Equity – Page 69

KCG Holdings – very inexpensive risk-reward ratio

KCG Holdings (NYSE: KCG) is probably best known as previously being “Knight Capital”, which was one of the top-tier US market-making firms back in the days when the Nasdaq traded in quotations of 1/16ths.

The second reason why they are well-known is because due to a badly botched software upgrade on August 1, 2012, where their algorithms managed to incur $440 million in 30 minutes of trading losses before technicians were able to pull the plug. I am quite confident with an unlimited amount of equity on my Interactive Brokers account I could not manage to lose that much money using my fingertips and mouse.

The company was forced to recapitalize and what incurred after was a reverse-takeover by the algorithmic trading firm GETCO. The existing shareholders were massively diluted and this functionally served as a way for GETCO shareholders to liquidate their holdings (backed by General Atlantic). The combined entity was renamed “KCG” (yet another example of a firm acronym-ing their name) and what ensued was an internal purge of legacy Knight Capital personnel. The transition at this time is more or less complete.

The corporation still makes the bulk of their money through market making and related trade execution services. Their prime competitors include other high-frequency trading firms, including the newly public Virtu (Nasdaq: VIRT). In general, the firm makes money when market conditions are volatile and they operate at a loss when volatility is quite muted.

The July to September quarter was a disaster for KCG (and other market-making entities, including Interactive Brokers), while the April to June quarter was quite profitable (think about Brexit!).

Since the last quarter’s results, KCG shares have tail-spinned:

The business, quarter by quarter, is highly volatile. In the Q2-2016, they reported operating revenues of $280 million, and in Q3-2016 they reported $200 million. As you might tell by this seasonality, it creates volatility in the stock as quantitative algorithms that purchase and sell shares on fundamental data generally go wild with companies like these.

Profitability also varies. The corporation is still trying to cut costs and become lean and mean (like Virtu), but it is taking them time to get to that position where they can be profitable in a very low volatility environment like the last quarter. On the aggregate, they are profitable in the medium run, which means I do not regard them as much of a risk at this moment (unless if their programmers decide to botch up another software upgrade like what happened in August 1, 2012).

The balance sheet is a little more interesting.

Its tangible book value is $15.54/share at the end of September. The underlying corporation has $508 million in cash, and a whole host of financial instruments that vary from quarter to quarter as they maintain an inventory for market making purposes (13F-HR form attached for illustration). In addition, they also own 13.1 million shares of BATS (Nasdaq: BATS), which is presently in the middle of getting acquired by the CBOE (Nasdaq: CBOE) sometime in 2017. The BATS stake is worth a pre-tax amount of about US$380 million at current market value.

Where my accounting experience comes in handy is how this is reported. You would think that owning US$380 million in a publicly traded entity would be reflected as US$380 million on the balance sheet, but this is not the case with KCG’s BATS stake. Instead, it is reported under the equity method of accounting. I will leave out the complications and state that it is reported as $94 million at present on the balance sheet. As KCG sells their BATS shares, the differential between sale price and their carrying value on the asset side will be reported as a gain (subtracting a provision for income tax).

So there is actually about $285 million of pre-tax money that is bottled up and waiting to escape. After taxes, this will be about $200 million leftover (using 30% as a basis – the actual rate may be higher).

You can see why most people do not have the time or patience to go through this minutiae.

On the liability side, we have one significant liability – $465 million face value outstanding of secured senior debt, with an 6.875% coupon maturing March 2020. The debt restricts the corporation to repurchasing shares at a fraction of KCG’s income (if you care to read the fine print, it is available on this 8-K filing) in addition to other nitty gritty details that I will omit from this post.

KCG initially issued $500 million in debt, but decided to repurchase debt at a discount to market earlier this year, when their debt was trading at about 89 cents on the dollar.

Readers of this site perhaps would not be surprised to know that I decided to purchase a decent-sized block of debt at around 90 cents earlier this year. My first disclosure of that purchase is in this post. Unless if the corporation decides to do an August 1, 2012-style blow-up, I regard it as virtually impossible that they will be unable to pay back this debt.

The company has also been actively engaged with the repurchase of its equity (and warrants related to the GETCO merger) at values that have been below book. They conducted a dutch-auction tender last year with excess capital, and they have not made sufficient amounts of money this year to conduct further stock repurchases – their authorization after the previous quarter was a paltry $2 million. However, they can liquidate BATS shares and use those proceeds for equity buyback purposes.

Considering the firm is now trading at a 15% discount to tangible book value, any equity repurchases would be accretive to their book value, in addition to being an EPS boost whenever the markets are volatile enough for them to make money.

So this is a compelling business with a relatively wide moat (market-making is not as easy as initial perceptions may seem), a decent balance sheet, and reasonable prospects for much better business conditions (did I say anything about Donald Trump in my previous post?). It is a company that would find better business conditions when there are higher amounts of market volatility, and assuming they can keep some sort of competitive business edge on the algorithmic side of things, they should be able to generate positive cash flows.

In other words, the downside appears limited, but the upside is less defined.

A question of what their terminal value would be is an interesting study – one would think that if they decided to go private (which would be a legitimate avenue considering everything presented above) that they could do so at a share price obviously above the US$13.10 they closed at today. Management has made promotions of aiming for a “double digit return on equity” in 2017, which I believe is generous, especially on the operating side, but if they get anywhere close to this (or even half of it), the market should value this well north of US$13.10.

So I’m in. Both the equity and debt.

Looking back at Davis and Henderson

Once upon a time, I had invested some money in David and Henderson Income Fund, which was back in the days when a lot of viable corporate operations were structured in the form of an income trust. I made some reasonably quick capital gains, sold, and never looked back.

Davis and Henderson, similar to Kentucky Fried Chicken, Ernst and Young, PriceWaterhouseCoopers and many other establishments, decided to abbreviate their corporate name to their initials and become D+H Corp (TSX: DH). Considering that their previous business was the printing and processing of Canadian (paper) cheques, diversification of their business was correctly considered and for the most part, they made a fairly good transition into the broader realm of providing financial technology services for big banks.

You can see in the 10-year chart that this has really worked for them, and the market has been on their side, until recently:

What you don’t see is that in today’s trading, they fell 43% on a quarterly announcement (closing at $16.25/share, with a low of $14.97), bringing their stock price to levels frighteningly close to what I had invested back in 2010 with a cost base of $16.10 per unit. This was certainly a case of “back to the future” for Davis and Henderson.

The question of course is whether the six or so years it has been since I had last invested in them, whether they were worth taking another stab at again.

D+H’s fateful decision was the acquisition of Fundtech on March 30, 2015 (which closed a month later). In this acquisition, they issued many hundreds of millions of debt (in addition to doing a secondary offering at $37.95). Unfortunately, while the acquisition was designed to represent a diversification away from their traditional businesses, it has not materialized into anywhere that could be financially rationalized with the price paid. It has also bloated D+H’s balance sheet with the haunted scars of an additional $1.7 billion in goodwill and intangibles, and when considering their pre-existing goodwill and intangibles, they are sitting on a negative $1.3 billion of tangible equity.

Putting this into plain English, their balance sheet is a train wreck.

Train wreck balance sheets can only sustain themselves with positive cash flow, and continued good credit, as the generosity of lenders will be able to see them through.

For the first 9 months of the year, they have generated $167 million in free cash flow. A majority of this goes to dividend payments ($90 million), and the rest of it goes to debt repayment and acquiring other intangibles.

The problem is with the last quarterly result – it is quite evident that the corporation, on a consolidated basis, has flat-lined. While they still generate a very healthy amount of cash, it is obvious that they will be receiving future stress in the form of being able to repay debt as it matures.

They face the following debt situation:

They have an immediate maturity coming in June 2017, which they should be able to pay off with existing cash flow and/or their revolver without issues. The issue is what happens when they start getting into the bulk of their 2021-2023 maturities.

The math is simple – if they continue paying dividends at their current rate, they will have about $100 million a year in cash to acquire businesses (more intangible assets on the balance sheet) plus debt repayment. They will not have nearly enough to pay off the bond maturities without getting another extension of credit from bondholders.

Considering all of the bond issues and the revolving facilities are secured debt, you can be sure that the banks that supply the revolving debt are going to be nervous about using their money which is pari-passu to bondholders – which means that something is going to have to be negotiated in a couple years.

My guess is that the dividend is going to get slashed in half.

In terms of valuation, the balance sheet situation would make me quite uncomfortable as an equity investor. While I see the value in the cash generation potential of the underlying businesses (notwithstanding the fact that cheque processing is a dinosaur industry and is decreasing accordingly), I do not believe a leverage-adjusted valuation of this business is attractive at present prices.

For now, D+H is still a “pass” in my books. I did sell them at $21 back in the year 2010.

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.

Bombardier will get their money from the federal government

It is quite obvious that Bombardier will eventually get some equity infusion from the federal government, which will be the final signal to all market participants that Canada will not let the corporation fail, even if the C-Series turns out to be an economic disaster (it does not appear to be at the moment – the risk at this point is on execution).

The question is what type of concessions Bombardier will have to make, and I suspect the “win-win” agreement will be only dismantling the dual-class structure of stock if the company keeps less than X jobs outside of Canada (mainly in the Province of Quebec).

The Government of Quebec (and the Quebec Pension Plan) invested previously into Bombardier and received common shares and warrants for a half-stake in the C-Series jet and also a chunk of the Bombardier transportation division.

My whole line of thinking was that preferred shareholders and bondholders would be the primary beneficiary of all of this capital infusion. Currently, the Series 4 preferred shares (TSX: BBD.PR.C) is trading at a 9.4% yield, while the Series 2/3 (floating/fixed) shares are at 8.2% and 9.1%, respectively. The next rate reset will be in August of 2017.

The yield curve for debt is quite healthy for Bombardier and they’ll be in a good position to refinance maturities, especially when they receive another equity injection. Yields should continue to compress in this scenario.

Genworth MI: Opposing arguments

Interesting article posted by David Desjardins on Seeking Alpha – he has purchased deep out-of-the-money put options (January 2018 puts with a strike of 18) and is clearly anticipating a drop further in the stock price.

His arguments can be summed up as follows:

1. Vancouver housing prices are ridiculously high, inventories are climbing, and prices are dropping;
2. Alberta unemployment is at relative highs and their delinquency rates should spike to 2010 levels;
3. Ontario housing prices have ascended and when they taper, delinquency rates should rise to averages;
4. Higher delinquencies will result in higher claims, and these claims will have a serious negative impact on the corporation;
5. Increased capital requirements, both as a result of claims but government regulatory changes, will require MIC to issue shares.

My comments:

1. My own overall thesis is that we will see a tapering of pricing demand in the urban real estate markets, but not a crash. The housing targeted to foreign interests will depreciate considerably (my own on-the-ground research has shown this has had a 10-15% impact on asking prices in BC), but these markets have not been eligible for mortgage insurance since July 7, 2012. The spill-over is what happens to the townhouses and condominiums in the Vancouver marketplace – there will be undoubtedly be price compression due to decreased demand as a result of decreased credit availability.

I do agree, however, that BC’s delinquency ratio (currently 0.07%) is abnormally low. Ontario’s (0.04%) is also abnormally low, but the company’s loss ratio guidance has always been above the expectations of what delinquency numbers would imply – original 2016 guidance was 25%-40%, but it is fairly obvious that it is going to be well under 40%, and they decreased the upper band for loss guidance to 35%.

2. If we see the delinquency rates as he suggests in his article (1% in BC, 0.7% in Ontario), then Genworth MI and CMHC will be in very rough shape. You would see a significantly lower stock price and you will be seeing huge political ripples about the whole Canadian housing market going from boom to bust in short order. Genworth MI’s peak delinquency rate was 0.3% in June 30, 2009 during the 2008/2009 global economic meltdown, and their loss ratio was 46%. It is not a stretch that a delinquency ratio larger than that would be the result of another meltdown in equal size, something I do not believe in the offering.

If the author’s worst case scenario of 1.5% delinquency rates occur in the insured mortgage space then you will be seeing crisis headlines that would ripple well beyond the financial state of the mortgage insurance industry.

It is also important to note that lending practices in the USA during 2008-2009 had significant differences than lending practices in Canada today.

3. Genworth MI, in general, has a healthier mortgage insurance portfolio than CMHC (I will leave speculation why out of this discussion). In Q2-2016, Genworth MI’s delinquency rate was 0.1%, CMHC was 0.32%. Any changes in regulatory burdens will impact CMHC’s profitability more so than Genworth MI; while this doesn’t directly impact whether there will be a spike in delinquencies, the federal government clearly does not want to knee-cap its own crown corporation in the process (one that generated about $550 million in net income to the Crown in the first half of this year).

4. Housing prices are the primary driver of claim severity, while unemployment is the primary driver of claims. Insured mortgages in Canada are full-recourse, which means the metric to watch for is unemployment and not housing prices. An unemployment rate of 7% nationally is not concerning for housing.

5. In Alberta, unemployment is anti-correlated with increases in energy prices and has probably peaked around 9%. Housing prices have decreased by 5-10% in the province, and delinquencies have climbed from 0.09% (Q2-2015) to 0.17% (Q2-2016), but this has been well-anticipated by management. Delinquencies peaked in Alberta at 0.62% for Genworth MI in Q4-2010 (the primary after-effect of oil going down to US$33 at the beginning of 2009). My estimate for delinquencies in Alberta should taper off around 0.25-0.3%.

6. The author appears to be misunderstanding the minimum capital test. The new regulations by OSFI introduce a new regime for minimum capital required to retain insured mortgages. While the statutory minimum is 100%, the supervisory target is 150%, and the company typically keeps an internal buffer higher than the supervisory target to ensure that month-to-month operations do not bring the ratio under 150% – the pro-forma at Q2-2016 was 153-156% of the new MCT, while I suspect the internal target will be somewhat higher. Genworth MI will book another $100 million of after-tax income for the second half of the year (after dividends) and this will push it to the 160% level. They do not need to raise capital – they just need to slow down issuing insurance and continue amortize their current book.

In addition, there are transitional arrangements to the new capital levels that will only “kick-in” after they are lower than the old capital test levels. That said, the old and the new capital test levels include a 20% buffer for “operational risk”, and since the new capital test levels are higher, this will also increase the capital required for operational risk (which in the new rules, is the operating capital minus the supplementary capital required for insuring mortgages in “hot” markets). This increase in required capital is transitioned in over a 3 year period.

The effect of these changes, however, will definitely increase capital required for mortgages, especially for lower ratio mortgages:

These changes affect MIC and also CMHC. CMHC is relatively less affected as in Q2-2016, its MCT level was 366%.

As a result of these changes, I expect transactional mortgage insurance origination to decrease significantly (guessing around 20%). As I said before, if Genworth MI stopped writing insurance, their share price would still increase as their liability book would shrink and capital is released for asset distribution.

7. 92% of MIC’s mortgage business is written on loans under $550,000. 8% would be between $550k to $1M. In relation to income capacity of borrowers, this does appear to be reasonable (especially considering the average gross debt service ratio of borrowers is a reasonable-sounding 24% on Q2-2016).

8. Even if home values drop below mortgage values, the option to strategically default in Canada is much, much more expensive due to full recourse rules on insured mortgages. As long as people are employed, they will continue paying their mortgages (albeit be a bit bitter about paying down a debt on a property that is valued less than the debt).

While the author’s “what-if” estimates in the event of a spike in delinquencies is an excellent stress test, they appear to stem from a scenario that is the result of something worse than what happened in 2008-2009. If the 2008-2009 scenario happened, there are far better short sales out there than Genworth MI (candidates that come to mind include HCG, EQB, FN, etc.).

Recall that Genworth MI went public in 2009 at CAD$19/share (the first window of opportunity after the financial crisis) and this was a forced IPO because Genworth Financial desperately needed to raise capital. CAD$19 back then was a fire-sale price and the entity today is larger and more profitable than it was back then (and also noting that they had 117.1 million shares outstanding after IPO, compared to 91.9 million today) – and they IPOed at 10% under book value, compared to 25% under book today!