector in Europe, but there is also spill-over effect in the USA as well – I had previously written about Bank of America, but this is also affecting other financial institutions.

However, I do have a general rule and that is whenever it hits the headlines of mainstream publications, it is likely closer to the 9th inning of the ballgame rather than the beginning.

I observe on the Drudge Report, which is usually ahead on things:

drudge

Once news like this starts getting on the covers of the various US magazines and such, then it is likely over.

Canadian publications are also picking up on the fact that the government bond yield curve is flat-to-inverting:

Target overnight rate: 0.5%
1 month: 0.43%
1 year: 0.42%
2 years: 0.35%
3 years: 0.35%
5 years: 0.48%
7 years: 0.79%
10 years: 1.01%

The half-point spread is a very pessimistic for the Canadian economy – people are willing to pay dearly for safety at the moment.

With government bond yields so low, investors must look elsewhere to obtain yield. This leads institutions into the wonderful world of corporate debt, and you can ask how the big 5 Canadian Banks (Royal, Scotia, CIBC, TD and BMO) are doing with all of their secured credit lines they’ve given to a lot of the oil and gas industry, in addition to their mortgage portfolios.

The Bank of Canada must be watching the sector like a hawk right now because if there is a cascade of confidence loss, things will get very ugly and very quickly. Conversely if this crisis starts to fade away, investors will be handsomely rewarded for taking the risk right now.

In the meantime, enjoy the volatility. The environment right now is once again reminding me of something like mid-2008 when everything is all panicky. Bargains that have good potential for double-digit appreciation are hitting the radar in huge frequency.

Bank of America warrants look expensive relative to common shares

I don’t profess to have a deep understanding of the large American banks, whether we are talking about Citigroup, Wells Fargo or Bank of America. In the case of Citigroup and Bank of America, they are all trading under book value. Wells Fargo undoubtedly has a premium because of the Warren Buffett influence and probably because its balance sheet is cleaner. There are multiple analysts in high-paid jobs that spend their careers understanding these entities and I have no chance on obtaining a competitive edge on them.

I do not have any positions in these stocks nor will I – they are too large for me and too difficult to understand.

That said, I will examine Bank of America (NYSE: BAC) and specifically their “A” warrants, which trade as BAC-WTA.

BAC has been a prominent entity among various value investors (i.e. I’ve read many recommendations to buy them) and year-to-date their stock has tanked about 25%. I do not know why other than there is a general concern about the large-scale US banking system and the stress that is going on in the financial system (i.e. China’s pending devaluation, macroeconomic games being played, and the impact of a negative rate environment to name a few).

The warrants have an interesting feature – while initially issued with an exercise price of $13.30/share, the exercise price gets adjusted downwards if BAC declares dividends in excess of a certain amount. You can read the details on BAC’s site here. The warrants expire January 16, 2019, or about 2.94 years from today. The current strike price is $13.106/share.

BAC shares closed at $12.95 last Friday, while their warrants closed at $3.75. There is a ton of liquidity on the warrants so there is no premium associated with liquidity concerns.

Without knowing anything about the company at all, we will ask ourselves: Would we rather want to buy the warrants or the common shares?

The calculations are much easier without having to factor in the 20 cents/share annual dividend of BAC, so I will leave the extra (required) analysis as an exercise for the reader. However, any dividends would still work mildly against the warrant holders despite the strike price revisions – the strike revision is not a 1:1 relationship and the warrant holders do not get the benefit of receiving any cash on hand between today and expiry.

If you buy a notional $100 of common shares or warrants, the results after 2.94 years given certain price changes in the common shares is as follows:

BAC Common vs. Warrants Decision

A quick and dirty results table, not including the impact of dividends, of a notional $100 investment in BAC Common or BAC A Warrants at the end of February 6, 2016.
ChangeCommonCommon ResultOptionsOption ResultDiff
-50%$6.48$50.00$-$-$(50.00)
-45%$7.12$55.00$-$-$(55.00)
-40%$7.77$60.00$-$-$(60.00)
-35%$8.42$65.00$-$-$(65.00)
-30%$9.07$70.00$-$-$(70.00)
-25%$9.71$75.00$-$-$(75.00)
-20%$10.36$80.00$-$-$(80.00)
-15%$11.01$85.00$-$-$(85.00)
-10%$11.66$90.00$-$-$(90.00)
-5%$12.30$95.00$-$-$(95.00)
0%$12.95$100.00$-$-$(100.00)
5%$13.60$105.00$0.49$13.08$(91.92)
10%$14.25$110.00$1.14$30.35$(79.65)
15%$14.89$115.00$1.79$47.61$(67.39)
20%$15.54$120.00$2.43$64.88$(55.12)
25%$16.19$125.00$3.08$82.15$(42.85)
30%$16.84$130.00$3.73$99.41$(30.59)
35%$17.48$135.00$4.38$116.68$(18.32)
40%$18.13$140.00$5.02$133.95$(6.05)
45%$18.78$145.00$5.67$151.21$6.21
50%$19.43$150.00$6.32$168.48$18.48

Basic options 101 states that if BAC does not rise above the strike price, your warrants would expire worthless. However, we are concerned about the “break-even” point of calculation. Most amateur option traders fail to take into consideration the impact of an equivalent investment in common shares. If they were quickly asked what the break-even point of a call option trading at $1 with a strike price of $10 is, they will quickly say the common shares would have to be at $11, but in actuality the answer would be something higher than that because you could have invested in the common and received a higher gain.

So in BAC’s case, you can see that the indifference point is between 40 to 45% on the table. I will save the calculation and state it is 42.5%.

42.5% over 2.94 years implies a CAGR of 12.8% for break-even. This is a reasonably high hurdle for any stock.

What do we measure 12.8% against?

Analyst consensus is earnings of $1.69/share and contrasted to the $12.95/share price, this is a ratio of 13.1%. Return on equity is reported as 6.36%, but even if you take out some assumed junk on their book and normalize their equity to market capitalization, you still have a ratio of 10.8% there.

The quick conclusion is that I’d purchase the common shares rather than the warrants – the risk/reward on the common seems to be much better. If you’re interested in leverage, just buy the shares on margin.

Genworth MI – 4th quarter 2015 report

Genworth MI (TSX: MIC) reported their 4th quarter and year-end earnings yesterday.

I have been covering Genworth MI since 2012. While I liquidated a significant portion of the company in 2014, as a result of the price depreciation exhibited over the past three months I have taken the liberty to once again make MIC the largest position in my portfolio (at prices from 22 to 25 a share) as I believe it is trading well below my estimate of their fair value. Companies trading at a discount of over 1/3rd of their tangible book value and at a P/E of 6 either are fraudulent (which is clearly not the case with Genworth MI) or have external sources of perceived stress causing such an intense discount.

Financial Statement Review

I will pick off some salient details of their report.

1. From year-to-year the balance sheet saw an increase of about CAD$450 million of real assets (cash, bonds, preferred shares, common stock) relative to the end of 2014. Roughly half of this was through an increase in deferred premiums (money collected for mortgage insurance that is held on the liability column of the balance sheet until it is recognized as actual revenue in accordance to a model for historical loss experience) and a good chunk through retained earnings.

2. Premiums written were up to $809 million for the year, compared to $640 million the year before (a 26% growth). You can thank the CMHC for this. Alberta went down from 26% in 2014 to 22% in 2015.

3. They continued to add to their preferred share portfolio; they sold their common shares and moved to preferred shares, which is still sitting on an unrealized loss position of $33 million on a $281 million cost base; this is better than Q3-2015 which was $42 million unrealized loss and $236 million, respectively. Given the existing valuation state of the Canadian preferred share market, shifting to preferred shares is a value-added decision especially when considering the positive tax consequences of inter-corporate dividend income for insurance companies. 92% of their portfolio is rated “P2” and the remainder is “P3”.

4. The company repurchased $50 million of shares and outstanding shares is down from 93.1 million at the end of 2014 to 91.8 million on December 2015.

5. The company’s debt maturing in 4.5 years has a yield to maturity of roughly 3.5% (traded at 109 cents on the dollar at year end). Their maturity at 8.25 years out was trading at a very slight premium and is YTM 4.2%. Back on November 6, the company was exploring a debenture offering. Their cost of raising debt capital seems to be relatively low, so it is curious why they never proceeded with it.

6. Delinquencies have not materially picked up in Q4-2015 (rate still is 0.1%).

7. Minimum capital test ratio goes from 227% to 233%. Management has pledged repeatedly that their target is “modestly above 220%” in terms of capital management. It is getting to the point where they will likely execute on another share buyback, and considering the huge discount to book value, they should consider a dutch auction at around CAD$25 to get those shares very cheaply off the books instead of dealing with a thin marketplace (recognizing that Genworth Financial owns 57% of the shares outstanding). As they have 13% in excess of 220%, this translates into about $203 million in excess capital.

If they managed to buy back 8 million shares for $200 million, they’d be able to increase book value by over a dollar a share! At existing valuations it would make complete sense for them to go private, but since Genworth Financial is facing huge financial challenges, they’re not the entity that is going to do it. This is a contributor to the depressed share price of Genworth MI (the market knows that Genworth Financial is facing pressure to sell the entire asset for a pittance).

8. The company expects lower amounts of mortgage originations in 2016. This will negatively impact premiums written in 2016. They did take 4% market share from CMHC in 2015, however, which may offset the decrease in originations.

9. Loss ratio is expected to be between 25-40%, which is more than the 20-30% guidance given for the 2015 year. Loss ratio guidance has always typically been conservative in nature. Considering the combined ratio for 2015 has been around 40%, an extra 10% on the loss side would put it at 50% and thus not anywhere close to endangering the profitability of the company.

Extra thoughts concerning valuation

Stated book value per diluted share is $36.82 – this is 35% less than the current market value of $23.91/share. If the company continues to book premiums written at $800 million in 2016 and maintain a combined ratio of 50% (30% loss, 20% expense), this would still be quite an undervalued entity.

I see two issues of market price stress:

1. The perception that the Canadian housing market will collapse and cause a huge wave of defaults which would bring mortgage insurers down like what happened in the USA in 2008;

2. Parent Genworth Financial’s issues spilling over onto Genworth MI – Genworth Financial needs money out of their subsidiaries and the trickle-down effect of dividends will not cut it for them. They can consider capital transactions (share buybacks) and keep their proportionate stake which enables them to bleed money out of the company at an accelerated pace, but this would still not be adequate for their situation. The market is likely taking the MIC subsidiary down in value on the implied assumption of a fire-sale of the 57% stake in the company. Of course, Genworth Financial would have to be completely desperate to do it at a 35% discount to book value (not to mention a P/E of 6), but the question here would be: Would they be willing to sell the whole thing at book?

Dundee Corporation – DC.PR.C – Series 4 Preferred Shares – Amended Exchange Offer

You can read my previous analysis piece on the original exchange offer here.

Dundee Corporation has announced a revision to the exchange offer. This offer would have never been made if there were sufficient votes to accept the original exchange offer (2/3rds of votes required).

The management information circular has not been posted yet, but James Hymas beat me to the punch to providing some of his always excellent analysis on anything relating to preferred shares.

My own quick summary is: the deal stinks less compared to the original offer, but it still stinks.

The revised terms of the amended offer compared to the original exchange offer include:

– The removal of the $0.223/share consent payment for shareholders voting yes to the proposal before a specified date.
– The ability to redeem 15% of the issue on June 30, 2016 and a further 17% of the then-issue (i.e. another 14.45% of original issue size) on June 30, 2018January 31, 2018;
– An increase of the dividend rate from 6% to 7.5%;
– Granting of 0.25 warrants to buy DC.A stock with a strike price of CAD$6.00 with an exercise price of June 30, 2019 (which will be listed on the TSX).

Closing Market Prices for Reference

DC.A: $5.95/share (no dividend)
DC.PR.B: $12.00/share (11.9% yield)
DC.PR.C: $14.43/share (6.2% yield)
DC.PR.D: $9.50/share (11.8% yield)

Analysis

The meeting date has been postponed to January 28, 2016, but shareholders of record on December 3, 2015 (per the original exchange offer) will have a vote on the matter. They chose to keep the original record date – a revised record date would include shareholders that were more willing to buy into the terms of a sweetened exchange offer.

By far and away the most important provision is the removal of the $0.223/share consent payment. This consent payment introduced the concept of a prisoner’s dilemma where if you believe the deal was going to pass, you would be incentivized to vote in favour of the deal despite how bad it was.

Without a prisoner’s dilemma, there is no incentive to voting yes for a marginal or mildly adverse offering (which was the only way the previous offering had any chance of passing).

This deal still stinks, but the removal of the $0.223/share carrot will remove votes in favour because (and this is my personal speculation) most of the shareholders are angling for the June 30, 2016 redemption.

So now, shareholders can vote against the proposal and face no “punishment” of having missed out on a consent payment.

Notably the consent payment for the intermediaries is still in effect – brokers will receive $0.1784/share for each vote in favour received by January 21, 2016 and $0.0892 by January 26; so if you are indeed in favour of this bad deal, it would be in your best interest to vote your shares at the actual meeting so the company doesn’t have to pay out consent payments to third parties!

The ability to redeem 15% of the shares on the original June 30, 2016 redemption date is “nice”, but not of material economic consequence. The subsequent tranche (14.45% of the original offering size) on June 30, 2018January 31, 2018 is long-dated enough that credit risk considerations come into play (for instance, the company’s credit facility would have to be renegotiated at this point and you would expect their subsidiaries would actually start making money at this point).

The increase of the dividend rate to 7.5% reflects the very weak trading performances of the other two preferred share issues (yielding nearly 12% at current prices). James Hymas has done a much better job than I could explaining the quantitative details of this component. Credit risk, especially by redemption time, becomes a huge factor in properly determining the course of action for this exchange offer. Dundee is good for a June 30, 2016 redemption through the unused portion of their credit facility. After this, who knows?

I will attempt to ballpark a valuation of the warrants. The company stated the warrants would be listed on the TSX if the exchange offer is accepted and this would give preferred shareholders a venue to liquidate for immediate cash proceeds. While the historical volatility of Dundee common shares as of the past 30 days has been around 80%, their at-the-money options currently trade at an implied volatility of 42%. Using Black-Scholes valuation (which is not the best way to value long-dated options, but is good enough for paper napkin purposes such as this post) we get an option value of $1.84/share, or about 46 cents per preferred share (as each share would receive a quarter warrant).

Using some more formal methods involves different results – if you are that bullish on Dundee’s common stock, why bother playing around with the preferred shares when you can simply buy the common shares or even the other preferred shares?

Doing some simple sensitivity analysis, if Dundee traded to $8 (25% higher) between now and the January 28, 2016 special meeting, the implied value of the warrants per preferred share would be approximately 83 cents (50 cents intrinsic value and 33 cents time value), assuming implied volatility doesn’t drop (in reality – it would slightly). 83 cents does not come close to mitigating the capital losses that have occurred between the initial offering (when shares were trading at CAD$17) and when the exchange offer was proposed. Right now preferred shareholders are sitting on a $2.60 drop in market value and this exchange offer will come nowhere close to compensating them even with the increased coupon and partial early redemption rights.

I also find this statement to be amusing:

The determination of the Board of Directors is based on various factors, including a fairness opinion prepared by GMP.

Apparently the original exchange offer was fair, but the amended one is as well! Is there any offer that wouldn’t be considered fair by GMP?

Conclusion

Preferred shareholders have an even easier decision this time around – vote against the offer. It is still terrible compared to the existing Series 4 preferred shares.

As I have disclosed in my prior post, I sold out my DC.PR.C position between $17.20-$17.44/share in late November/early December. I’m a spectator at this point.

Update January 9, 2016: The initial part of this post had the second redemption date as June 30, 2018 when it should be January 31, 2018. The above has been corrected and the 5 month difference does not materially change the above analysis.