NMI Holdings: The Rising Star Of The Mortgage Insurance Industry

Summary

• The company has enjoyed impressive growth and is challenging the established industry leaders.
• The company's strong workforce results in a very high level of revenue per employee and healthy EBITDA margins.
• Great entry point: Despite its strong financial position, YTD, the stock is down 60% compared to a range of decline of 18% to 47% for its peers.

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NMI Holdings Inc. (NASDAQ:NMIH) provides mortgage insurance, an insurance product required to be paid by mortgage borrowers who make down payments that are lower than 20% of the home purchase price. We are bullish on NMIH because the company has a strong balance sheet to survive the storm, the current stock price provides an attractive entry point and the company has demonstrated its ability to compete against larger rivals.

We arrive at a fair value of $16 (rounded up) by taking the average of our comparable analysis ($14.23) and DCF model ($17.14), as explained in detail below. We assign a rate of "Overweight" because we expect the company's past growth to continue into the long-term future despite the potential hurdles the mortgage insurance industry is likely to face in the near term.

Founded in 2012 by Bradley Shuster and Jay Sherwood, NMIH sells mortgage insurance nationwide to its 1,476 customers, which include national banks, regional banks, credit unions and community banks. With $97 billion of total Insurance In Force (IIF), the company has made a name for itself as a high-quality player that delegates underwriting (with no verification) for only 5% of its loans. The remaining 95% of loans are either underwritten directly by the company or delegated with an independent verification.

(Created by Author using company's 10K report and Yahoo Finance)

Recommendation and Investment Thesis:

With unemployment rising to record levels, it is certain that mortgage defaults will increase in 2020. In addition, new loan production is likely to be minimal as would-be-home-buyers may be hesitant to visit potential properties. These COVID-19 effects will make it challenging for NMIH to operate at a normal level this year, but we are bullish on the stock long term because of three main reasons:

1. Strong financial condition: NMIH has accumulated over $1.1B in fixed maturity investments (reserves), an impressive accomplishment considering the company wrote its first policy only seven years ago and has a modest number of employees, 321. High revenue per employee of $1.1M and a strong EBITDA margin of 66% allowed the company to grow with minimal debt, $146M, and a low net debt/EBITDA ratio of 0.42x.

2. Attractive entry point: Despite its strong financial position, YTD, NMIH stock is down 60% compared to a range of decline of 18% to 47% for its peers. This translated into a P/E and an EV/EBITDA multiple of 5.2x and 4.0x respectively, which is slightly below its peer average of 5.64x and 4.57x. The company has been overly penalized by the market. The COVID-19 crisis created an opportunity for investors who have the resilience to trust the smallest (but strong) company in the peer group to navigate higher delinquency rates in the short term in exchange for high returns in the long term.

3. Demonstrated ability to compete with larger rivals: NMIH leaders have extensive experience. The current chairman, Mr. Shuster, founded the company and served as the CEO until 2019. Prior to NMIH he was a partner at Deloitte where he led the insurance and mortgage segment in northern California. The current CEO, Ms. Merkle, has served in numerous capacities at the firm including COO, EVP of Risk Operations and Chief of Insurance Operations. Together they have been able to break into an industry with heavy regulation and high capital requirements and produce impressive growth. The company recorded a remarkable 26% and 91% 3-year and 5-year revenue CAGR respectively. This revenue growth took place while maintaining high net profit margins, 45% in 2019. These impressive results confirm their potential to increase market share and become a large player in the industry.

Risks:

1. Size: Access to capital is more readily available to more established competitors. In addition, more established competitors have bigger balance sheets to navigate the COVID-19 crisis. For example, Arch Capital has $24B in fixed investments (compared to NMIH $1.1B) and a revolving line of credit of $750M (compared to $100M for NMIH). Despite this disadvantage, the company has grown and has more than doubled its revenues since 2016.

2. Delinquencies: Delinquencies will increase with the COVID-19 crisis. As of Q1 2020, JPM increased its reserves for credit losses from $1.5B to $8.3B. While those reserves are available for all types of loans, not just mortgages, they provide a good indicator of the increase in delinquencies. Our cash flow projections assume those delinquencies are temporary and only a small percentage will actually default.

3. Decline in underwriting: With 16M people filing for unemployment in March, states imposing restrictions on people's mobility and condominium associations prohibiting visitors, the potential for new mortgage loans in 2020 is grim at best. However, the expectation is that the virus will be contained by the end of the year and that new underwriting will return to normal levels by 2021.

4. Liquidity: In this uncertain COVID-19 environment, the most important question is the likelihood of companies surviving short term. We consider NMIH to be in a strong position to navigate the current storm. The company has a net debt/EBITDA ratio of only 0.42x, which is slightly below the average for the peer group of 0.46x. In addition to the $25M that it has in cash, the company also has $100M of remaining borrowing capacity under its senior secured credit facility. This amount might not be enough for a prolonged COVID-19 crisis, but should be sufficient to sustain the company over the next months. More specifically, given the level of fixed expenses, approximately $141M, and the interest expense of $12M, we estimate that the company has enough liquidity to survive for approximately 9.8 months even with a significant drop in revenue as follows:

Cash $25M + revolver $100M = $125M

Fixed Expenses $141 + Interest $12M = $153M

$125/$153 = 0.82 years of liquidity = 9.8 months

We excluded capex, dividends and share buyback expenses as the exercise is focused purely on essential payments required for survival.

Comparable Assumptions:

We use P/E and EV/EBITDA to arrive at our comparable price estimate. Using the comps' P/E average of 5.58x and NMIH' EPS for 2019 of $2.47, we arrive at a value of $13.76 (rounding). Using the EV/EBITDA multiple for the comparable companies of 4.57x and adjusted EBITDA for 2019 of $251M we compute an enterprise value of $1.1B, which translates into a price per share of $14.71, after considering debt and cash as explained in the table below.

(Created by Author using the 10K reports for Mgic Investmetns (MTG), Genworth (GNW), Essent (ESNT), and Arch Capital (ACGL).

Comparable sensitivity:

(Created by Author using the comparable information from the previous table)

Discounted Cash Flow Analysis:

Using the DCF methodology, we arrive at a price per share of $17.14 making the following assumptions:

1. Due to COVID-19, cash flows suffer a 30% decline in 2020, but grow 40% in 2021. The 40% figure may seem high, but it is just enough for the company to come back to stabilized levels seen in 2019.

2. Once cash flows are stabilized, we assume a growth rate of 1.5%, which conservatively only keeps up with inflation.

3. Maintenance capex is assumed to be 2.75% of sales, apart from 2020, when we expect the company to take a prudent approach and not spend any capex. Unlike most companies, its capex is not used for new PPE or maintenance of existing equipment. Instead it is invested in fixed-maturity securities, which increases the company's liquidity and can be used as collateral for reinsurance deals.

(Created by Author from his own discounted cash flow valuation model)

Discounted Cash Flow Sensitivity:Conclusion:

We recommend NMIH to investors with a long time horizon. We expect an increase in defaults and a decrease in underwriting in 2020, but we expect those challenges to be temporary. We see the $2.2 trillion intervention from the Fed as a strong back stop to the recession and a confidence builder for credit and debt markets. NMIH already accomplished the most difficult part - it broke into the industry, established partners, grew its revenue and maintained impressive profit margins. In the short term, we see the company as a survivor. In the long term, we see it as the rising start that can challenge the big players and provide a strong return for your equity portfolio.

Analyst’s Disclosure: I am/we are long 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.