Genworth Financial (GNW) has significantly outperformed the S&P 500 (SPY) in recent days without any real news with respect to the underlying business. However, it is known, or should be known, that Genworth is undergoing a transformation, strengthening its core businesses (namely U.S. mortgage insurance) and shedding ancillary businesses, including its wealth management and international protection businesses.
As management likes to tout: Genworth is a turnaround story with multiple levers to drive shareholder value.
With the recent surge in the share price, is the market being efficient and rational or inefficient and irrational?
Genworth Financial is a holding company with various insurance businesses and assets, including: (1) life insurance, including long term care ("LTC") and fixed annuities; (2) mortgage insurance (U.S. - wholly owned; International, including Canada - 57.5% owned; Australia - wholly owned, but 40% IPO planned; Europe); (3) ancillary businesses (wealth management and international protection); and (4) the "float."
At a current market capitalization of $4.6 billion, how much are the underlying assets of Genworth worth?
The life insurance segment has been the most stable and profitable for the Genworth holding company over the years, and provided stability when faced with mounting U.S. mortgage insurance losses stemming from the housing crisis. The life insurance business generated revenue (premiums and net investment income on its float) of $6.25 billion, $6.13 billion and $5.79 billion in 2012, 2011 and 2010, respectively. Operating profits came in at $417 million, $545 million and $443 million for the same years, respectively, with an operating margin fluctuating between 7% and 9%. Of course, with insurance businesses forced to reinvest their premiums at lower yields, net investment income may suffer in the future. I can't predict future interest rates, so the best thing to do is to apply a conservative multiple.
If the life insurance business were a standalone enterprise, I would expect that earnings stream and relative stable, slow growth business to be assigned at least a 10x multiple, for a valuation of somewhere around $4 billion, or about 85% of the holding company's current market capitalization.
Canadian Mortgage Insurance Business:
Let's not complicate the Canadian mortgage insurance business valuation. It trades publicly in Canada, and the market says it is worth $2.5 billion, and is valued at 5x LTM earnings (13x adjusted earnings, excluding a one time favorable tax adjustment). Its probably fair to say the market is ascribing a modest discount to the underlying value of the Canadian mortgage business. The holding company's share is 57.5% of the Canadian mortgage business, making its portion worth about $1.4 billion based on a straight market valuation approach, or 31% of the holding company's total market capitalization.
Australian Mortgage Business:
Management is making plans to unlock shareholder value by selling a 40% minority stake in its Australian mortgage insurance business. For comparison sake, let's look at the Canadian and Australian businesses fundamentals:
|International Mortgage ($mil)||2012||2011||2010||2009|
Since we know the market is valuing the Canadian business at $2.5 billion, how does the value of the Australian business compare to its publicly traded sister? We can see that the holding company's share of the Australian revenues are about 60-75% of its share of Canadian revenue in each given year, but operating profit percentages are higher, except in 2012 given some macroeconomic headwinds in the Australian housing market, which delayed the IPO.
For conservatism, let's apply a discounted multiple of 10x to a depressed 2012 operating profit figure, resulting in a valuation of $1.4 billion for the Australian mortgage business, or about 30% of the holding company's current market capitalization.
U.S. Mortgage Insurance Business:
For conservatism, let's assume the U.S. Mortgage business is worth nothing. That assumption, however, is clearly wrong.
While the U.S. mortgage business continues to operate at a loss, the more newly written mortgage insurance programs from the 2008 vintages onward are profitable, considering tighter risk mitigation strategies and more appropriately priced premiums given the risk profile of the homeowner. While the unprofitable vintages continue to be in run off mode, the U.S. mortgage business will likely become profitable at some point in 2013.
In its Q4 earnings conference call, management indicated it thought it would turn the corner to profitability on the U.S. mortgage insurance business in the second half of 2013, citing seasonality, improving trends and the burn out of older, unprofitable books of business:
If you go back to the trends that we identified really last February, when we begin talking about the improving performance and our expectations for this business [U.S. MI], our trends largely remain in line with those expectations and continue to head towards the potential for really significant improvement in the overall U.S. MI earnings and a potential again for breakeven or a modest profitability in 1 or 2 quarters. When I start to more directly ask your -- address your timing question, I think about it this way. First off, we do have the benefit of seasonality in this business. And taking account the usual trends when -- in the seasonality delinquencies and cures, you could expect that, that would point towards that breakeven or return to profitability sometime in the first half of the year, either Q1 or Q2. At the same time we also have another dynamic that continues to play through our portfolio, and that is as the older books, the unprofitable legacy books of business, continue to burn out and the further you get into the year in that burnout dynamic, adding to that the benefit we continue to realize of incremental new well-priced and highly performing production, you get to a tipping point that conceivably could be more in the later part of the year, Q3 or Q4.
Prior to the fallout in the U.S. housing market, Genworth earned $259 million, $238 million and $224 million in operating profit from this business in 2006, 2005 and 2004, respectively. If it gets back to that figure, the U.S. mortgage insurance business will likely be worth between $2 and $3 billion.
The Ancillary Businesses:
The holding company also operates two other profitable businesses: a wealth management unit and international protection unit. Reports have indicated the wealth management unit is being shopped for around $400-$450 million. As for international protection, CFO Marty Klein will take on additional duties to maximize value and the sale price. International protection has been more profitable than wealth management in recent years (except for 2012, due to tough European markets, although it did pay the holding company $119 million in dividends). I expect in a normalized European market that international protection could fetch up to $800 million.
As Warren Buffett, Chairman of Berkshire Hathaway (BRK.A),(BRK.B) pointed out in his most recent investor letter, "float" is an asset to an insurance business, although it is recorded as a liability on its books. Float is effectively the timing difference from which an insurance business collects its premiums and when it pays claims on its insurance policies. Mr. Buffett likes to think of float as getting paid to hold customers' money, meanwhile generating investment return on the float.
However, the value of the float will be reduced as insurers are forced to reinvest in assets with lower yields. Nonetheless, the float has enormous value to Genworth and Berkshire Hathaway because it generates income while the company waits to pay out claims.
The value of the net investment income is included in the segment operating profits described above, nonetheless, it is still a source of value.
Genworth Financial is undervalued. While it is levered to an industry eschewed by common wisdom of investors (the housing market has been dismal, hasn't it?), that is precisely why Genworth is undervalued. When the U.S. mortgage insurance business gets back to "normal," it should generate profits in excess of $200 million a year as it burns through unprofitable books of business. And a number of catalysts are close to fruition, including the sale of the wealth management and international protection businesses and the minority IPO of the Australian mortgage insurance business.
Disclosure: I am long GNW.