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?