Genworth MI – Q2-2013 report

Genworth MI (TSX: MIC) reported second quarter results yesterday. They continue being a cash generation machine, with the latest quarter reporting a 0.12% delinquency rate on mortgages and a 43% combined ratio. With this and some investment gains, the company was able to report $88 million in operating income, or 89 cents per share.

Severity on claims was also down to 30%, from 34% a couple quarters ago.

The only negative a discriminating investor could see is the amount of insurance written this quarter was down about 40% (translating into net premiums written down by 22%), but this is strictly due to the federal government’s intervention on mortgage rules. It will also have a corresponding positive impact on claim frequency as the insurance pool will be of higher quality. It should be important to note that insurance companies make profits on underwriting risks that are priced below actual risk, not on sales volume.

On the balance sheet side, the company remains overcapitalized and has commenced its share repurchase since early May; they bought back 2.01 million shares at an average price of $24.88/share. This was a very astute purchase. It is likely they will keep repurchasing shares from the market until the buyback is exhausted, which will likely be at the end of the third quarter at the rate they are going. After that, they will probably look at the share price before deciding whether to increase the buyback or just give out a special dividend. Tangible book value at the end of Q2-2013 is $29.48/share.

Otherwise, there is not too much to report in this quarter report that hasn’t already been covered in previous reports of Genworth MI. While it is not the screaming value buy it was back last year when it was trading at $18/share, at $28/share, it is still undervalued and the share price still represents a degree of skepticism on the Canadian real estate market and the fortunes of the parent subsidiary that owns 57.4% of Genworth MI (Genworth Financial, NYSE: GNW). As long as one does not forecast some precipitous collapse in the real estate market (which will occur if unemployment rises suddenly) or interest rates start to rise rapidly (which would cause a country-wide devaluation of real estate assets), I still am amazed that this company has traded under $30/share for so long. It will get there.

Investors are also paid to wait, with a 32 cent dividend, which represents a 4.57% yield at a $28 share price.

As people are aware, there are two major players in the Canadian mortgage insurance market: the 100% federally-owned CMHC, and Genworth MI. Both entities are making insane amounts of profits for their shareholders (in the former case, for the public, in the latter for the shareholders) and it is rather reassuring to know that there is alignment between the government’s interests and the company’s – mainly keeping the premiums for mortgage insurance considerably higher than what appears to be needed. This is obtaining duopoly-style pricing without all the media attention. Finally, investors in Genworth MI also have to take into consideration the motivations of the parent subsidiary, which currently seems to be in the role of a passive investor at the moment that is clipping dividend coupons and cashing out shares as needed (this is in proportion to the buyback). Whether Genworth MI gives out its cash as dividends or as a share buyback does not make too much difference to me, although back at $25/share I was quite happy to see the shares repurchased. At $28, lesser so, but the breakeven point would be $30 for me, where I’d believe it would generate more value for dividends to be the conduit for excess cash.

Suffice to say, I am still long and am not interested in selling at current prices. They are still trading at less than tangible book value and generated $1.85/share in cash for the first half of the year. Why would anybody want to sell unless if they are panic-stricken?

Junk debt is being accumulated

It is very evident that money is once again flowing into junk debt. I am finding every piece of junk debt securities being bidded up over the past week. Amazing what happens when the Federal Reserve talks about not wanting to ease up on quantitative easing – liquidity and party-time again for everybody! Back to the strategy of borrowing at 1%, and buy up those 8% junk debt securities and skim the spread… until the music stops.

Of course, I do not endorse or condemn this strategy – it will work, until it stops working. Such are the markets we are currently in.

Genworth MI update

Genworth MI (TSX: MIC) has been treading water since last March, but lately seems to have caught some upside momentum:

mic

Possible substantiations why the price is rising:

– Macroeconomic aspects of the Bank of Canada determining to keep short term interest rates low (which will enable more principal payments on mortgage and thus reduce default risk);
– No big blowups in the Canadian housing market;
– The stock repurchase of 71,540 shares a day since the last course issuer bid has been announced. In May and June they took about 2 million shares out of circulation – just over 2% of their shares outstanding, which will boost earnings per share by about 7 cents a year. This will also save the corporation about $2.5 million in cash flow a year from not having to pay out the associated dividends. They have sufficient cash reserves to keep this up for quite some time.
– Notably such buybacks (especially at around the $25 price they executed the buyback with in May and June) are accretive from a tangible book value perspective, i.e. every dollar spent in repurchasing equity actually increases the per-share tangible book value.

It looks like they were able to mop up the willing sellers out there at the $24-25 price range and the market is now bidding the shares at a price that is closer to fair value, but my own calculations suggest that there is more upside.

Management should continue repurchasing shares until roughly $30/share as these repurchases are clearly adding value. After that, they should taper the buyback and accumulate cash and consider a special dividend.

The corporation is generating considerable sums of cash and will not be in a position needing to raise capital. Its next debt maturity is December 2015, where they have a $150 million issue outstanding at a coupon of 4.59%. Considering they currently have $289 million in free cash balances, this will not be a problem to either just pay it off or to re-borrow the amount for a modest amount of financial leverage. This decision will likely take place sometime in the first half of 2015. If interest rates rise, they’ll just repay the debt. If interest rates continue at the historically low rates we are currently experiencing, then they’ll be able to get a good rate.

Disclosure: I do own shares, it is just over a year since I last took my position.

Finding financial needles in haystacks – an investment opportunity

During the great fixed income purge over the past month, there have been a few babies thrown out with the bathwater. I am still working on accumulation since these securities are not that highly traded. It is my general belief that hedge funds and other institutional managers are still on auto-liquidation mode with their algorithms with respect to these securities and they are being relatively indiscriminate on price – they are just hitting sizable bids at opportune moments. Whenever this selling pressure subsides, prices should rise again.

Anyhow, the next candidate for investment is a debt security that has an embedded debt-to-assets covenant that is well below 1:1 and is currently the most senior debt structure in the corporation. The corporation has tangible equity to more than cover double its outstanding debt, yet the market is worried that there is a solvency risk to the point where the debt product is deeply discounted despite the fact that such investors clearly will get a full recovery if it goes into creditor protection (and it will not unless if management is clearly insane, since their own vested economic interests will take over and pay the debtors).

This is a type of situation where an investor can make a capital gain of roughly 50% over a year time frame, plus interest payments. The risk is that the corporation’s assets are misstated, or cannot be liquidated at book value. The risk/reward, however, seems to be disproportionately positive and there is a very clear reason why the market is actively dumping the product at present. The company’s economic condition is partially the reason but I believe a further factor is the indiscriminate selling by existing holders.

I can’t give more specific figures without giving away the name of the company. I also generally have a belief that the selling pressure will be met with more demand sometime after August 9-12, so investors will have about three weeks left to capitalize on what will likely be the rock bottom for this security.

First Capital Realty – Cheap capital

First Capital Realty (TSX: FCR) owns and operates shopping centres. They do so quite profitably, and while not technically an REIT, it does have REIT-type characteristics, including a policy of distributing most of its cash flows through dividends.

When doing some research on this company, I did notice they were able to raise the following debt offering a couple months ago:

First Capital Realty Inc. (TSX:FCR) (the “Company”), Canada’s leading owner, developer and operator of supermarket and drugstore anchored neighbourhood and community shopping centres, located predominantly in growing urban markets, announced today that as a result of investor demand for its public offering of Series Q senior unsecured debentures which was announced earlier today, the size of the offering has been increased by C$75 million to C$175 million. These debentures will bear interest at a rate of 3.90% per annum and will mature on October 30, 2023. The $175 million of debentures were sold at a price of $100.952 per $100 principal amount plus accrued interest, with an effective yield of 3.788% if held to maturity. An aggregate of $300 million of such debentures will be outstanding after giving effect to the offering. The offering is being underwritten by a syndicate co-led by TD Securities, CIBC World Markets Inc. and RBC Capital Markets. Subject to customary closing conditions, the offering will close on May 15, 2013. It is a condition of closing to the offering that the debentures be rated at least BBB (high) with a stable trend by DBRS and at least Baa2 (stable) by Moody’s Investors Service.

This is giving the company 10-year money at 3.8%, which is an amazingly low rate for unsecured debt. If they could raise even more money at this rate, they should – indeed the original offering was for quite less volume. This was at the peak of the market’s thirst for yield.

Something also very different about this company is they have a series of convertible debentures, and a prominent policy of the company states:

It is the current intention of First Capital Realty to satisfy its obligations to pay principal and interest on all of its Convertible Debentures by the issuance of Common Shares.

This is the only corporation I can think of that has this policy.

This leads to some very interesting financial results in terms of shareholder dilution, but it has not impacted the net return to shareholders in the meantime. Glossing through some historical reports, shares outstanding on March 31, 2003 was (split adjusted to present levels) 64.5 million shares, while shares outstanding on March 31, 2013 was 207.3 million. Still, a shareholder on March 31, 2003 would have paid about $7.60 and received at March 31, 2013: a $19 share plus $7.56 in cash dividends. Working the math, that is about 13%/year compounded annually, not a bad haul at all.

The only time I can see this strategy failing is if there is some transient condition where the equity falls below a certain threshold level. Even during the depths of the 2008-2009 economic crisis, the company was fairly resolute in keeping this policy despite the 40% haircut shareholders took from the previous peak.

I won’t be buying into this company (or its debt), but I have to commend their finance crew for a very unconventional policy that does seem to deliver results for shareholders.