A Mortgage Insurer Sum-Of-The-Parts Valuation Underscores How Cheap They Are

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Includes: ESNT, MTG, NMIH, RDN
by: Gary J. Gordon
Summary

I calculated sum-of-the-parts values for MGIC and Essent.  These stocks, along with peers Radian and National Mortgage, are cheap!

The macro picture for the MIs remains very healthy:

Housing is still pretty affordable because of low mortgage rates.

Home purchase applications continue to grow.

Mortgage foreclosures are essentially zero.

As I’ve said before, I love the four private mortgage insurance stocks – MGIC (MTG), Radian (RDN), Essent (ESNT) and National Mortgage (NMIH) – like my own children. Children that earn $2 billion a year. Can your kids do that?

But I have to admit that it’s hard to think of duller companies than MIs. Their businesses move glacially:

  • Housing cycles are measured in multiple years, and often decades.
  • Mortgage underwriting standard cycles last almost as long.
  • Insurance premium price changes and other competitive issues rarely change.
  • Regulatory capital adjustments occur once in a generation.

So what’s a poor MI superfan to do to encourage you to buy these stocks, which I continue to believe offer a terrific risk/reward opportunity for investors? OK, every three months they report their earnings. But those earnings reports are pretty boring, because the MIs keep beating estimates by a penny or two. In between? I have to get creative.

Here's my latest attempts at creativity. First, I did a sum-of-the-parts valuation for MGIC and Essent. Second, I present some big-picture housing data that helps affirm that the current housing up-cycle, already a decade long, very likely has a long stable stretch ahead. Hopefully these new angles can convince some of you to pull the trigger and buy a few shares of MGIC, Radian, Essent or National Mortgage.

A sum-of-the-parts valuation highlights who cheap the MI stocks remain.

We investors normally use a stock’s P/E ratio as a quick value indicator. On this basis, the MI’s are certainly quite cheap. The S&P 500 is currently at a 17.2 P/E on 2019 expected EPS. MGIC is at 8.4, Essent at 9.2, or basically at half the average stock. I am quite confident that they deserve 11-12 P/Es. My sum-of-the-parts approach may help you decide to agree with me.

My four valuation parts are:

  1. Net cash
  2. Liquidation
  3. New business
  4. Capital management

I’ll start with the conclusion. Here’s my value per share of the parts for MGIC and Essent:

MGIC Essent

Net cash value $12 $28

Liquidation value 4 11

New business value 4 12

Capital management value 5 20

Total sum-of-the-parts value $25 $70

Current stock price $14 $49

Here’s how I got these numbers:

Net cash value

This one is easy. Insurance companies must hold cash reserves to cover potential insurance claims payments. My numbers subtract off their debt outstanding as well. I assume the cash is paid out as dividends.

Liquidation value – Insurance in force

As we speak, MGIC has $225 billion of mortgage insurance in force, and Essent $145 billion. Insurance in force is an off-balance sheet asset. It does run off over time, but a long time; probably a decade. The liquidation value numbers are my estimate of the present value of these added cash flows when paid out as dividends.

The two key valuation variables for insurance in force are the retention rate and the claims payment rate. The faster the MIs’ customers refinance their loans the faster the MIs' insurance in force pays off and less cash flow is generated. But since the bulk of the customers take out a new MI policy with their new loan, a lower liquidation value means a higher new business value. And I don’t worry about a material increase in the claims payment rate because of the data I presented above.

New business value

MGIC, Essent and their competitors are writing new policies as you read this. Lots of them – MGIC over $50 billion annually and Essent about $40 billion. But the MIs must retain capital in order to write new business, capital that could have been paid to us as dividends. I therefore credit new business only for a 9% return on capital employed, which is the difference between (A) the roughly 15% ROE the MIs say they earn on new business, and (B) the 6% I assume we investors could achieve by investing dividends paid. I then discount each year’s new business earnings back to the present using a conservative 12% discount rate. If housing stays healthy, my new business value estimates will prove very conservative.

Capital management value

My sum-of-the-parts estimates above all assume that the MIs use all their excess cash to pay dividends. But they could also use the extra capital to buy back stock. Should they? At their current low stock prices, yes they should. Assuming 7% annual appreciation in the stock price, using excess capital to buy MGIC’s stock at a continuing discount to franchise value adds another $5 per share in total value! And another $20 per share for Essent!

These capital management values can only shrink or disappear if the stocks rise sharply. Which wouldn’t be such a bad thing, would it? Sort of a win/win.

Big picture housing data #1 – Housing affordability

Bad things happen to MIs when large numbers of their customers can’t afford to make their mortgage payments. One key risk is when buyers have to stretch to buy a home, so any future bad personal financial event risks foreclosure. To assess how affordable buying a home is today, I calculated housing affordability in two ways. The first compares the average home price to household income. The second compares average mortgage interest payments to average household income. Here’s the data:

Sources: Bureau of Economic Analysis, Federal Housing Finance Agency, Federal Reserve of St. Louis (FRED), Census Bureau

The home price affordability measure at present is not far off from the peak back in the bad old days of 2007. Not good. But payment affordability is presently very strong, because home mortgage rates are currently near their historic lows. Very good. Net/net, I conclude that housing today is reasonably affordable. The risk to my conclusion is a sharp rise in interest rates over the next few years, which I believe is less likely than a Kardashian sister getting a Ph.D. in biochemistry.

Big picture housing data #2 – Home purchase applications

The Mortgage Bankers Association surveys its members every week to measure applications to buy a home. The purchase index gives a sense for the direction of the insurers’ collateral, namely home prices. The index says things are looking pretty darn good:

Source: Mortgage Banks Association, as compiled by Calculated Risk

Note that the data moves in a sawtooth pattern, not a straight line. Home purchases remain in an upcycle, with occasional down months along the way very much to be expected.

Big picture housing data #3 – Home mortgage foreclosures

As a bank regulator, the Federal Reserve rightfully keeps tabs on their “chargeoffs,” which is the losses banks incur when loans go sour. This chart shows a history of U.S. banks’ home mortgage chargeoffs as a percent of total home mortgage loans:

Source: Federal Reserve

The chart makes three important points:

  1. Banks’ home mortgage chargeoffs are literally zero at present. Similarly, MI claim payments on loans insured since 2009 are near zero. That’s good, right?
  2. A recession doesn’t automatically send home mortgage chargeoffs soaring. Yes, home mortgage chargeoffs were quite ugly during the past recession. But during the ’01 recession they peaked at less than 20% of the ’09 level. And during the ’91 recession (sorry, I have only one datapoint to show), they were only 10% of the ’09 top. So the next recession won’t automatically send home foreclosures soaring.
  3. “Average historical losses” is a meaningless statistic. The chart shows that actual loss rates are almost always well above or below the historical average. Some of MIs talk about their earnings outlook assuming historic average loss rates. Ignore those forecasts. Instead, determine whether the current trend is under or over average. I give “under” a 98% probability, for two reasons. First, the MIs have maintained very conservative underwriting standards for over a decade, which was very far from the case during the ‘08/’09 recession. Second, housing is in somewhat short supply today, unlike the serious excess going into the last recession. To see the data of these claims, check out this Seeking Alpha post of mine.

So stand out in the investment crowd. Buy some MI stock.

Disclosure: I am/we are long MTG RDN ESNT NMIH. 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.