Equity – Page 76

Genworth MI Q3-2015 report

Late last month, Genworth MI (TSX: MIC) reported their 3rd quarter results for 2015.

The headline results were quite positive – premiums written were up from $217 to $260 million in 2015 vs. 2014 for the same quarter. As a result of premiums written increasing, revenues (premiums earned) will also be booked at an increasing rate for years to come. The loss and expense ratios remained in-line (at 21% and 19%, respectively) which still give an extraordinarily low combined ratio of 40%.

Management during the conference call pre-emptively went out of its way to explain the situation in Alberta and how they are well prepared for the upcoming onslaught of the double-whammy of increased unemployment (triggering mortgage defaults) and lowering property prices (triggering an increase of loss severity when mortgage claims do occur).

Balance-sheet wise, there were a couple negative developments. One is that the company dipped into preferred shares (selling their common share portfolio at the beginning of the year and investing in preferred shares) and are currently (as of September 30, 2015) sitting on an unrealized loss position of $42 million or 18% under the cost they paid for them (which in the preferred share market is huge!). It is currently 3.4% of their investment portfolio.

The company announced it is increasing its dividend to 42 cents per share quarterly instead of 39 cents, which is consistent with previous years’ behaviour to increment the dividend rate. They did telegraph on the conference call that they will likely not be repurchasing shares with their minimum capital test ratio at 227% even though their goal is to be “modestly above 220%”. The diluted shares outstanding has dropped from 95.6 million to 92.2 million from the end of Sepetember 2014 to 2015, but as I have discussed before, I generally view these period when market value is considerably under book value to be a golden opportunity to repurchase shares instead of issue dividends.

Conflicting with this apparent excess capital is the recent announcement that they are considering a debenture offering, which would allow them to raise more cheap capital. Would this be for leveraging purposes? They were quite successful at their last capital raising attempt – $160 million of debt raised on April 1, 2014 at a coupon of 4.242% and maturity of 10 years. Current market indications suggest they would receive roughly the same yield and maturity terms if they attempted another debt financing. Raising another $250 million in debt financing and attempting a dutch auction tender at around CAD$33/share seems to be a possibility at this stage.

Finance wise, it seems like a win-win: Raise money at 4.5%, fully tax-deductible interest expense. Use to repurchase shares that yield 5.1% (which is not a tax deductible cash outlay for the company). At a corporate tax rate of 26.5%, it is a gain of 1.8% after taxes! Remains to be seen if this is what they are thinking.

This might also be because the Genworth MI subsidiary is 57% owned by subsidiaries of Genworth Financial (NYSE: GNW), which are facing financial challenges of their own – perhaps this will be an inexpensive way for Genworth Financial to raise a cheap $140 million of equity financing and still not give up any ownership in their prize profit-generating subsidiary?

Valuation-wise, Genworth MI is still trading at 15% below diluted book value which still puts it in value range, but this market valuation is clearly influenced on negative market perceptions of the Canadian real estate market – Genworth MI has still not recovered fully from the aftermath of the effects of the drop of crude oil prices. Still, if they effected a buyback at around CAD$33/share, it would still be accretive to their book value!

The company did dip below (dividend-adjusted) CAD$27/share on a couple occasions on single days in late July and August, but I was nowhere near nimble enough to capitalize on that freak trading activity. At such valuations (25% below book value) it would be difficult to not re-purchase shares that I sold in 2014 when MIC was trading at and above $40. The fundamentals of the company are that of a bond fund asset management, sprinkled with the profit generator of Canadian home mortgage insurance.

The other elephant in the room is questioning the effects of the change in the federal government – the new mandate for CMHC might be to get it more involved in mortgage insurance instead of being (relatively) non-interventionist like the previous Conservative government. This might functionally increase the competitive space for Genworth, but it remains to be seen what the Liberal Party’s intentions are with CMHC. The only line in the Liberal Platform is the following:

We will direct the Canada Mortgage and Housing Corporation and the new Canada Infrastructure Bank to provide financing to support the construction of new, affordable rental housing for middle- and low-income Canadians.

This does not appear to conflict with the profitability of Genworth MI. But one can never depend on any new majority government to stay strictly within their platform points!

Bombardier bailout

Bombardier reported their financial results on October 29, which were ugly as expected – they bled through about $315 million cash on the operating side and a gross $500 million on the investment side for the 3 month period.

This and the next quarter should be the the worst of it.

There are a few tail-winds now that will make an investment in their preferred shares likely to pay off beyond the receipt of dividend coupons.

I did not mention this in my July 29th post, a strong component of this investment is due to the political factor – the Government of Quebec, and now by extension by virtue of the Liberal Party’s recent victory nationally, the Government of Canada is not going to let Bombardier fail due to the political connections existing between the controlling shareholder and the government apparatus.

In other words, the company will not fail due to liquidity concerns alone – it may fail due to simply being unable to produce a jet, but it won’t be for financial reasons.

Bombardier took a billion dollars from the government of Quebec for a half equity interest in the liabilities of the new jet they are producing. They also issued 200 million warrants to purchase Class B shares at a strike price that is a premium of approximately 50% above the existing market rate – which would dilute shareholders in the event that things went well.

Examining the market reaction (which on net was rather mute), the BBD.PR.C issue, in particular, is trading at an increased yield, presumably due to conversion threat (they can be converted into BBD.B shares at the higher of 95% of market value or $2/share – and at current market prices, this means 12.5 Class B shares per preferred share).

The short end for Bombardier’s bond yield curve also came down – with their new term issue (March 2018) suddenly trading at par from about 94 cents a month earlier.

The new federal government is sworn in on November 4, 2015. It is virtually certain the new government will table an interim budget measure that will announce the easy to implement campaign platforms during the past election campaign – ratcheting down TFSA contribution limits, adjusting marginal tax rates for middle income earners, creating a new tax bracket for high income earners, etc. But one of the early decisions the new government will face is whether they wish to throw some money at Bombardier. I do not believe a federal investment is likely right now (just simply due to transition and the lack of immediate political necessity), but it remains a distinct possibility in the 2016 budget which will probably be tabled around February or March.

The Quebec investment is on the equity side – and preferred shareholders should benefit from this transaction.

I find it very difficult to believe at this juncture that Bombardier will suspend dividends on their preferred shares and they will muddle their way through what has been a financially disastrous investment in the C-Series jet.

The preferred shares continue to be a high risk, very high reward type investment if things proceed to fruition.

A short squeeze on Bombardier

Back on July 29th, I posted I had purchased preferred shares in Bombardier. I wish I had started my averaging a couple weeks later (did pick up a few on the dip), but nonetheless what I expected to happen has happened over the past week, especially over the past couple days.

The catalyst (or rather the assumed story to cause all the excitement) was that a “crown corporation” in China was interested in purchasing lump-sum the rail division for a huge amount of money (enough to pay off nearly all the debt the company had).

While this may be the cited story, the reality is that sentiment was horribly depressed in the marketplace for a company, while clearly having operational issues, that was punched well below what should be a fair valuation range. It took a catalyst event for the mindsets of the traders, investors and institutions to re-value the company in-line to something that was more reasonable.

There will likely be a few slip-ups in the preferred share pricing between now and over the next year, but anybody picking up preferred equity is likely to receive their stated cash flows for quite some time to come.

While in general I think the market is still not showing many investment opportunities (at least from my eye), this was a rare opportunity in a very well-known Canadian TSX 60 issuer in the large-cap space (or at least they were large cap before this all began!). I very rarely dip my toes into the large cap sector.

The bond yield curve has also taken a similar descent.

If my nominal scenario comes through you’ll see the preferred shares at around a 7.5-8.0% yield range in a year. This will be about $20 for the BBD.PR.C and $9 for the BBD.PR.B series (interest rates are still projected to be very low going forward), which represents another 50% capital appreciation or so for much less risk (albeit slightly less reward) than the common shares.

I remain long Bombardier preferred shares.

Genworth MI Q2-2015 review

This is part of my continued coverage of Genworth MI (TSX: MIC). There wasn’t anything too remarkable about Q2-2015’s report other than that delinquencies in Alberta have not been materially increasing. Combined ratio is at 37% for the quarter, which is in-line, and the company wrote $205 million in premiums, which is significantly higher than the $160 million from the previous year’s quarter. As the premiums recognized is significantly less than this number ($144 million) as policies amortize, the revenues to be recognized will be increasing over time.

The conference call transcript would suggest that management is quite aware of the economic fallout with regards to oil prices and Alberta’s economy and also the mortgage fraud issues that Home Capital Group (TSX: HCG) disclosed.

Portfolio management moved out of common shares and into preferred shares – from the beginning of the year they moved about $190 million of capital into preferred shares in the financial and energy sectors. Considering all the carnage going on in that sector (please read James Hymas for his most brilliant descriptions of the Canadian preferred share market) this is probably a reasonable decision on valuation.

The company repurchased 1.54 million shares at $34.38/share during the quarter. Considering this is below their book value, share buybacks are an accretive transaction. The company’s ability to conduct share buybacks relies upon them being “modestly” above a 220% minimum capital test ratio (which was at 231% at the end of Q2).

With MIC.TO shares trading at $29 as of last Friday, any further share repurchases at this price range (in my humblest of opinions) would be a highly beneficial transaction for remaining shareholders and the company should be exercising another share buyback this quarter – basically at current prices every dollar they spend on a buyback is minting about 25 cents of value from thin air.

The market price is clearly trading on fears of some sort of downturn in the Canadian real estate market. With the carnage going on in China there may be some foreign liquidation of domestic land, but how much collateral damage this may cause in the broader market remains to be seen. Employment rates are the primary determinant of the ability for people to be servicing their mortgages and right now this is appearing to hold steady at 6.8%. Although the horizon appears to be stormy, there seems to be a reasonable economic buffer between the fundamental valuation of Genworth MI and the risks ahead concerning the mortgage insurance market. Cash generation is still immensely huge and combined ratios are incredibly low.

I have always likened Genworth MI to be a glorified bond fund with a housing-linked component that will boost returns providing the Canadian economy doesn’t implode (i.e. default rates will rise) beyond the 2008-2009 economic crisis levels. The current trading price is on the lower depths of my fair value range and I am eyeing it closely.

Search for yield – Dundee Corp

Dundee (TSX: DC.A) is an investment corporation. They are family-controlled (by the Goodman family) who control approximately 87% of the voting interest and 18% of the economic interest of the firm through a typical dual class share structure.

By virtue of owning Dundee Financial and other majority and minority-held investments, their consolidated financial statements are a mess to read. When pulling apart the components, they are diversified among real estate, energy, financial, mining and agriculture, in that order.

At the end of the day their stated book value is about $1.45 billion dollars, trading at a market capitalization of about $540 million. There are good reasons to believe the book value will be impaired simply due to their slowness in writing down some investments that clearly will not perform, but even assuming a 50% write-down (which seems appropriate) this brings the entity down to a liquidation value that is still well above its market capitalization.

On the liability side, the holding company has $92 million in term facility debt and subsidiaries make up approximately $100 million more in non-recourse debt. The leverage is not huge. The term facility is good for $250 million total and expires in November 2016 which is salient to the discussion below.

I generally have an aversion to controlled corporate structures as a minority holder unless if there are significant reasons why one would believe there is an alignment of interests. There also needs to be some reasonable assurances there isn’t a cesspool of conflict of interests in the other subsidiaries / operating companies that would cause shareholders to believe they are being taken to the cleaners with. I don’t get this element of confidence with Dundee, so I would steer away from the common shares. This is also found in companies with similar capital holding companies, including firms that have been on and off my radar (let’s be specific: Pinetree Capital is one of them – trading at around 50% of reported net asset value!).

On a more humorous note, Dundee’s logo also looks like the Blackberry logo, which is kind of disturbing considering how Blackberry has fared:

At least their logo is pointing upwards instead of flat.

I am writing not about the common shares, but rather the preferred share securities of Dundee. They have a series of preferred shares (Series 4) which has a par value of $17.84/share. The reason for the unusual par value was because Dundee split off DREAM Unlimited (TSX: DRM) which partitioned the original preferred share series issue (into DC.PR.C and DRM.PR.A). The shares have a coupon of 5%, paid out quarterly.

The preferred share series has an interesting feature: they are redeemable by the holder for $17.84/share after June 30, 2016. They are also retractable by the company indefinitely (at $17.84/share cash) and convertible into common shares at 95% of TSX market pricing or $2/share, whichever is more until June 30, 2016. The aggregate value of the preferred shares at par is $107 million.

This creates a rather interesting situation where an investor can purchase shares today (trading at roughly 97 cents on the dollar) and force a redemption in about 10.5 months’ time, skimming a 5.15% preferred yield and a 3% capital gain. One clear risk is whether the common shares will be trading above $2/share by June 30, 2016, which would seem to be a likely bet even if the underlying asset value of Dundee’s oil and gas companies are seriously impaired. It also does not help that most of their operating entities and equity-accounted entities are losing money, but the question is how much money will they actually end up losing between now and June 30?

There is also sufficient management interest in ensuring that their (not trivial) 18% economic stake in the firm is not diluted with a share conversion, coupled the with the fact that their operating credit line appears sufficient to pick up the bill (in addition to the $87 million cash they already have on hand in the holding corporation).

The preferred shares are extremely illiquid and trade in a narrow range that is presumably due to the redemption/retraction feature.

It is an interesting gamble that seems like it is reaching out for yield, but with an element of security given the pre-existing credit facility and 80% distance between the existing common share price and the $2 floor for preferred conversion.

In relation to the tax-preferred status of an eligible dividend coupled with a (presumed) capital gain at the end, one is looking at a functional tax-preferred 8% with a reasonable amount of asset security (although the security is implied by redeem-ability, definitely not direct security!), contrasted with a fully-taxable 1-year GIC at 1.2% (without liquidity) or 0.85% with liquidity. The spread seems to be a reasonable compensation for risk.

I would like to thank a comment poster by the name of Safety, who on May 25, 2015 posted about this in one of my prior rantings. I was indeed quite surprised at the quality of this person’s comments and hope he can chime in here again.

Anyhow, I finally picked up a few shares.