MGIC Investment Corp.: Investors Should Wait For More Clarity

| About: MGIC Investment (MTG)
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Investors in MGIC Investment Corp (NYSE:MTG) were no doubt cheered by the firm's recent second quarter earnings release; against consensus expectations for a loss of $0.13, MGIC managed to rake in a tidy profit of $0.04 per share. The result has been a sharp rise in the stock price from roughly $7.40 before earnings to around $8.30 today. Yet before investors jump on board the stock hoping for similar future results, it's worth remembering that this is still a very troubled company. While things are getting better, MTG is still far too risky to buy into right now. Instead investors should take a 'wait and watch' approach to the firm.

Recent Developments:

In the most recent quarter, MGIC incurred significantly lower expenses and losses as a direct result of fewer new delinquencies in its mortgage insurance portfolio. Given the firm's business essentially revolves around insuring mortgages for Fannie and Freddie (MTG is the largest mortgage insurer for the pair), the company is critically levered to the overall economy. In particular, the appreciation in home prices has given most homeowners much less of an incentive to walk away from their mortgages (by reducing the amount of homeowners underwater), while the stabilizing unemployment rate has led to a lot less in the way of new economic distress. As of the end of the quarter, the number of loans that were delinquent feel to 9.69% from year ago levels of 12.34%.

While this quarter marked the second straight quarter of surprising outperformance by the firm, caution regarding the firm is still warranted if for no other reason than a lot of good news is now baked into the stock's price. It is true that lending standards have become much tighter in recent years and as a result the post-crisis portfolio of MTG looks very different than its pre-crisis portfolio. Further, MTG has written off or down many of its delinquent policies, and new insurance written has increased markedly this year. All of these are good reasons to not short MTG, yet with the stock having quadrupled this year, caution is definitely warranted.

Further, this is not the first time that investors have been too eager and gotten ahead of themselves on MTG. In the last five years, the stock has seen several spikes play out over a period of several months, only to have the stock settle back down again in time.

It's also worth remembering that while the move from $2 to $8 and change over the last twelve months has been great for recent investors, MTG was once a much more valuable firm.

I don't know whether MGIC will ever again reach its former lofty valuations, but there are several issues that bear watching in the medium and longer term.

Wait and Watch:

The first issue to be aware of with MTG is that the company is highly leveraged. As of the end of the third quarter the firm and its combined insurance subsidiaries had a risk-to-capital ratio of 20x and 22.7x respectively. While these ratios have been coming down slowly over time (20.2x and 23.0x last quarter), this is still an extreme level of leverage in an industry barely keeping its head above water. Indeed, the government sponsored entities [GSE] eligibility standards will probably come out before the end of the year and it looks likely that the standards will limit the risk that mortgage insurers like MTG can take to 18.0x or so.

The new standards will have some sort of implementation lag, but baring something very unexpected, MGIC will still have to commit cash from the parent company to its mortgage insurance writing subsidiaries in order to meet the new threshold. This will not help ROE for the firm. This issue is not enough to derail MTG shares, but it may hold them back for the next few months, particularly if other headwinds persist.

A second issue facing MGIC, and the broader housing market as a whole, is the slow but steady upward creep in mortgage rates. While refinancing volumes do lead to some additional mortgage insurance origination, new purchases are the much greater driver. (New purchases are roughly 3x as likely to carry mortgage insurance as a refinancing.) Both the refinancing and new homes sales markets have been under pressure lately though as numerous regional and community bank earnings bear out. The rising interest rate climate, political dysfunction in DC, and general economic weakness have all contributed to a significant cooling of the housing market, and this won't help MGIC. In fact, most of MGIC's recent outperformance has been a result of a slight improvement in its pre-2009 vintage portfolio rather than robust new insurance writing. Again, the concerns swirling around the housing market won't be enough to significantly hurt MTG's stock for now, but they are one more headwind the recovering company doesn't need.

Increased competition from peer Radian (NYSE:RDN) and other private mortgage insurance companies also won't help MTG. For a long time, MTG and RDN were both hobbled by the recession, and then in more recent quarters both worked hard to shed legacy portfolios, rid themselves of costly debt, and maintain enough financial flexibility to write new business.

Now though, with most of these issues in the past and a great deal of uncertainty still lingering around the long term future of Fannie and Freddie, MTG is likely to be forced to compete more heavily for future insurance business against RDN, Genworth, United Guaranty (a subsidiary for AIG), and others. The one thing that will help to ameliorate some of the damage from this competition is that the FHA has begun slowly stepping back from the mortgage insurance market due in part to political pressures.

Adding to these hurdles, MTG is also facing an increasing share count in the next couple of years. The firm has sold a couple of large convertible bond issues, and given the share price appreciation, it looks like these will end up being converted. The dilutive effect of these conversions won't be helpful for existing common stock holders. Add this to a stretched valuation (consensus EPS is in flux right now, but I believe the firm will end up earning around $0.50 for 2014, $0.55 for 2015, and $0.75 in 2016) and it's hard to see MTG is a strong buy. In fact, I think the stock is close to fairly value or even slightly overvalued at current levels.

Despite all of the headwinds I have outlined and the strained valuation, I do not see MTG as a sell. The company does not appear to be headed for bankruptcy, it has survived the financial crisis, and things are clearly getting better as the outperformance over the last couple of quarters shows. Yet in order to justify further substantial gains in share price, one has to believe the housing market is going to take off like a rocket, and in this case most of the homebuilders offer a lot better return for the risk than MTG does. Instead, investors not currently long MTG should sit back and wait a good long term reason to buy the stock. Thus far, I have not seen such a reason emerge.

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.