MGIC Investment: Deep Value

| About: MGIC Investment (MTG)

Summary

MGIC investment posted strong operating data for the third quarter.

Margins were steady, and Losses incurred are normalizing, boosting underlying profitability.

The market will rightly think of when dividends will come. This will take time. But valuation suggests the wait will be worth it.

MGIC Investment (NYSE:MTG) produced a strong set of third quarter operating results that confirmed the investment thesis.

The key takeaways for investors are:

(1) the top line has proved resilient to minor pricing changes which unnerved the market last year and in early 2016

(2) the losses incurred line is normalizing more rapidly than the market assumes and

(3) modest assumptions on revenue growth through 2017-18 combine with the lower losses incurred number to suggest the stock is undervalued for long term investors.

(4) the final part of the puzzle, though not the most important, is when dividends will resume - this remains unclear.

Through the brutal decline of MGIC's stock price from June '15-June '16 ($11.5-$5.9) the market was stuck between the cult of specialists who follow the private mortgage insurers in detail and whoever was dumping the shares. As often happens in these situations, the close followers - and it must be said the company - were scratching their heads as to the causes of the decline. Yes, there was a new pricing model being deployed by new entrant Arch Capital, but the predominant market players Radian and MGIC explained at length how this should not undermine sector ROE, being mainly a new way of differentiating between clients without lowering risk pricing on average. The steady top line at MGIC puts the firm on course for net premium growth in the region of 5% this year (in line with its growth in insurance in force) suggests firm pricing and lends credibility to management on this topic. Market anxiety should ease over pricing from here.

The pricing story to my mind is a red herring. The real story at MGIC is the falling away of its losses incurred line. The hard work of getting away from the financial crisis of 2008/9 is done. The old books of underwritten mortgages have been heavily provisioned and the remnants are burning off. The newer vintages, from 2009 onwards, are of much higher quality in terms of mix, with very low incidence of default. The question for the P&L has been simply how quickly the remaining legacy risk falls away. The chart below shows the hits taken by MGIC through 2011-12, and the subsequent normalization of losses incurred. The charge in 3Q was $61m so it's arguable that the $260-$270 range modeled in the chart for 2016-18E is conservative. Management noted today that that the current charge reflects a 12% claim rate across its books, and the post 2009 average should fall out at 10% post legacy 2006. The forecast implied below then contains a margin of error and leaves further upside.

Company data and FIG Ideas forecasts

Losses incurred at 3Q 15 was $76m. With this falling to $61mn this year we can adjust the forecasts I showed in my previous article on MGIC. As well as the losses adjustment, we need to reflect a little growth in the top line given that the housing and mortgage markets in the US are in good shape. Let's then assume that the present 4-5% growth clip continues midterm.

I have not touched other expenses, which include sales and underwriting costs since management noted on the call these should not change above previous guidance due to scalability of their model. As you can see, all this leaves MGIC on a very low PE.

The company purchased some of its Convertible Senior Notes in the quarter, and thereby removed a ~12% dilution risk at the cost of $75.2m cost of debt extinguishment. The company will consider repeating this exercise with respect to remaining convertible debt. As the company is not paying material dividends right now, I think this is a value creating measure for long term investors.

With losses incurred in the home straight of full normalization I think attention will inevitably turn to when ordinary dividends will become payable and this was raised on the analyst call. Ordinary dividends are still "years out" according to management, though there may be exceptional dividends in the meantime, with the key variable being the level of contingency reserves and regulator sign off on them. Capital adequacy, as measured by risk/capital is fine and the company has nominal excess capital of around $1.3bn.

Conclusion:

MGIC is trading at less than 7x 2017 EPS and while investors will have to wait for capital return the end game for this stock - a recovered, well capitalized, low growth credit risk utility company - makes the current multiple very attractive. This is deep value for the patient.

Disclosure: I/we 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.