Genworth: Why This $2 Stock Will Be The Turnaround Play Of 2016

| About: Genworth Financial, (GNW)

Summary

In the past couple of years, Genworth shares have declined due to concerns about long term care, or "LTC", but the concerns appear way overblown.

The LTC division recently had a $19 million profit for the quarter and with major premium increases approved for 2016, even bigger profits are likely.

By looking at historical earnings data, it is very clear that the LTC charge in 2014 and more recent one-time charges are an anomaly, not a never-ending situation.

Overblown fears should diminish and allow Genworth shares to be a "mean reversion" play, allowing the stock to return to much higher levels.

I recently wrote about Genworth (NYSE:GNW) and I have also been buying more shares. In my last article I discussed how a string of events ranging from selling due to a market index change (in November 2015), to tax loss selling, selling based on technicals and margin calls, a market correction, etc., had all taken a major toll on Genworth's shares over the past few months. As I pointed out, all of these are temporary, one-time events that have no real impact on fundamentals, business operations or on Genworth's assets or book value. I think this string of events and the subsequent decline in the share price has unfortunately spooked some investors into either panic selling or just altogether avoiding this as an investment. My last article also details how Genworth shares have jumped from the low single digits to $10, and even to $18 more than once in the past. During the Financial Crisis, this stock was crushed (and significantly mis-priced) due to fears about the mortgage insurance division. Now, the long-term care insurance division is the cause of excessive pessimism and has given us a chance to buy at bargain prices once again.

Clearly, I think this decline has created a huge buying opportunity in the stock. In this article, I want to take a closer look at the long-term care or "LTC" division because this has been a big concern for many investors ever since Genworth took a significant charge in late 2014, in order to boost reserves. I think that by looking at facts, historical data, recent financial results and premium increases, this division is actually not the pariah that it is being made out to be by many investors. I also think this division is about to experience a turnaround that is similar to the turnaround Genworth had with the mortgage insurance division after the financial crisis. In order to do this let's go back in time a bit to 2014:

In September 2014, Genworth was trading for about $13, when Barron's published a bullish article suggesting this stock could trade back up to book value which was around $24 per share. At that time, Genworth shares were already experiencing a pullback on news that the company would take a charge for the LTC division. The Barron's article detailed the main issue for the LTC division, which was a block of policies that were sold many years ago, the article states:

"The big problem for Genworth's LTC business remains its older block of policies covering some 331,000 lives. The policies, which were sold between 1974 and 2001, assumed a lapse rate of 5% to 5.5%, or the percentage that would be canceled over the policy's life. A higher lapse rate means Genworth would be able to pocket years of premiums and investment returns without having to pay a benefit. However, folks hung on to their policies: Lapse rates were 1% or less. Also, the company assumed premium investment returns on these policies as high as 6.75%, but yields are currently running at 5.5%.

Genworth hopes only to break even on the policies. A recent investor figures the block of 331,000 should shrink to 123,000 policyholders in the next decade based on mortality statistics.

Such is the calculus of the LTC business. A grim denouement for the policyholder is a boon for the investor. "

This sums up the LTC division problems which are that: people are living longer than expected, medical care has become more expensive and investment returns have been lower than projected. However, as the article points out, about 70% of these under-performing policies will be taken off the books in the next several years. That means there will be a significant improvement each year as time passes. Judging by Genworth's current share price, it seems that investors are acting as if the LTC woes are never-ending and can't ever get better, but this is simply not the case. Human mortality is not the only factor that many investors seem to be forgetting about, because there are also significant premium increases that are becoming effective in 2016 and beyond. As I pointed out in my last article, Genworth has won regulatory approvals for significant premium increases that could add about $210 million to the bottom line in 2016. This is already going to make a significant difference for the profitability of the LTC division, but there is more good news:

In a recent and obscure state filing from January 23, 2016, I found out that Genworth is continuing to push for additional rate increases for many of its LTC policies. In these filings Genworth is requesting approval for rate increases on about 23,000 LTC policies that range from a minimum 60% increase to a maximum of 130%. These notices also state that "Unless formal administrative action is taken prior to April 7, 2016, the subject filing may be deemed approved by operation of law." Take a look below at some of the very recent premium increase filings made on January 23, 2016:

"Genworth Life Insurance Company is requesting approval to increase the premium an aggregate 118% on 6,316 policyholders with the following individual policy forms: the 7030 Series and 7032 Series. The company is requesting a 130% increase on policies with unlimited benefit periods and a 111% increase on policies with limited benefit periods. Unless formal administrative action is taken prior to April 7, 2016, the subject filing may be deemed approved by operation of law.

Genworth Life Insurance Company is requesting approval to increase the premium an aggregate 67% on 14,127 policyholders with the following individual policy forms: the 7035 Series. The company is requesting a 78% increase on policies with unlimited benefit periods and a 60% increase on policies with limited benefit periods. Unless formal administrative action is taken prior to April 7, 2016, the subject filing may be deemed approved by operation of law.

Genworth Life Insurance Company is requesting approval to increase the premium an aggregate 89% on 3,090 policyholders with the following individual policy forms: the 7000 Series and 7020 Series. The company is requesting a 103% increase on policies with unlimited benefit periods and a 67% increase on policies with limited benefit periods. Unless formal administrative action is taken prior to April 7, 2016, the subject filing may be deemed approved by operation of law."

Even if Genworth only gets a fraction of the (up to 130%) requested policy increases approved, it can be a major positive for the financial results of this division. This recent filing also shows that Genworth management is continuing strong efforts to restore stability and solid profits to the LTC division. As of yet, the company and the stock has not seen any benefit from the ongoing premium increases and other improvements in the LTC division turnaround. But, I believe it will sooner or later, as more investors take notice of these very positive developments and also focus on the fact that policies do not last forever. Each year that goes by will reduce the number of undesirable policies for Genworth, and regular and significant rate hikes will also greatly benefit the financial results. That means that time is on Genworth's side and financial results are likely to improve significantly, going forward.

The recent financial results show that Genworth made money in Q4 of 2015 for the LTC division and every other line of business. The LTC division actually earned a profit of $19 million in the fourth quarter of 2015. If it can make money in the last quarter, it is likely to make a lot more in 2016, thanks to significant premium increases, many of which have just become effective this year. It is worth noting that Genworth made money in every single one of its business units in the last quarter of 2015: The U.S. mortgage insurance division had net operating income of $41 million, its Canadian division reported net operating income of $37 million, Australia division posted a $22 million profit, and its fixed annuities division earned $19 million for the quarter. The life insurance division had a profit of $21 million for the quarter, if you exclude a $194 million charge for deferred acquisition costs. The current share price for Genworth seems to indicate that LTC problems are never-ending, but that is absolutely not true. There is a limit to everything, including the exposure to undesirable LTC policies. I believe the $531 million LTC charge taken in late 2014, was the right thing to do as it strengthened reserves and it also positioned the company to get regulatory approvals for the significant premium increases. It is worth noting that state officials and regulators want to see Genworth remain profitable and financially strong because LTC policy benefits limit potential medical expenses for the states and reduce the chances for Medicaid enrollment. A financially strong Genworth also means that policy holders are protected and have piece of mind for their future. Genworth is just about to see the benefits of these major premium increases in 2016 and beyond, which is why the stock could have very significant upside potential from these very low levels.

Based on these facts, I believe that Genworth management is confident that the LTC division is poised for stability, much stronger financial results and profits in 2016. All of this is putting the company in a position whereby it could decide to spin-off the LTC division. Back in April, 2015, Genworth shares surged on reports that it would consider a breakup of the company. At that time, the stock was trading at around $8 per share, and now that the company confirmed (in the Q4 earnings release) that it was looking to move forward with a spin-off, the market has simply shrugged it off. I think management has held back in the past on the potential spin-off of the LTC division in order to be prudent and allow premium increases to start positively impacting financial results. I also believe that it is a positive sign from management that they now see the LTC division as being properly reserved and financially stable and strong enough to be considered as a stand alone company.

It is clear that investors are frustrated with the significant reserve charge taken for the LTC division back in 2014, and also with the additional one-time charges that have come since then, due to life policy sales. However, these charges are not never-ending and it has positioned the company for a turnaround in LTC and for a potential spin-off. Genworth has assets that are far more valuable that what is reflected in the current share price. Furthermore, (as mentioned above) the company posted an operational profit in every single division last quarter and those profits should be even higher in 2016, due to major premium increases. Analysts expect Genworth to earn 87 cents per share in 2016, and see profits rise to nearly $1 per share in 2017. These estimates are credible, and show how Genworth's earnings potential can drive this stock much higher in the next couple of years. Again, time is on Genworth's side for a number of reasons, and as rate increases begin to significantly boost profits, investor confidence should be restored and help propel this stock back to a more reasonable valuation.

In many cases, the markets and investors have short memories and want nearly instant gratification. If investors see growth, they might be willing to pay 30 or 40 times earnings for a stock, but when investors see challenges, uncertainty or recent losses, valuations can get extremely compressed and even totally irrational. At times like this, it makes sense to take a look back at historical data to try to see if recent events are part of a long-term pattern, or simply a short-term anomaly. I wanted to research this to see if Genworth and the LTC division (in particular) has had a history of being consistently problematic, or if it has been much more stable and profitable than investors are giving it credit for today. The answer is that Genworth and the LTC division have been historically profitable and that leads me to believe even more that the company and the LTC division can see a reversion back to solid and consistent profits. Genworth was part of General Electric (NYSE:GE) and it was spun off as an initial public offering in 2004. The earnings history below for 10 plus years shows that losses caused by the reserve charges in 2014 and one-time charges taken in 2015, appear to be an anomaly and not part of some long-term trend. In fact, ever since the spin-off from General Electric in 2004, the only years besides 2014 and 2015 that Genworth posted a loss, was during the Financial Crisis in 2008-09. The historical earnings data below clearly shows that the long-term care division and Genworth as a whole, has a consistent history of profitability. That is another reason why I believe Genworth profits and the share price will experience a "reversion to the mean", which will take it to much higher levels:

2004: Genworth posted $2.36 in earnings per share.

2005: Genworth posted $2.52 in earnings per share.

2006: Genworth posted $2.83 in earnings per share.

2007: Genworth posted $2.73 in earnings per share.

2008: Genworth posted a loss of $1.32 per share.

2009: Genworth posted a loss of 88 cents per share.

2010: Genworth posted 58 cents in earnings per share.

2011: Genworth posted 8 cents in earnings per share.

2012: Genworth posted 66 cents in earnings per share.

2013: Genworth posted $1.13 in earnings per share.

2014: Genworth posted a loss of $2.51 per share.

2015: Genworth posted a loss of $1.24 per share.

2016: Genworth is expected to report 87 cents in earnings per share.

2017: Genworth is expected to report about $1 in earnings per share.

In summary, the LTC division has a track record of producing profits as do the other lines of business at Genworth. The company is clearly making progress on getting very significant premium increases approved and the LTC division is already back to generating profits. The major LTC reserve charge in 2014 and the subsequent one-time charges appear to be non-recurring anomalies that were strategically required in order to win regulatory approvals for rate hikes and return this company back to the profitability it has consistently shown in the past. All of this suggests that Genworth is extremely undervalued and that significant upside exists as it could be poised for a "reversion to the mean". With earnings of about $1 per share expected in each of the next couple of years, it is not unreasonable for this stock to eventually trade at a PE ratio of around 10 times earnings, or $10 per share. That seems like a stretch when looking at the share price today, but not when you consider that Genworth was trading for nearly $10 per share as recently as May 2015. Please consider following me for future updates on Genworth and other deep value stocks.

Data is sourced from Yahoo Finance. No guarantees or representations are made. Hawkinvest is not a registered investment advisor and does not provide specific investment advice. The information is for informational purposes only. You should always consult a financial advisor.

Disclosure: I am/we are long GNW.

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.