I have found that by focusing on companies in financial distress, I often find investment opportunities; these stocks are often so depressed in price that the underlying price more than compensates an investor for the risk. The risk reward is asymmetric. My personal theory is that investors often overreact to bad news and uncertainty. They sell their stock at any price in order to cut their losses and as they do, they create compelling investment opportunities. Genworth (GNW) is a good example.
This is an opportunity to buy a large financial services company at a (potentially) deep discount to intrinsic value where the path is being cleared for a turnaround. Even at $9 per share, the stock represents significant value.
Consider the following: Genworth has $112.6 billion in assets at the end of third quarter fiscal year 2012. If it could earn a return on assets of 100 basis points (not an unreasonable assumption), this would be equal to $1.12 billion dollars. If we assign a price to earnings ratio of 10, then this would equal a market capitalization of $11.2 billion, or a more than 100 percent increase from its current market value of $4.5 billion. It is not unreasonable to expect a financial services company to earn 100 basis points on assets when the spread between 2-year Treasuries and 10-year Treasuries is more than 150 basis points as it is now.
An alternative valuation measure is price to book value. GNW trades at 0.27x of third quarter fiscal year Q3 2012 book value. with a book value of $33.39 per share (i.e., I am using GAAP book value). If GNW were to trade at just 20% discount to book value (instead of the 73% now), the stock would more than double.
Of course, for the company to trade at 10 times earnings, investor confidence will have to return, and herein lies the challenge. How long will it take the company to once again be able to earn 100 basis points on assets? Who really knows? But when it does, the stock will certainly be trading at a much higher price than it is now. As value investors, we have to be willing to invest in the unknown and the unknowable where the reward greatly exceeds the risk.
Genworth is a financial services company that was carved out of General Electric in May of 2004. It provides insurance, wealth management, investment and financial services to more than 15 million customers, with a presence in more than 25 countries. Headquartered in Richmond, Virginia, GNW has approximately 6,300 employees. It has market capitalization of $4.2 billion and $112 billion in assets.
|Market Capitalization||$4.5 billion|
|Enterprise Value||$8.4 billion|
GNW is cheap for a good reason. It did not qualify for TARP like AIG, and therefore, it was NOT too big to fail, unlike Lehman and Bear Stearns.
What has GNW investors nervous is the U.S. mortgage insurance unit. This unit provided mortgage insurance to predominantly insuring prime based, individually underwritten residential mortgage loans, also known as flow mortgage insurance. It also selectively provides mortgage insurance on a bulk basis, with essentially all of its bulk underwriting prime-based. Operating income from the mortgage unit was a loss of $507 million in fiscal year 2011, and it got "buried!"
This was not the only business segment that has been losing money. GNW had losses from discontinued operations of $25 million in 2011, too. These included non-strategic products such as variable annuity, variable life insurance, corporate-owned life insurance and Medicare supplement insurance products.
GNW also had losses from what it calls "Corporate and Other Activities" in 2011 of $239 million. This included debt financing expenses that were incurred at its holding company level, unallocated corporate income and expenses, eliminations of inter-segment transactions and the results of other non-core businesses that were managed outside of its operating segments. Losses from these units added up to three quarters of billion dollars in fiscal 2011. Ouch!
|Operating Segment||Operating Income FY 2011,|
|International Mortgage Insurance||$332|
|U.S. Mortgage Insurance||(507)|
|Runoff (discontinued operations)||(25)|
|Corporate and Other Activities||(239)|
The bright spot was Life Insurance. For the year ended December 31, 2011, the U.S. Life Insurance segment's net income available to common stockholders and net operating income available to common stockholders were $432 million and $462 billion, respectively. The profitable operating segments like Life Insurance and Wealth Management were supporting the poorly performing units.
However, the real problem was the uncertainty and poor visibility about the future. Nobody likes uncertainty, and the uncertainty about the direction in housing prices and the industry recovery was taking its toll on shareholder confidence. There were no easy solutions. Regulatory obstacles and bond indentures prevented the simple solution of separating the mortgage insurance business from the more profitable parts of the company. This has changed, and it is the reason I am bullish on GNW.
Throughout 2012, GNW has been making steady progress in fixing itself. However, the announcement on January 16, 2013 represents a clear turning point. The company announced a comprehensive U.S. Mortgage Insurance capital plan that, when implemented, will reduce Genworth Mortgage Insurance Company's ("GMICO") -- the company's main U.S. mortgage insurance subsidiary -- risk-to-capital by 12 to 15 points, decrease the likelihood that the U.S. mortgage insurance subsidiaries will require additional capital for the foreseeable future, ensure the continued ability to write new business and reduce the risk of a default under the indenture governing GNW's senior notes. The restructuring separates the mortgage insurance business from the other business segments.
The GNW's restructuring-capital plan is composed of several steps, some of which still require regulatory approval. The first is transferring ownership of the European mortgage insurance subsidiaries to GMICO. The second is enabling a future option, under certain adverse conditions, should they occur, to implement a "NewCo" type structure, for the continued writing of new business in all 50 states. And finally, GNW intends to implement an internal legal entity reorganization, which creates a new holding company structure that will remove the U.S. mortgage insurance subsidiaries from the companies covered by the indenture governing GNW's senior notes. GNW will also contribute $100 million to GMICO as part of the comprehensive capital plan, anticipated to occur in the second quarter of 2013. The company anticipates the combined risk-to-capital ratio of the U.S. mortgage insurance subsidiaries will be reduced by 8 to 10 points from this plan. Cash and highly liquid securities at the holding company totaled approximately $1.0 billion as of December 31, 2012.
GNW is a turnaround opportunity with a new CEO and multiple levers to drive shareholder value. Management has laid out clear objectives to improve business performance through their capital-restructuring plan. The following summarizes why I like Genworth:
· Attractive Valuation: Genworth currently trades at 0.27 of book value for the third quarter 2012, 7.4 times 2013 consensus earnings, and 12.12 times trailing earnings.
· Significant Asset Base: GNW has a significant asset base that can potentially drive future profitability. GNW had $17.6 billion of total stockholders' equity and $114.3 billion of total assets as of the third quarter 2012.
· Improving Operating Results: Operating results have started to improve for Genworth as the housing market has improved. U.S. MI net operating loss was $38 million, compared with $25 million in the prior quarter and $79 million in the prior year. Total mortgage flow delinquencies have decreased four percent sequentially and 19 percent from the prior year
· Improving Visibility: With the announcement of the January 16th capital restructuring plan, the company is on a path to improve its capital structure by separating its mortgage unit from the rest of the company. This has the effect of improving financial strength and flexibility.
· Potential Dividends: In its restructuring presentation, management indicated their desire to return capital to investors in the form of dividends. Martin P. Klein, acting chief executive officer and chief financial officer, said in a recent press release, "We are committed to improving business performance and generating capital as we rebuild shareholder value."
While I am bullish on GNW, it is not without risks. The turnaround has just begun. A global recession or a European debt crisis could easily delay or halt the turnaround. Investors might panic as they have in the past, and the stock could retest the lows. An investor who is thinking about taking a position in GNW should consider it a high-risk position.
 Source: GNW Annual Report 2011
Disclosure: I am long GNW.
Additional disclosure: Does not represent a recomendaton to buy or sell any security. Potential investors are encouraged to do their own due dilligence.