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.

A nice time to be holding cash

This is a rambling post.

Downward volatility is the best friend of an investor that has plenty of cash.

You will also see these punctuated by magnificent rallies upwards which will get everybody that wanted to get in thinking they should have gotten in, until the floor drops from them again which explains today.

By virtue of having well over half cash and watching the carnage, I’m still not finding anything in fire-sale range except for items in the oil and gas industry which are having their own issues for rather obvious reasons. Examples: Penn West (TSX: PWT) and Pengrowth (TSX: PGF) simultaneously made announcements scrapping and cutting the dividends, respectively, and announcing capital expenditure reductions and their equity both tanked over 10% today. Crescent Point (TSX: CPG) had a fairly good “V” bounce on their chart, but until oil companies as an aggregate start going into bankruptcy and disappearing, it is still going to be a brutal sector to extract investor value from.

I just imagine if I was one of the big 5 banks in Canada and having a half billion line of credit that is fully drawn out in one of these companies. Although you’re secured, you don’t envy the train wreck you have to inherit if your creditors pull the plug.

The REIT sector appears to be relatively stable. Looking at charts of the top 10 majors by market capitalization, you don’t see a recession in those charts. If there was a true downturn you’d expect to see depreciation in the major income trusts. I don’t see it, at least not yet.

Even when I exhaustively explore all the Canadian debentures that are publicly traded, I do not see anything that is compelling. The last debt investment which was glaringly undervalued was Pinetree Capital (TSX: PNP.DB) – but this was in February. They recently executed on another debt redemption which puts them on course to (barely) fulfilling their debt covenants provided they can squeeze more blood from their rock of a portfolio. I wouldn’t invest any further in them since most of what they have left is junk assets (Level 3 assets which will be very difficult to liquidate). One of those investments is a senior secured $3 million investment (12% coupon!) in notes of Keek (TSXV: KEK) which somehow managed to raise equity financing very recently.

The preferred share market has interesting elements to them as well. Although I’m looking for capital appreciation and not yield, it is odd how there are some issuers that are trading at compellingly low valuations – even when factoring in significant dividend cuts due to rate resets (linked to 5-year Government of Canada treasury bonds yielding 0.77%!). I wonder if Canada’s bond market will go negative yield like some countries in Europe have – if so, it means those rate reset preferred shares will have even further to decline!