Essent Group - Very Strong Offering Of This Mortgage Insurance Company

Nov. 5.13 | About: Essent Group (ESNT)

Essent Group (NYSE:ESNT) made its public debut on Thursday, October 31. Shares of the private mortgage insurance company ended the first day with gains of 23.5% at $21.00 per share.

I remain on the sidelines. The strong public offering has boosted the valuation of the business too much. Furthermore, the nature of the business model of Essent Group leaves the company vulnerable to large losses in case of a strong correction in the housing market.

The Public Offering

Essent Group is a growing private mortgage insurance company, formed in 2010 as the financial crisis and changing housing market created the need for privately funded mortgage insurance.

Private mortgage insurance is crucial within the housing finance system, by providing credit protection to lenders and mortgage investors. Its services protect investors, while make it possible to make greater financing available to prospective homeowners.

The role of private mortgage insurance extends the home ownership for sale of low down payment loans in the secondary markets. GSE's Fannie Mae and Freddie Mac are restricted from purchasing or guaranteeing low down payment loans.

Essent Group sold 19.7 million shares for $17 apiece, thereby raising $335 million in gross proceeds. Some 17.0 million shares were sold by the company which thereby raised $289 million. The remaining 2.7 million shares were being offered by selling shareholders.

Initially, bankers and the firm set an initial price range of $13.50-$15.50 per share. Shares were eventually sold above the high end of the initial public price range.

Some 24% of the total shares were offered in the public offering. At Friday's closing price of $22.53 per share, the firm is valued at $1.88 billion.

The major banks that brought the company public were Goldman Sachs (NYSE:GS), JPMorgan (NYSE:JPM), Credit Suisse (NYSE:CS), Barclays (NYSE:BCS), Bank of America/Merrill Lynch (NYSE:BAC) and Wells Fargo Securities (NYSE:WFC), among others.

Valuation

Essent Group was the first mortgage insurer to be approved since 1995, licensed to write coverage in all 50 states of the US. The company has relationship with 865 customers including 20 out of the 25 biggest mortgage originators.

These customers account for nearly 70% of annual new insurances being underwritten in the private insurance market. The company currently employs 274 employees, including 77 in underwriting. On top of the demand being driven by the housing recovery, the private mortgage insurance industry will see additional growth as large GSEs will slowly retreat from the market.

For the year of 2012, Essent Group generated annual revenues of $72.7 million, roughly four-folded from revenues being generated in 2011. Net losses narrowed from $33.6 million to $13.5 million.

For the first nine months of 2013, Essent Group generated revenues of $133.3 million, triple the amount being generated last year. The company reported earnings of $46.4 million, which compares to a $14.6 million loss in the comparable period last year.

The company operates with $131.3 million in cash and equivalents and $90.9 million in unearned premium reserves. Factoring in the gross proceeds of $289 million from the offering, Essent Group will operate with a net cash position of almost $400 million.

With the equity in the business being valued around $1.88 billion, operating assets are valued around $1.5 billion. This values assets at roughly 8 times 2013's expected revenues of $185 million and 23 times earnings, seen at $65 million.

Investment Thesis

As noted above, the offering of Essent Group has been a huge success. The company priced the offering at $17 per share, some 17.2% above the midpoint of the original preliminary offering range. Shares advanced to $22.53 in the days following the offering, trading with gains of 55.4% from the midpoint of the preliminary offering range.

Clearly the market has been upbeat about the offering of Essent Group. The US market for mortgage origination had a size of $1.75 trillion for 2012, of which private insurers accounted some 32% for. While this was double the market share of 16% in 2010, it is still far below market shares of 77% being achieved by private insurers in 2007.

As such, private insurers, including Essent Group have a lot of room to grow. Note that total underwritten policies by Essent Group amounted to $16.6 billion in the first nine months of the year, boosting the combined insurance company leverage ratio to 18.1 to 1.

While the growth prospects continue to look good for the time being, through a US housing recovery, and a recovery of the private insurance market share, there are some long-term risks to investing in Essent Group. For now the leverage has already increased, while the 55% returns since the midpoint of the public offering range, have pushed up the valuation already quite a bit.

While the growth looks attractive for now, I remain very cautious given the history of the industry during the crisis and the exposure to events which can easily bankrupt such a businesses.

I remain on the sidelines.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.