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| Date post: | 02-Dec-2014 |
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Economy & Finance |
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• MIC is the largest private residential mortgage insurer in Canada, and has been in business since 1995§ Underwriting and distribution platform services a vast majority of residential
mortgage lenders and originators across Canada§ Pure play residential mortgage underwriter
• Investment thesis:
Long Idea: Genworth MI Canada (MIC:CN)
Current Price: $C 27(1)
1 Yr. Target Price: $C 33
Expected Return: ~ 21%
§ Consensus estimates for 2010 earnings, which anticipate an increase in loss expense from a fall out in Canadian housing, are too conservative
§ Sell side estimates based on either applying % YoY change on P&L accounts, or by simple regression (inappropriate b/c of lack of data points)§ A bottoms up analysis that incorporates a drop in average house prices, slow
down in new & existing home sales, and a rise in the foreclosure rate to an all-time high, reveal that losses will be at the low end of management guidance
§ MIC’s share price already reflects significant losses for 2010; if actual losses are less than expected, we will likely see MIC’s earnings and multiple expand
(1) Based on the five-day average closing price between 3/01/2010 and 3/05/2010.
• Preliminary 2009 results:§ Underwrote insurance on $C 18 billion worth of mortgages in 2009.
§ Policies in-force at end of 2009: $C 224 billion (~25% of Canadian market)§ MIC surprised by reporting a sequential decline in its loss ratio – demonstrating the
effectiveness of its loss mitigation measures related to workout activities § Cash and investments of $C 4.4 billion vs. technical reserves of $C 2.1 billion
• Capitalization:
Fundamentals & Valuation
• Capitalization:§ Enterprise value(1): $C 2.9 billion§ Equity market value: $C 3.2 billion§ No debt; Cash of $C 378 million§ Excess regulatory capital of just over $C 600 million (or ~$C 6/share)
• Consensus implied valuation multiples:§ Forward P/E in 2010: 11x ; 2011: 10x § Forward P/BV in 2010: 1.2x; 2011: 1.1x
(1) Includes unfunded pension & OPEB obligations of $11 million; capitalized value of operating lease is de minimis.
• Lack of coverage from the sell-side§ None of the sell side analysts attempted a “bottoms-up” analysis of the Canadian
mortgage market to estimate claims loss§ Applying traditional analytics on P&C insurers (and US mortgage insurers) does not
work; MIC operates in a very unique market
• Many US institutional investors unfamiliar with Canadian equity market
• Uncertainty clouds the Canadian residential housing market
Inefficiencies + Pessimism = Mispriced Stock
• Uncertainty clouds the Canadian residential housing market§ Valid arguments made by both sides re: whether market is in a “bubble”§ When it comes to evaluating MIC, the best approach is to assess the strength of its
balance sheet to weather anticipated losses
• Investors still pained by losses from the US sub-prime market§ MIC is being unjustly painted with the same brush§ Retaining the “Genworth” (TARP recipient in the US) name is not helping MIC
• YoY% change in unit sales: 0% (2009 pace is pre-04 level)• For both new and existing homes• 19 year average YoY % change: +1.1% for new homes; +3.6% for existing homes
• YoY% change in average sales price: -12% (to adjust prices to pre-06 levels) • For both new and existing homes• 19 year average YoY % change: +4.3% (for both new and existing)
Key Assumptions for 2010 Base Case
• Foreclosure rate on total insurance in-force: 100 bps• Assumed that all delinquent loans will be foreclosed (very conservative)• 19 year average delinquency rate is ~40 bps (high: 64 bps; low: 19 bps)
• Net earned premium as a % of beginning unearned premium reserve: 27.5%• 5 year average: 26.5% (30.6% in 2009)• 100 bps added to reflect impact of change to premium recognition curve in 2009(1)
(1) MIC submitted a change to its premium recognition curve in 2009 due to an expectation of accelerated loss development; the change was approved by OSFI – the insurance regulator in Canada
• Market share on new residential mortgage originations: 25%• Regained market share to “Mid to high 20%” in Q4 2009 after falling to “low 20s”
early in the year during the apex of the credit crisis
• Interest on investments: 4.25% • Duration cut on investments, and Bank of Canada is expected to hold rates steady
at 0.50% until at least Q3 2010
Key Assumptions for 2010 Base Case (cont’d)
• Increase dividends by 20%• MIC currently has excess regulatory capital • Management indicated that an announcement will be made during Q2 2010
regarding plan(s) to deploy excess cash
Bottoms Up Estimate of 2010 Claims LossConsensus est. of $255m, implying 10bps difference in loss ratio (0.35 vs. 0.45);
mgmt guidance: 0.35 to 0.40
High LTV mortgages in-force ($CAD millions) 177,905$ Less assumed principal pay down % -2.3%Roll forward value for 2010 173,902$ Plus new mortgages insured in 2010 18,069$ Estimated high LTV mortgages in-force at 2010 191,971$
Vintage Value Foreclosure SeverityYear % in-force Rate 2010 Loss Exp2006 12.0% 21,349$ 1.0% 1.5% 3.1$ 2007 24.0% 42,697$ 1.0% 20.3% 86.8$ 2008 15.0% 26,686$ 1.0% 22.0% 58.7$ 2009 9.0% 16,011$ 1.0% 26.2% 41.9$
2010 loss expense ($CAD millions) 190.5$
Assumed foreclosure
60% of mortgages in-force at end of 2009 were originated from ‘06 to ‘09
rate exceeds delinquency rate
• Severity represents the actual claim paid by MIC as a % of the total insured amount. Using data from MIC’s filings and Canadian mortgage and statistical agencies, severity ratio was estimated by comparing the average home price (adjusted for appreciation or decline) in each vintage year, against the average unpaid mortgage principal balance (including fees, taxes, and 12 months of unpaid interest)
• Mortgages were assumed to be amortized over 25 years, and a fixed rate of 6% for a five year term (paid monthly).
• Comparables analysis not applicable• No other publicly traded monoline insurer in Canada• US comps distorted by differences in US and Canadian residential mortgage
insurance market; Canadian banks and insurers also trade at a premium (~20% on both P/E and P/BV) to their US peers
• Decision tree analysis (multiples approach)• Weighted average probability of MIC’s 2010 EPS under 4 possible scenarios
Valuation
• Adjusted key assumptions to determine EPS impact
• DCF analysis• Reflects assumptions that supports “base case” scenario in the decision tree
analysis
Decision Tree Analysis: Basis for Target Price
Loss Value % P/ '10e RoE ExpectedScenario Description Ratio EPS P/E Comment p/sh Chg BVPS 10e P(n) % Rtn.
Bull Case 27% mkt share; 0.8% Foreclosure 27% $2.95 13.5x High P/E of US Monolines $39.83 48% 1.6x 12.0% 10% $3.98
Consensus 45% Loss Ratio for 2010 45% $2.50 10.0x Median P/E of Cdn insurers $25.03 -7% 1.0x 10.5% 30% $7.51
Base Case 1% Foreclosure rate; 0% YoY 34% $2.72 13.5x High P/E of US Monolines $36.75 36% 1.5x 11.2% 50% $18.38homes sold; -12% YoY avg prices Premium on Canadian insurers
Bear Case 22% mkt share; -15% YoY homes 60% $1.85 10.0x Median P/E of Cdn insurers $18.50 -31% 0.8x 7.9% 10% $1.85sold & avg price; 1.5% foreclosure 100% $31.72
2010e
Applying the weighted average probabilities into the likely outcomes affecting MIC’s 2010 earnings, the result suggests upside of ~21% from its current share price
(vs. ~41% for the base case scenario)
sold & avg price; 1.5% foreclosure 100% $31.72
Share Price $27.0 Expected Return $31.72Market Cap $3.2bn Plus Dividends $1.06P/E '10e 9.9x Total Return $32.77P/E Cons '10e 10.8x Share Price $27.00P/BVPS 1.1x % chg 21.4%ROE '10e 11.2%
Terminal2009a 2010e 2011e 2012e 2013e 2014e 2015e 2016e 2017e 2018e 2019e 2020e Value
Net earned premiums 557$ 547$ 542$ 548$ 553$ 564$ 576$ 587$ 599$ 611$ 623$ % chg yoy -22% -2% -1% 1% 1% 2% 2% 2% 2% 2% 2%
Combined ratio 0.512 0.422 0.393 0.550 0.550 0.570 0.570 0.570 0.570 0.570 0.570 Expense ratio 0.170 0.170 0.170 0.200 0.200 0.210 0.210 0.210 0.210 0.210 0.210 Claims ratio 0.342 0.252 0.223 0.350 0.350 0.360 0.360 0.360 0.360 0.360 0.360
U/W profit 271 317 329 247 249 243 248 253 258 263 268 - Margin 0.488 0.579 0.607 0.450 0.450 0.430 0.430 0.430 0.430 0.430 0.430
Investment income 184 187 207 175 177 186 190 194 198 202 206 % of NEP 33% 34% 38% 32% 32% 33% 33% 33% 33% 33% 33%
Insurance profit 455$ 504$ 536$ 422$ 426$ 429$ 438$ 446$ 455$ 464$ 474$ Insurance margin 81.8% 92.0% 98.8% 77.0% 77.0% 76.0% 76.0% 76.0% 76.0% 76.0% 76.0%Tax provision (137) (151) (161) (127) (128) (129) (131) (134) (137) (139) (142) Tax rate % 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% 30.0%
Long Term Value Embedded in the “Base Case”
Tax rate % 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% 30.0%
FCFE 379$ 319$ 353$ 375$ 295$ 298$ 300$ 306$ 312$ 319$ 325$ 332$ 5,394$
Equity 2,643$ 2,838$ 3,055$ 3,281$ 2,395$ 2,096$ 1,796$ 1,949$ 2,105$ 2,265$ 2,427$ 2,593$ % chg yoy 7% 8% 7% -27% -12% -14% 9% 8% 8% 7% 7%Dividend 28 124 136 150 1,181 597 601 153 156 159 163 166 DPO 7% 39% 39% 40% 400% 200% 200% 50% 50% 50% 50% 50%RoE 14% 12% 12% 12% 10% 13% 15% 16% 15% 15% 14% 13%
NPV 306$ 311$ 304$ 220$ 204$ 189$ 177$ 166$ 156$ 146$ 137$ 2,133$
Sum of NPV 4,447$ Less debt -$ Implied equity value 4,447$ # of shares o/s 117.1Implied per share value 37.98$ Current share price 27.00$ Upside % 41%
WACC of 8.8% used assuming RFR of 4%; 4% risk premium; and beta of 1.2
Reflects need to return excess capital to
shareholders (or pursue M&A opportunity) to
sustain “mid-teens” ROE
• “Double dip” recession§ Probability: LOW to MODERATE§ Economy is highly levered to commodity markets; global slowdown = trouble
• US style housing blow up in Canada§ Probability: VERY LOW§ Radically different market, conservative lending, low inventory, lender recourse, etc
• Lending “cap” for private mortgage insurers is not increased
Key Risks to the Investment Thesis
• Lending “cap” for private mortgage insurers is not increased§ Probability: LOW§ Cap increased in the past when near limit; can’t have a government monopoly
• New competition enters the market§ Probability: LOW§ High barriers to entry; potential competitors were US mortgage insurers
Down side risk if the thesis is wrong: 28% based on MIC’s current price
Tale of Two Countries: Canada vs. US Mortgages
• Other distinguishing features of the Canadian mortgage market:– Canadian lenders have more conservative underwriting practices vs. US lenders– More emphasis on relationship based lending– Lenders can attach personal assets and/or garnish wages if loan is deficient– Annual principal repayment is limited (and costly), which limits refinancing
Canadian Housing Market ChartsYoY % Change in Units Sold & Average Price: Existing Homes
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
1991 1994 1997 2000 2003 2006 2009F
Number of Units Average Price
Base case estimate for YoY %change in average
selling price
Base case estimate for YoY %change in units sold
76%
78%
80%
82%
84%
86%
88%
90%
92%
94%
96%
1991 1994 1997 2000 2003 2006-40%
-30%
-20%
-10%
0%
10%
20%
30%
Unit Sales as a % of Completions (LHS) YoY %Chg # of New Homes Sold (RHS)
Base case estimate for YoY %change in # of new
homes sold
Canadian Residential Mortgage Market ChartsGross Written Premiums - Residential Mortgage Insurance
480 611828 865 898 850
1,0491,285 1,203
1,446 1,492 1,3831,740
2,132 2,090
229
86 105 146 141
200
282 385
504 471 604
997
722
374
$0
$500
$1,000
$1,500
$2,000
$2,500
$3,000
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009F
MIC Market1995 to 2009 45% 12%2004 to 2009 -6% 5%
CAGRGWP - Residential Mortgage Ins
MIC lost market share in ’08 and ’09 b/c:
1) Gov’t ban on mortgages with terms of 35 yrs+
2) Banks fear that MIC would not be able to stay afloat to provide coverage on future claims
CMHC Genworth Canada
Proportion of GWP Written by Year0% 5% 9% 11% 14% 14% 16% 18%
24% 26% 24%30%
36%25% 25%
0%
20%
40%
60%
80%
100%
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009FCMHC Genworth Canada
Base case assumed MIC’s market share of 25% in
2010
future claims
MIC is Overpaid to Insure Residential MortgagesMIC’s Policies in force as at March 31, 2009
Mortgage Insurance Premium Grid Unemployment Rate vs. Mortgage Delinquency Rate
Average of 200bps for premiums vs. long run avg delinquency rate of 40bps
Conservatively Managed Investment Portfolio
~75% of investments are rated AA and higherPortfolio duration of 3.1 years (vs. 5 yrs at Y/E 2008)
Book yield of 4.0%
Ownership Summary
Type # of Common Shares Held % of Shares Outstanding Market Value (CAD in mm)
Institutions 90,642,841 77.40 2,515.3
Hedge Fund Managers - - -
Corporations 1,000 0.00 0.0
Insiders 66,025 0.06 1.8
ESOPs - - -
Corporate Foundation - - -
Public and Other 26,393,135 22.54 732.4
Total 117,103,001 100.00 3,249.6
Owners of Genworth MI Canada’s Stock
Top 5 Holders
Holder # of Common Shares Held % of Shares Outstanding Market Value (CAD in mm) Position Date
Genworth Financial Asset Management, Inc. 67,325,900 57.49 1,858.7 Jul-30-2009
Fidelity Investments 6,123,100 5.23 169.0 Nov-30-2009
Phillips, Hager & North Investment Management Ltd 3,626,700 3.10 100.1 Nov-30-2009
CI Investments Inc. 3,230,900 2.76 89.2 Sep-30-2009
I.A. Michael Investment Counsel Ltd. 1,417,500 1.21 39.1 Dec-31-2009
Genworth (GNW.US) controls ~57.5% of MIC’s stock
Source: Capital IQ
MIC vs. S&P TSX (Q2 2009 – YTD 2010)
Outperformed S&P TSX by over 30% since IPO
52 wk High: $C 17.30
52 wk Low: $C 30.50
IPO price: $C 19.00
