Capitalized vs. Operating expenses

The easiest way of inflating current year earnings to the detriment of future years is to capitalize cash outlays when they should be expended when they are incurred.

The new financial management at Penn West (TSX: PWT) are looking at the degree as to which this has permeated into the balance sheet of the corporation.

The numbers are not extreme, but a change of 20 cents per share on the income statement is significant. There will likely be some sort of re-statement issued at the end of this process that will take a non-cash hit on equity.

Just strictly from a balance sheet perspective this looks like a deep value play, especially if your prognostication on crude believes that prices will rise. Companies like this are not my thing, but this recent accounting crisis has put the value of the firm clearly in low territory.

This is also another indication of how corporate auditors are not as comprehensive as one would believe. In an ideal world, they would be held accountable in addition to the (no longer working with the company) staff that transacted the questionable journal entries.

Genworth MI Q2-2014 report

Genworth MI (TSX: MIC) reported 2nd quarter earnings yesterday. The results were smashingly positive for the company and show that the state of credit stability in the Canadian mortgage market is very high.

My calculated tangible book value for share, diluted, is $34.11 compared to the current market price today of approximately $39.70 per share (a 16% premium over book value). Booked income was $1.02 per share, noting the mild accounting change regarding how deferred policy acquisition costs are processed. This also would have been even higher if one backs out the extingushment of debt expense that occurred during their bond refinancing (offset by backing away the one-time capital gains from their portfolio).

In general, the trend for the company has been very positive with declining loss ratios and delinquencies in their mortgage insurance portfolio. This quarter has proven to be an exception in that the ratio has gone even further lower than the prevailing trend:

Loss Ratio
Q1-2013: 31%
Q2-2013: 25%
Q3-2013: 22%
Q4-2013: 22%
Q1-2014: 20%
Q2-2014: 12%

Suffice to say, this is incredibly low – indeed, a record low since the company went public. The existing stability in the Canadian mortgage insurance market is leading to the top dogs (mainly CMHC and Genworth MI) to book a lot of revenues as people continue to amortize their mortgages (and thus reduce the risk even further of mortgage defaults occurring).

On the top line, premiums written was also better than last year’s Q2 (160 million vs. 137 million), but not quite as good as 2012 (which had 176 million). This amount bodes fairly well for revenue stabilization (which is lagged behind the actual premiums written as most of this gets amortized in the subsequent 5+ years of the life of the mortgage).

In terms of their portfolio, it continues to be relatively unexciting, consisting of the usual staples of bonds and a small smattering of equity – yield is 3.6%, duration 3.7 years.

The other significant piece of news is the establishment of a new amount of internal minimum capital required to operate the business:

The Insurance Subsidiary is regulated by OSFI. Under the MCT, an insurer calculates a ratio of capital available to capital required in a prescribed manner. Mortgage insurers are required to maintain a minimum ratio of core capital (capital available as defined for MCT purposes, but excluding subordinated debt) to required capital of 100%.

Under PRMHIA and the Insurance Companies Act (Canada) (“ICA”), the minimum MCT ratio for the Insurance Subsidiary is 175%. In
conjunction with this requirement, the Insurance Subsidiary has set its internal MCT target capital ratio to 185%. The Company manages its capital base to maintain a balance between capital strength, efficiency and flexibility. As at June 30, 2014, the Insurance Subsidiary’s MCT ratio was approximately 230%, or 45 percentage points higher than the Company’s internal target of 185%. The Company regularly reviews its capital levels, and after reviewing stress testing results and after consulting with OSFI, the Company established an operating MCT holding target of 220% pending the development by OSFI of a new regulatory test for mortgage insurers which is targeted for implementation in 2017. While our internal capital target of 185% MCT is calibrated to cover the various risks that the business would face in a severe recession, the holding target of 220% MCT is designed to provide a capital buffer to allow management time to take the necessary actions should capital levels be pressured by deteriorating macroeconomic conditions. Under this framework, capital in excess of the operating holding target may be redeployed.

Currently the company’s MCT is at 230%, while the new minimum will be 220%.

The implication of this is fairly obvious – there will be a reduced amount of capital available to give out a special dividend and/or share buybacks. There is an excess of about $150 million over the 220% minimum required. The company declared a 35 cent dividend this quarter (which translates into roughly a $33 million distribution) and will likely increase the dividend to 38 cents in the next quarter with the potential of a special dividend of a dollar to bleed the excess capital away. Since the company is booking income of about $1 a quarter, this should not be a problem for them.

Since the Canadian mortgage insurance unit is so profitable at the moment, it will not be surprising if there was attempted encroachment in the market by competition, and I wonder if we are going to see price competition that deviates away from the CMHC payment schedule. If this happens, shares in Genworth would start to decrease.

Right now the market is pricing in perfection in the Canadian mortgage insurance scheme. This continues to worry me that the fundamental picture for Genworth MI cannot get much better than it is at present, especially with their 12% loss ratio.

I continue to remain long in Genworth MI as I generally see it being a reasonably good store of capital at the moment. I did sell some when it was trading in the upper 30’s and lower 40’s earlier this year, but this was to reduce concentration in what is otherwise a company that is firing on all cylinders.

Things to watch in the media

Whenever I see headlines like this, I know the stock market has not finished peaking:

yahoo

Yes, of course everything is over-valued, but as long as there are a significant minority of people that are holding back for nuclear armageddon, we have not peaked yet.

Quiet times

Sometimes doing nothing is the best policy and the last two weeks have been exactly that. There’s been a small amount of portfolio adjustments, but nothing too serious. If I have something more exciting to report, I would have. There isn’t anything. Credit spreads are tiny and investors are generally not being very adequately compensated for risk.

In a “would have, should have” world, Lululemon (Nasdaq: LULU) would have been a short in my portfolio a year ago, but that opportunity has now passed. Coach (NYSE: COH) is also on that short list. Both of these are subjected to confirmation bias by females that I know are into these sorts of things. Both of them are trading at valuations which can (now) be considered reasonable (LULU still being a tad expensive, but not as ridiculous as they were before), but both brand names are clearly on the downtrend. In fashion, trends are everything. Apparently Kate Spade (Nasdaq: KATE) is the next up-and-comer and while traditional valuation metrics say this one is very expensive, perhaps talk to some teenagers that have disposable income and your opinion may change.

No positions, just curious. It makes outlet shopping somewhat more tolerable when looking at these various brands from a purely financial perspective.