Focus Article: Genworth Financial (GNW)

Genworth Financial (GNW) $9.22

The Company:

Established in 1871, Genworth Financial is a Fortune 500 insurance holding company that was spun off from General Electric (GE) in 2004. The company is diversified geographically across 25 countries like Australia, Canada, Ireland, India, etc. as well as various lines of business such as life insurance, long-term care reinsurance, reinsurance, annuities, wealth management and the red-headed stepchild mortgage insurance.

Mortgage insurance is often required by lenders when a borrower makes a down payment of less than 20% when purchasing a home. The U.S. mortgage insurance industry came to its knees during the last recession with companies like California based PMI Group filing for bankruptcy and others seeing their stocks crushed due to losses from delinquencies.

Genworth has a 40% market share of the U.S. mortgage insurance industry. The company reported a whopping $352 million loss in its U.S. mortgage insurance division in Q4 2010 but managed to narrow that loss to $94 million in Q4 2011. Income from its other divisions like the life insurance business and international mortgage insurance business helped the company overcome the U.S. mortgage insurance losses and report positive net income for Q4 2011.

Genworth currently trades for just 0.27 times book value and as you can see from the competitors section below, it is trading at a significant discount to peers. The quality of loans insured by Genworth is higher than its peers and loans insured over the last few years are of better quality than the pre-recession loans. A breakdown of Genworth’s loan insurance portfolio when compared to peers is given below.

Overall delinquency rates have been dropping across the industry and Genworth has lower delinquency rates when compared to its peers. Genworth attributed the uptick you see in Q3 2011 to seasonal factors as they experienced a similar uptick in delinquency rates in Q3 2010 as well.

The company considered various options for its mortgage insurance business including a spin-off, a sale to another company and continuing to underwrite new business. Based on return on equity of 20% plus on new underwriting business and additional capital requirements related to spinning the division off, Genworth decided to retain the mortgage underwriting business with the realization that it will continue to generate losses in 2012.

The company increased its reserves to cover losses in the second quarter of 2011 by $200 million and used up $100 million of those reserves in Q3 and an additional $20 million in Q4. While new underwriting revenue currently appears profitable, it represents a drop in the bucket of overall revenues. A turnaround of Genworth will depend not only on how its other operating divisions and international businesses perform but also the state of the U.S. housing market.

The State of the U.S. Housing Market:

The U.S. housing market is not completely on stable footing yet but there are several signs that point to a recovery that is underway. Three out of the four metrics I track are showing positive signs.

1. Housing starts and building permits are both improving on a sequential basis and year-over-year basis. According to the U.S. Department of Housing, privately-owned housing starts in January were at a seasonally adjusted annual rate of 699,000. This is 1.5 percent above the revised December estimate of 689,000 and is 9.9 percent above the January 2011 rate of 636,000. Digging through the data, while single family housing permits are increasing, it is multi-family units (apartments, etc) that are seeing the biggest gains in this low interest environment.

2. Homebuilder confidence in the U.S. is the highest it has been since 2007. According to an article in Bloomberg BusinessWeek, “the National Association of Home Builders/Wells Fargo index of builder confidence rose for a fifth straight month, to 29 in February from 25 in January”.

3. Existing home inventory supply has been the lowest it has been in nearly 5 years. As astute executive who was previously the Vice-Chairman of one of the largest banks in the U.S. told me back in 2006, that when existing home inventory levels hit a 9 month supply, “the s–t will hit the fan”. Sure enough existing home inventory started creeping up and was up over the 9 month supply level by mid-2007. It eventually peaked at over 12 in mid-2010 and is now down to 6.2 months as of December 2011.

4. For confirmation that the housing market is not yet out of the woods, one can turn to the Case-Shiller Index that tracks national housing prices as well as a composite of the largest cities. The index reported two consecutive months of housing price declines in October and November. Since there is a two month lag in the data, it will be interesting to see if this index will reflect some of the optimism expressed in the other indicators when the next report comes out next week.

Business Statistics and Financials:

The company reported Q4 results earlier this month with net income coming in at $107 million or 22 cents per share when compared to a loss of $161 million or 33 cents per share in Q4 2010. The large loss in Q4 2010 was primarily on account of a $352 million loss in the U.S mortgage insurance division, which dropped to a loss of $94 million in Q4 2011.

Book value per share increased 19% year-over-year from $28.31/share in Q4 2010 to $33.70/share in Q4 2011. Analysts on average expect the company to earn $1.21/share in 2012.

Competitors:

Given Genworth’s diverse lines of businesses, we have included competitors both from the mortgage insurance industry as well as a broader group of insurance companies.

Insider Buying:

Given below is a list of purchases by the insiders of Genworth Financial over the last six months.

Genworth is not the only insurance company with a mortgage insurance division that is seeing insider buying. We reported a $1 million purchase by the CEO of MBIA (MBI) on November 18, 2010 and wrote the following about the company,

“Rising from the ashes of the subprime mortgage mess, MBIA appears to still be standing while its peer company Ambac filed for bankruptcy earlier this month. It was interesting to see that the CEO also purchased 50,000 shares of MBIA almost a year ago for just $3.45. The President & COO purchased 25,000 shares for $8.72 in August. There have been no insider sales this year.

The company is still reporting losses but the size of those losses has narrowed and it is benefiting from a process called “putbacks” where banks are forced to repurchase ineligible mortgages. MBIA has already booked $2 billion in putbacks on $4.3 billion of incurred losses on deals it made with banks.”

Risk Factors:

There are several risk factors that could negatively impact an investment in Genworth.

1. A double dip recession, an increase in the jobless rate or a drop in consumer confidence may delay a housing recovery and impact Genworth’s turnaround.

2. The company was able to offset a large part of its U.S. mortgage insurance losses through profits in its international mortgage insurance operations. A majority of Genworth’s international income comes from Canada and Australia. With both Canada and Australia in a potential real estate bubble, this may not necessarily be a good thing. In fact operating earnings dropped 15% in Canada and 9% in Australia last quarter due to higher delinquencies. The company also saw a sharp increase in delinquencies in Ireland and stopped writing new business there as of mid-2011.

3. The stock has appreciated significantly in recent weeks, rising 60% from $5.75 on December 19 to current levels. The stock has been volatilite over the last year and I expect this volatility to continue.

4. On account of new debt guidelines and changes to accounting practices, the company expects a negative impact on GAAP earnings of about $65 million to $75 million or about $0.13 to $0.15 per share in 2012 and beyond.

Conclusion:

Despite the challenges the company faces, Genworth appears to be on its way to recovery. With a potential improvement in the U.S. real estate market and delinquency rates dropping for its most troublesome books from the years 2007 and 2008, the company should see improving profitability in 2012 and a potential reinstatement of a dividend in 2013. Even if the stock only trades for half its book value of $33.70, this should be a $16.85 stock, representing a potential gain of over 80%.