MIC – Page 14 – Divestor

Genworth MI update

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

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.

Genworth MI’s sensitivity to unemployment rates

Genworth MI took a dive today because of the rise of unemployment in the Statistics Canada March release of the labour profile. Employment of full-time workers went down 54,000 workers.

A rise in unemployment will increase the frequency of claims on mortgage insurance, while a decrease in property value will result in an increase in the severity of claims.

I believe the market is over-reacting to this news, but it is true that the default and delinquency rates for Canadian mortgages at present is quite low compared to historical norms.

On the brighter side, a lower share price makes the share buyback option more attractive.

Genworth MI upcoming quarterly report

There is a strong possibility that Genworth MI (TSX: MIC) will make some sort of announcement this month, specifically with respect to what they are going to be doing with their excess capital.

A chart of MIC shows that it has gone nowhere over the past month, but this has been since quite a run-up since last August when it traded all the way down to about $16/share.

At the beginning of January 2013, MIC had about 210% of the minimum capital test that is required and the company has an internal target of 190%, which means that they had about $287 million in excess capital available. This does not include the additional capital that has accumulated in the first quarter of 2013.

Having this extra capital (noting that $337.87 million was in very low-yielding cash and short-term equivalents at the end of 2012) is lowering the return on equity, reducing portfolio yield and is producing a drag on performance. The cash can be safely returned into the hands of investors.

There are four options available, noting that it is unlikely that acquisition is a possibility given the very narrowly-defined scope of the industry the company is in:

1. Buy back shares: Likely through a dutch auction tender and at a higher level than existing market value. They have done this two times in the past.

On July 15, 2010, they announced a $325 million buyback between $24 to $28/share and on August 24, 2010 they announced that $26.40 would be the tender price. The stock closed on July 15, 2010 at $23.07/share and the day after it opened trading at $24.25. The market price on August 24, 2010 was $25.79/share. Genworth Financial proportionately tendered its shares to keep its 57.5% ownership stake in MIC.

On May 5, 2011, they announced a $160 million buyback between $26 to $29/share. The market value was $25.25 on the day of the announcement, and the stock opened at $25.55 the day after. On June 27, 2011, they announced that $26 was the price and the closing market value that day was at $25.77/share. Notably after this buyback, the market value fell in the subsequent months.

Given the current market value of the company, if they were to proceed with a similar tender, it would be almost on similar terms as the previous one, with perhaps a tender range between $26 to $29/share. This would be close to book value and this would achieve about a 10% reduction in share count and subsequent 11% increase in earnings per share.

2. Give a special dividend: A special dividend of $287 million would be equivalent to a $2.90/share dividend. The only special dividend declared to date was announced on November 3, 2011 of a $0.50 dividend, payable on December 1, 2011.

3. Some combination of the two;

4. No decision, keep the cash, and wait for less stormy days later.

Influential in this decision will be the needs of the parent company, Genworth (NYSE: GNW), whom is looking much more financially stable than it was back in 2010 and has no pressing need for an infusion of capital either way.

My guess at present is that Genworth MI will launch a tender for its own shares this month. They are still trading under my own estimate of its fair value.

As readers are aware, I have been long on Genworth MI since last July.

Market musing while being inactive

I hate to sound like a broken record, but I’ve still been doing nothing other than research but nothing worth investing in at the moment except for one illiquid play mentioned in an earlier post.

Here is a series of miscellaneous observations:

* I note that Apple (AAPL) continues its slide down to the point where I am wondering if they are pricing that the company is not going to be able to keep its premium pricing strategy. On paper, they are still massively profitable, but if competition continues to chip away at their product line (mainly through Samsung on the phone front and a variety of other realistic competitors on the tablet front), they might run into revenue growth problems. The company in their last fiscal year (ended September 2012) made $156.5 billion in revenues and this year the analysts are projecting an average of $182.8, which is a $26.3 billion increase year-to-year. This is a huge amount of growth and the law of large numbers will likely be catching up to Apple in short order.

* CP Rail (CP.TO) is trading at absurdly high valuations at present. They performed a change in management and the market is giving the new CEO a lot of credit, but the railroad business is very mature and I don’t have a clue why they are giving the equity such a huge premium at the moment. I’d be a seller at this price range (the C$130 mark).

* Anybody remember the big scare about rare earths a couple years ago when China started restricting the supply and most of those stocks went crazy? The big play here, Molycorp (MCP) has continued to slide into the gutter now that the market reality of the perceived shortage has completely gone away. The substitution effect is very powerful and MCP shareholders are holding the bag.

* Likewise, most other fossil fuel commodity companies, including my favourite company that has been so overrated by many, Petrobakken (PBN), are continuing to suffer. It is similar to how most gold mining companies are not faring nearly as well as the underlying commodity – it costs an increasing amount of money to extract the resource, so even if the commodity price is increasing, if your costs are increasing, you are not going to make much money. Even Crescent Point Energy (CPG.TO) is starting to lose its lustre.

* The other commodity market that is continuing to get my curiousity up is currency trading – the US dollar has continued to outperform most of the other global currencies. The only way that I play this is that I try to hedge my portfolio by having some US-denominated securities rather than using leveraged speculation.

* The two Canadian Real Estate financing proxies, Home Capital (HCG.TO) and Equitable Group (ETC.TO) warrant a further look. HCG has faded somewhat off of its 52-week high, but Equitable is still there. If people are still hyper-bearish on the Canadian real estate market, these two companies should be the first on anybody’s short selling list. Non-performing loans are still around the 0.3% level and currently still do not show any real signs of distress in the market. I am still riding the wave on Genworth MI (MIC.TO) and believe there is still a reasonable percentage gain to be realized from current price levels. The loan companies, however, are hugely leveraged and I’m finding it difficult to see value there when book values are so significantly below market prices.

* Long term interest rates have also taken a nose dive – the Canadian 10-year bond was skirting at the 2% yield a month ago, but now they are back down to 1.8%. The world is awash with capital and there are few places to deploy it where you’ll generate yield at an acceptable risk level. Eventually the leverage party will end and the fallout is going to be very brutal. Whether this happens in 2013, 2014 or later, nobody knows. But there will be fallout, and figuring out how to brace yourself for the fallout will be a big financial challenge over the next decade.

Genworth MI Canada Q4-2012

Genworth MI Canada (TSX: MIC) reported their 4th quarter and annual results today. Because they never bothered to post the full financials on their investors website, sadly I had to dredge it out of the parent company SEC filing.

The chart has suggested there is an improvement of sentiment and there was also a scurry of investors in the past few days lightening up their risk in the company in the leadup to the quarterly announcement:

The results have to be translated to exclude the positive impact of the December 20th announcement concerning how they were accounting for the government guarantee fund (which caused a non-trivial reversal in expenses). After doing all the adjustments, the magic number is 90 cents per share earned in the quarter.

The CMHC hitting its insured portfolio ceiling is also visibly helping the business on the private side, despite changes to amortization and down payment rules.

Delinquency rates continue to remain exceptionally low at 0.14% for the quarter (0.2% in the previous year’s quarter).

I haven’t been able to see the consolidated balance sheet as of yet, but book value is $30.62/share, while intangibles and goodwill is approximately 20 cents a share.

With a market value of $23.68/share, they are still deeply betting that the Canadian housing market is going into the gutter. While this might be true price-wise, what is important is the ability for people to pay off their mortgages, and this means employment. Nothing has changed in Canada at present with respect to this and although I believe housing prices will exhibit long-term depreciation (especially when interest rates decide to rise again), this will not adversely affect the mortgage insurance business unless if such price drops are precipitous.

The effective loan-to-value of the insurance portfolio is a good metric of how buffered the company is in the event of a mortgage default. Most of the embedded risk are on new purchases and as payments continue amortization of mortgages continue to result in risk reduction for the company. At the end of the year, the loan-to-value (essentially an inverse measurement of equity) on such insurance is as follows:

2006 and prior – 40%
2007 – 68%
2008 – 73%
2009 – 75%
2010 – 82%
2011 – 88%
2012 – 92%

It should be pointed out that on a typical 5-year fixed rate mortgage at current rates, if there was a 5/10% downpayment made, that the homeowner at the end of the 5-year period will have 18.7/23.0% equity in the property. This is the buffer room that insurance companies have with respect to price deprecation and also are compensated with the 2.75% premium paid on such mortgages.

Needless to say my original thesis is still in effect – Genworth MI is an inexpensive cash machine, even at current prices. Not as good as when it was in the teens when I bought my shares, but still is a very good value. All things being equal, at existing market values, investors should be realizing about a 14% annual return and this does not include any accretion that comes out of a realization of the negative differential between book value and market value. Compared to putting money in bonds, this is a pretty good return given the risk taken (which is low, but certainly not zero – this is what you are being compensated 11% over bonds with!).

The company also gives out a 32 cent/quarter dividend, but this is utterly irrelevant to the investment thesis, which is that there is incredibly deep value in the company. I am quite frankly surprised that the company already hasn’t been hived off to Sunlife (TSX: SLF) or Manulife (TSX: MFC), both of which desperately need diversification from the tragic errors they made with variable life annuities a few years back.

There’s excellent potential for this company to get back to book value and it is just a matter of being patient and not watching the Canadian real estate market implode. As long as that market does not implode, the shareholders should profit immensely.