Why The MGIC-Radian Price Gap Should Continue To Close

 |  About: Radian Group, Inc. (RDN), MTG
by: Oliver Davies

The last time I wrote, I said Radian Group (NYSE:RDN) is a riskier investment than MGIC Investment Corp (NYSE:MTG), and how the market prices did not reflect that.

Now that the risk that the Freddie Mac pool insurance saga stops MTG from writing business has disappeared, it is worth quantifying a fair share price ratio for the two stocks. If the market price of RDN is $5.07, what is a fair price for MTG?

Given the long-term business prospects for both companies, MTG's stock price should be at least 66% of RDN's stock price. And, since RDN is actually a riskier investment than MTG, the ratio should be even higher. With RDN at $5.07, MTG should be at least $3.34. And with MTG currently at $2.33, a long-short trade could yield more than 43% over the next few months.

Now the Freddie Mac risk has finally disappeared, it is hard to see what will stop the gap closing. Perhaps the market believes that Radian will continue to write significantly more business than MTG and justifies the price premium. As I will explain later, however, the market is wrong. Radian is only writing significantly more business because it is undercutting market pricing in high FICO score single premium business. Once the market returns to normal, Radian's capacity for new business will return to a level similar to MGIC.

The method

The method is simple: determine the earnings power of the two companies in the upside scenario, and then determine which company is more likely to achieve that upside scenario.

The upside

The upside for both these stocks is that they make it through the housing mess and start earning a normal profit on their premiums.

Given profit margins at both companies will be similar in a normal market, we only need to look at new insurance written to determine a fair value ratio. If both companies write the same amount of new insurance over the long-run, they will generate the same amount of premiums. And, if margins are similar, the same amount of profits.

So if we think MTG is going to write $2 billion a month over the long-run and RDN $4 billion, then it is fair to say that the market capitalization of RDN should be twice that of MTG. The logic is simple: profits at RDN will be 2x profits at MTG.

Over the first nine months of 2012, RDN has written $25.4 billion in new insurance. MTG, on the other hand, has only written $17.1 billion. Based on this data alone, the market cap of MTG should be two-thirds the market cap of RDN. If RDN was worth $6 billion, MTG should be worth $4 billion.

But that is an overly crude assessment of the long-term potential for new insurance written (NIW). In reality, as explained in my first article, Radian is undercutting competitors in single premium business in order to boost its cash flow. As Radian disclosed in its most recent earnings release, 35% of its new business was single premium.

In a normal market, it is fair to assume that Radian will stop undercutting competitors and take a normal share of the single premium market. MTG, on the other hand, will gain share in the single premium market.

So when assessing the long-term earnings capacity of Radian, we need to remove the single premium business completely from their NIW. Given single premium business accounted for 35% of Radian's NIW, they will probably write about the same level of new insurance written as MTG in a normal market (the math: $25.7 billion * 65%). In other words, the market capitalization of these two companies will be about the same in a normal market.

Conclusion: the upside market capitalization of RDN is the same as MTG.

The downside

My last two articles outline why RDN is significantly riskier than MTG. And, if RDN is more risky than MTG, then RDN should trade at a discount to MTG. In other words, at the very worst, MTG's market cap should be equal to RDN's market cap, but in reality should be higher.

The minimum MTG-RDN share price ratio

RDN's current market cap is $677 million; MTG's current market cap is $470 million. Adjusting the market cap ratio for differences in share counts, the share price ratio of MTG to RDN should be at worst 2/3rds. So if RDN's share price was $6, MTG's should be at least $4, and so on.

Today, RDN's share price is $5.07. Following the rule, MTG's share price should be at least $3.34.

Disclosure: I am long MTG and short RDN. This is not a recommendation to buy or sell any securities. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.