Genworth Valuation and Restructuring Considerations

Background & Summary

Genworth (GNW) took a dive last week due to long term care (LTC) concerns. The valuation looks absurdly low from a book value perspective. Is it a bargain? Here’s my take on it.

• Sum of the parts analysis shows that GNW is trading within a range of fair value depending on where LTC comes out.
• To realize the value here, GNW should restructure and cleanly separate the various mortgage insurance (MI) subsidiaries from the life insurance businesses (life insurance, annuities, and LTC).
• However, GNW’s unique corporate and capital structure means that any restructuring would require paying down debt – the difficulties of doing so reduces upside from restructuring.

What Is It Worth

Here I did a sum of the part approach. I will intentionally leave LTC blank for now and come back later.  I get to about $9.5 per share excluding LTC. If we say US MI is probably worth more than I assigned here this thing could be worth $10-11+ excluding LTC.

·         Canada (MIC.TO) and Australia MI (GMA.AX) are valued using their respective stock prices and exchange rates.

·         Segments that do not earn its cost of capital (judged by ROE against tangible book) would certainly not deserve book value, so I used a normalized earning x multiple approach. This is unfortunately most of the businesses (US MI, Life insurance, fixed annuities, international protection)

·         “Normalized earnings” are basically taking average earnings for last 3-7 quarters and annualized. 

·         I’m probably underestimating US MI here. Earnings here should be growing due to legacy vintage losses running off. On the other hand, US MI will have to raise about $500-700mm of capital due to new regulations. Management plans to use reinsurance to meet that requirement and that would decrease earnings. The $1.2bn I assigned here is equivalent to 75% of tangible book value (ex AOCI and DAC)

·         Life insurance and fixed annuities earnings could be at risk. Genworth just got downgraded so that could hurt sales.

·         Use book value for runoff segment.

·         Corporate is basically net debt.  Netting $2.2bn of cash/investment against $500mm deferred tax liabilities and ~4.2bn of debt leaves ~- 2450mm of book value at corporate.

·         Why only ~$4.2mm of total debt vs $6.7bn total?  In segments that are valued using earnings, we implicitly netted out the debt already so we have to be careful not to double count. Interest expenses are already accounted for in Australia, Canada MI, Life Insurance (not including LTC), so those related debt are excluded here. 

·         I noticed that international protection segment has interest expenses allocated to it but I’m not sure which piece of debt that should be attributed to. So maybe I’m overestimating the debt in corporate segment, if that’s the case value would be even higher

An Ideal Restructuring

Let’s say LTC is not totally negative (a big assumption). At $8.5 / share GNW would seem undervalued. But how do we unlock this value? I attempted a stub trade: buy GNW, short Australia and Canada MI. Unfortunately my broker is telling me Australia MI is not available to short. (I’m just an individual investor and I bet a big time hedgie can get those share to short but even then international shorting surely have its own complications).

For shareholders to realize value, GNW should cleanly separate out the MI segments from Life insurance businesses. These businesses have little synergies between them (aside from financial ones which I will discuss next section). At this point, a highly specialized headache such as LTC would be better served by dedicated management and analyst attention.

On the other hand I’m not sure it’s possible to separate out life insurance between life, LTC, and annuities, as LTC is a capital hog. Those 3 will have to remain together in the near future.

Problem with Restructuring

A barrier to restructuring is the ~$4.2bn of debt at Genworth Holdings, Inc.  As seen in the corporate structure below, Genworth Holdings Inc is just a holding company and services its debt by 1) hoarding cash on hand, 2) subsidiaries to dividend upward. With life insurance subsidiaries not planning for dividends in the near future, Genworth will be even more dependent the various MI subs.

It’s fair to say any corporate break up would require paying down debt due to 1) rating concerns, 2) current reliance on mortgage subsidiaries for holdco debt service. 

However, companies don’t just get to pay down debt whenever they want. The bonds I looked at are all non-callable and make-whole premiums at T+30 would be very expensive. Tender-offers would also be tough as most bonds are still trading above par.

The valuation above already needs to be way above stock price for an activist to take on the black hole that is LTC, having the additional cost of retiring debt just makes it that much tougher.

Upside

That’s not to say a restructuring can’t be done. GNW can selectively retire some but not all of the bonds and optimize between debt service coverage, ratings, and costs.

Genworth has plenty of assets that can be converted into cash. Australia and Canada MI are already publicly traded so Genworth can sell more stakes. US MI should have plenty of bidders. Upstarts like ESNT and NMIH are better buyers than RDN/MTG due to their lack of legacy issues and thus capital needs. Also, I’m sure some banker is pitching AIG to combine United Guaranty with Genworth’s US MI and be spun off into its own company. Because GNW holds some cash cushion for debt service, deleveraging would itself free up some of that cash on hand.

Maybe if 4Q reserve reviews leaves capital in a good position and thus more visibility on the LTC end, management can start deleveraging and set the stage for restructuring. I'm not counting on it.

Simplified Corporate Structure

 

Capital Structure

MGIC Investment Corporation (MTG) - Normalized ROE does not look attractive

This could turn out to be a multi-part project. I just started looking at this company last week so my insights would be limited. However, I’m writing anyways as it helps me gather my thoughts and move forward.

An Inherently Unattractive Industry

MGIC Investment Corp (MTG) is a Private Mortgage Insurer (PMI). This is one crappy industry. Results are incredibility cyclical and sensitive to some assumptions. On the competitive front, we have already seeing new players trying to compete on not just price, but underwriting terms (NMIH Holdings is an example). Now it looks like the 7 players will not be putting a united front with respect to proposed capital requirements.

Why would anyone buy a PMI then? The standard long thesis says 1) FHA will be giving away market share to the private sector, this coupled with an improving mortgage market will lead to high volumes. 2) Lower losses from legacy vintages running off, as well as fixed cost/operating leverage would lead to a spike in earnings.

Some parts of this hypothesis are valid but I think the sell side tends to bake in both 1) mortgage industry recovery, AND 2) losses stay low at post crisis levels, when in fact the two may not be compatible. While losses are sure to come down from present levels in the next couple years, some analysts seem to assume the pristine underwriting quality of 2009-11 vintage will continue forever. Given that 1) first time homebuyers will be needed to drive housing recover and 2) they tend to be of lower credit quality, the assumption of “2009 forever” is clearly unrealistic.

So you have multiple offsetting factors at play and investing in the sector requires one to say “ok, new businesses will have higher losses at some point, but I don’t think it will be that bad, and meanwhile this thing is dirt cheap and I like the risk and reward”.  This reminds me of my write up on Santander Consumer USA. While there’s a place in your portfolio for a speculative play like this, these could be good ideas but not the best ideas.

Normalized Losses and ROE

Unattractive industries demand great valuations. I want to get some sense of economics and value before filing this away. To do that, some conception of a “normalized return” is needed. Anyone who has followed the industry would know that current loss levels are far from “normal”, since MTG is still working off legacy businesses. So blindly applying some P/E or P/B ratio to next year’s forecast would be meaningless. 

Below are my estimates of new businesses economics when losses normalize, under the current capital regime, and then under the proposed PMIERs.  I’m thinking about this at the opco level so that’s why there’s no interest expense.

 

Two part discussion here, first on impact of capital requirement, then on normalized losses.

First, capital requirements. Management said that if PMIERs goes through, capital requirements for recent businesses probably correspond to 11.5-12x in the old risk to capital framework and that gets them to low teens ROE before reinsurance.  

From 2Q14 transcript: “…Under the proposed eligibility requirements, the mix in the first half of the year seems to require a risk to capital of about 14-to-1 at time of origination, i.e. they are all current. But as we know, even with the high-quality profile, some will go delinquent. So, if you factored that in and probably goes to 13-to-1. And then if you want to add some room away from the capital requirement just to give yourself some margin you probably talking 11.5-to-12-to-1.

And by our calculations, on a direct basis before any reinsurance and whatnot, we think that delivers a return in the lower double-digits. On the current or prior to eligibility requirements that we are issued here, we were think and closer to 18-to-1. And if you give yourself a little room and whatnot operate around 16-to-1. We think those returns are kind of back as Curt said where they probably should be for the overall risk of the business in the mid-teens.”

So let’s say losses will revert higher in new vintages going forward, I think a 10:1 risk to capital, single digit ROE after reinsurance is probably reasonable.

How about normalized losses? In the 2Q14 call, management said the 2009-2011 books are running about 15-20% loss ratio. This is how I got the 35bps loss as % of RIF assumption (50bps premium * 17.5% loss ratio / 25% RIF = 35bps). Keep in mind 2009-2011 vintages are loans with pristine underwriting standards. Going forward as the mortgage industry reach down the credit spectrum, it’s reasonable to think that losses will be higher. How much higher? To give an idea of how volatile these items are, below are historical loss ratios from 1996 to 2006 before the whole industry blew up. I used 50bps credit loss in the above table as a placeholder, but the ROE sensitivity table is all over the place.

So you got a cyclical, competitive industry getting hit with higher capital requirements. What should investors demand? The CEO gave some jumbled answers on the 2Q14 call but I think he meant to say mid-teens return overall and high teens for low FICO/High LTV businesses:

GS analyst: “Now, but if you were just, say, isolated – let's say you were the only player in the industry in a very hypothetical scenario, I mean, what required return would you want to get on those lower FICO, higher LTV buckets? I mean, would you be looking at low-teens? High-teens to account for some of the greater volatility in those buckets?

Curt S. Culver: “Yes, but I, on your question, I think for the lower FICO you need a mid-teens minimum return, given the variability on that business and how quickly things can change. So, certainly it demands a higher return. The returns on the other business will be, I think low-to-mid teens so that certainly would require in my opinion, a high-teens return.

So management want double digit returns but the analysis above shows that ROE with 1) normalized credit loss, and 2) new capital regime will likely be in the high single digits. And MGIC trades at 3x book value when the only thing we can really count on is volume growth. Surely there are better ways to play a housing market improvements? 

Up to now, I have referred to new business economics at the opco level, assuming equity capital = investment assets. In reality there's a mix of vintages books, the investment portfolio is much higher and there's interest expense from the holdco debt. To value MTG you have to take those into account. I won't bore anyone with the model here but my calculation shows that MTG is about fairly valued right now ($8.4 per share).

A Cash Flow Model

REIT Analyst did an SA article on MGIC last week. Specifically, he actually tried to project out the cash flows of mortgage insurance premiums and losses, then calculate a present value. Financials analysts as a group tend to stay away from cash flow statements, so what he’s doing is very different. That and the result of over 100% upside got my attention.

I can understand why his valuation is so much higher than market and what I have above. My guesses are 1) discount rate used - the market is rightly demanding more than 10%, 2) Not all investments are excess. Put another way, they are operating assets required to back the day to day MI business, so the investment income stream needs to be discounted together with other operating cash flow streams.  3) subtle assumption difference in premium, loss curves, reinsurance...can all make a big difference. 

Nevertheless, some sort of cash flow analysis would be useful to quantify the positive effect of legacy vintage running off - a big part of the long thesis. A real deep dive here would mean building a full cash flow model myself. At this point it is not a high priority given all the negatives I discussed earlier.

For now, I say we give this guy the sensitivity table and a set of darts, and call it a day.