|Shares Out. (in M):||498||P/E||0||0|
|Market Cap (in $M):||1,933||P/FCF||0||0|
|Net Debt (in $M):||3,029||EBIT||0||0|
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GNW presents a very unique special situation opportunity as a case in which the share price has suffered a significant downturn following a received Oct 21, 2016 proposal to be acquired for $5.43 per share in cash by China Oceanwide (“CO”).
Following the proposal and the release of Q3 earnings, the share price has dropped from $5.21(price pre-buyout announcement) to $3.88 at Jan 13, 2017 close, offering a +39.9% merger arbitrage premium with an expected mid 2017 close.
What makes this opportunity unique is that the fundamental intrinsic value of GNW standalone appears in line with the $5.43 buyout offer, presenting investors a binary outcome of:
The merger is completed and shareholders receive +39.9% in 6-9 months – I WIN
The merger is not completed and shareholders can realize the unlocked GNW intrinsic value potential of $5.36 to $7.32 per share (+38.3% to +88.7% vs. current). The valuation floor appears to be the $3.39 per share (-12.7% vs. current) where I assign no value to the US Life, Fixed Annuities and LTC business – I LIKE MY ODDS, EITHER I WIN OR I DON’T LOSE MUCH
Based on the above valuation considerations, it appears puzzling how to explain the stock price movement post merger announcement. My explanation would be that some investors are balancing the $5.43 capped upside vs. the liquidity risk at GNW holding company, believing its sources and uses of cash deficiency combined with the inability to refinance the upcoming 2018 debt expiration could lead to further credit agency downgrades, permanent business impairment and potentially bankruptcy.
I do not agree with this view, as I believe that the opportunistic monetization of parts or whole of the GNW mortgage insurance assets could resolve these liquidity issues, while providing the ability to complete the isolation of the LTC business from the life and FA business and further reduce the downside exposure.
In the following sections I will analyze both the prospects for the merger completion and the standalone entity, highlighting my rationale in support of this opportunity.
Merger Completion Prospects
GNW has released a preliminary merger proxy document on Dec 21, 2016, in which it states that it expects the merger to be completed by mid 2017 and assigns a merger completion deadline of Aug 31, 2017 (date that can be extended by the parties mutual agreement).
The merger has no financing contingencies, but is pending the approval of 3 significant stakeholders: GNW shareholders, US, Canada and Australia insurance regulators, Greater China governmental and regulatory entities.
GNW shareholder approval: a vote from GNW shareholders is expected for Q1 2017. GNW ownership is predominantly composed of institutional mutual funds (top 4 holders: Blackrock, Vanguard, Fidelity and T.Rowe Price alone account for 27.24% of the outstanding shares per the PREM proxy document), which, in addition to substantial premium based on the current share price, appears to improve the chances for obtaining the necessary quorum and approval vote. Based on these factors, the probability appears high (75%+)
US, Canada and Australia insurance regulator approvals: the merger requires the approval from several insurance regulators and it is contingent to their approval of the isolation of the LTC business. CO has committed to contribute in connection with the transaction additional $600mm of cash to address GNW debt maturing in 2018, on or before its maturity, as well as $525 million of cash to the U.S. life insurance businesses to facilitate the isolation of LTC. The terms of the transaction and additional contributions have been shared with the main insurance regulators during the merger discussions and the Board of GNW has decided to support the transaction after having received their positive feedback. Potential risk could be posed from the influence deriving from the perceived bias of the new Presidential administration vs. foreign buyers. Based on the preliminary feedback received and the financial strengthening provided by the additional contributions, the probability appears high (75%+)
Greater China governmental and regulatory entities: the merger requires CO to receive all relevant approvals from their domestic governmental and regulatory entities. As part of the merger agreement, CO is obligated to pay a termination fee of $210mm if these approvals are not granted. Based on the absence of clear negative precedents and the substantial termination fee commitment from CO, the probability appears high (75%+)
In addition to these approvals the merger agreement has customary reps, warranties and material adverse development clauses. In summary, it appears that based on the above evaluation, the merger has at least a 50%+ probability of being completed in the next 6-9 months.
Standalone Prospects - Intrinsic Value
The quantification of intrinsic value for GNW through a sum of the parts analysis for GNW mortgage insurance segment is robust as the MI businesses in Canada and Australia are publicly traded and the US MI business has been performing strongly and has clear market comps.
The corporate segment valuation can be confidently estimated through analysis of the net cash position at the holding company and the projected recurring corporate expenses going forward (excluding the interest expense to avoid double counting).
I assigned a very conservative valuation to the run-off portfolio and did not assign any value to the NOLs, deferred tax assets or liabilities, thus creating additional margin of safety on potential cash tax savings going forward.
The US Life, Fixed Annuities and LTC valuation can be approximated with the least amount of precision as the range of outcomes could vary significantly based on the development of assumptions including interest rates changes, equity valuations, LTC and life insurance experience (including future morbidity or mortality, policyholder behavior, expense, etc) and magnitude of regulator LTC premium increase approvals.
Based on this wide range of potential outcomes, and in absence of the isolation of the LTC business, I believe prudent to add a worst case scenario where there is no assigned value to the US Life, Fixed Annuities and LTC. If the isolation of the LTC business were accomplished, the $1bn+ value of the life and FA business would be released.
Sum of the Parts Analysis
57% stake in Genworth Canada (MIC.TO)
Market cap of CAD3.02bn X 57% = CAD1.72bn X 0.7625 fx rate = $1.31b. Data from Bloomberg and Yahoo finance as of Jan 13, 2017 close
52% stake in Genworth Australia (GMA.AX)
Market cap of AUS 1.68bn X 52% = AUS0.87bn X 0.7502 fx rate = $0.66bn. Data from Bloomberg and Yahoo finance as of Jan 13, 2017 close
US Mortgage Insurance
Q3 2016 Book Value $2,089mm X 1.3-1.4 p/bv multiple = $2.72 to 2.92bn. BV from GNW Q3 earning presentation, multiple range based on RDN and MTG comps (1.33 and 1.37 respectively)
Q3 TTM Operating Income $230mm X 12-13 p/e multiple = $2.76 to 2.99bn. Op. income from GNW Q3 Financial supplement, multiple range based on RDN and MTG comps (12.7 and 12.3 respectively).
Blended valuation range (50% p/bv and 50% p/e) = $2.74 to $2.96bn
US Life, Fixed Annuities and LTC
2017 Non-GAAP Operating Income (per management Base Forecast projections) $178mm X 6-10 p/e = $1.07bn to $1.78bn. Based on management Base Forecast, from GNW Dec 21 PREM14A merger proxy statement.
Goldman Sachs dividend discount model fairness opinion: $888mm to $1,431mm (as of Oct 20, 2016). Based on management Base Forecast, from GNW Dec 21 PREM14A merger proxy statement.
Lazard dividend discount model fairness opinion: $921mm to $1,484mm (as of Oct 20, 2016). Based on management Base Forecast, from GNW Dec 21 PREM14A merger proxy statement.
Blended Valuation Range (50% p/e multiple, 25% GS estimate, 25% Lazard estimate) = $0.99bn to $1.62bn
Q3 2016 equity of $616mm X 0.1 to 0.5 p/bv = $62mm to $308mm. Based on Q3 2016 GNW financial supplement
Q3 2016 TTM Operating Income $10mm X 10p/e = $100mm. Based on Q3 2016 GNW financial supplement
Blended valuation range (50% p/bv and 50% p/e) = $81mm to $204mm
Assets: Q3 2016 Holdco cash and liquid assets $1,165mm - $3,774 Corporate Debt = - $2,609. Based on Q3 2016 GNW earnings presentation and Q3 10Q, assumes no value to deferred tax assets and liabilities.
Q3 2016 TTM Operating Income excluding interest expense: $317mm - $268mm of non-recurring expenses = $49mm X 10 p/e = -$0.49bn. Based on Q3 2016 GNW financial supplement; non recurring expenses include: $83 million of legal fees and expenses, $20 million of make-whole expense on the early redemption of Genworth Holdings’ 2016 senior notes in January 2016; $18 million associated with Genworth Holdings’ bond consent solicitation for broker, advisor and investment banking fees; and $147 million related to the planned sale of the mortgage insurance business in Europe.
Total Corporate Value of -$2.61bn and -$0.49bn = negative $3.10bn
Sum of the Parts Total, excluding value of deferred tax assets and liabilities
Base Case: $1.31bn +$0.66bn + $2.74bn + $0.99bn + $0.08bn - $3.10bn = $2.67bn / 498.4mm fully diluted shares = $5.36 price per share
Better Case: $1.31bn +$0.66bn + $2.96bn + $1.62bn + $0.20bn - $3.10bn = $3.65bn / 498.4mm fully diluted shares = $7.32 price per share
Worst Case Scenario (No value to US Life, Fixed Annuities and LTC): $1.31bn +$0.66bn + $2.74bn + $0.08bn - $3.10bn = $1.69bn / 498.4mm fully diluted shares = $3.39 price per share
Standalone Prospects - Liquidity Position Analysis
GNW holding company significant debt is the primary overhang over the valuation of the company standalone prospects.
The total holdco debt amounts to $3,774mm as of Q3 and the run-rate interest payments equal to $246mm.
The holdco liquidity amounts to $1,165mm of cash and liquid assets as of Q3 2016, but needs to be adjusted for: $175mm earmarked for capital infusion to the US Life, FA and LTC business, $80mm of restricted cash, $719 minimum safety cash levels (1.5x annual debt service plus $350mm of buffer as provided by management). This leads to a total adjusted excess liquidity of $191mm
Sources and Uses
Interest payments are currently supported only by the dividend payments of the Canadian and Australian MI operations, as the US MI has been in capital rebuilding mode to comply with PMIERs requirements and the US Life, FA and LTC has not been able to pay dividends in light of the capital inadequacy resulting from the LTC portfolio assumption charges.
The Q3 2016 Canada MI TTM Operating income available to GNW stockholders $145mm and the Australia MI Q3 2016 TTM Operating Income available to GNW stockholders of $73mm for a total of $218mm vs $246mm of interest payments highlights a significant current gap in sources and uses at the holding company.
The limited adjusted excess liquidity and current holdco prospective cash burn, is important in the context of the $597mm 2018, $397mm 2020 and $1,086mm 2021 debt expirations, particularly in light of GNW prospects for refinancing, which at this point do not appear realistic.
While the future liquidity prospects issues are real and could lead to distress if not resolved, there are available solutions for GNW in advance of the May 2018 debt deadline.
Specifically, the monetization of parts or whole of the MI assets, especially in light of the recent equity rally post US presidential elections, could enable GNW to strengthen its holdco balance sheet and liquidity position, while achieving the isolation of the LTC portfolio and unlocking the value of the Life and FA business.
A scenario in which GNW proceeded in 2017 towards the monetization of Australia MI and the sale of 20% of US MI through an IPO would provide the company $1.21bn of cash ($0.66bn and $0.55bn respectively based on the base case valuations from the sum of the parts section).
This amount would be sufficient to repay the $597mm May 2018 debt maturity and inject $525mm additional capital to achieve isolation of the LTC business (same injections amount discussed with the regulators in the context of the CO merger), which would enable the Life and FA segments to re-start dividends to the holdco.
Post-completion of these transactions, the holdco run-rate sources and uses could be projected to be $100+mm positive each year, assuming conservative dividend payout ratios of 50% for US MI (which is expected to restart dividend payments in 2017), 75% for Canada MI, US Life and US FA businesses and no dividend releases from LTC.
80% US MI business = $230mm Q3 TTM op income X 80% = $184 X 50% dividend payout = $92mm. Op. Income from Q3 2016 GNW financial supplement
57% Canada MI business = $145mm Q3 TTM op income available to GNW stockholders X 75% dividend payout = 109mm. Op. Income from Q3 2016 GNW financial supplement
US Life = Q3 2016 TTM op income $131mm (excludes $194mm Unfavorable Impact From Universal Life (UL) Assumption/Model Updates in Q4 2015) X 75% payout = $98mm. Op. Income from Q3 2016 GNW financial supplement
US FA = Q3 2016 TTM op income $35mm (excludes $28mm one off charges in Q2 2016) X 75% = $26mm. Op. Income from Q3 2016 GNW financial supplement
Uses: remaining interest payments $207mm (based on remaining $3,177mm of holdco debt post 2018 debt retirement)
Additional holdco sources and uses from run-off portfolio, non-reimbursable expenses and other miscellaneous items are excluded from the analysis as immaterial.
In alternative to the proposed scenario, GNW has other options including issuing $300mm debt at US MI to fund one-time dividend to holdco (as included in management Base Forecast per PREM merger proxy filing) or monetization of parts or whole of Canada MI (also as included in management Base Forecast).
Risks are connected with GNW non-completing the merger with CO. In addition, if GNW shareholders vote against the transaction, or GNW is in breach of its merger agreement, it would be obliged to pay CO a $105mm termination fee.
If the merger is not completed, GNW would face risks as a standalone company including:
Equity market downturn, affecting its ability to monetize parts or whole of MI assets at appealing valuations
Increase in real estate mortgage delinquencies, affecting its MI businesses
Negative interest rate progress, pressuring US Life, FA and LTC businesses
Unfavorable development of LTC and life insurance experience (including future morbidity or mortality, policyholder behavior, expense, etc) and magnitude of regulator LTC premium increase approvals
Regulatory risk, enforcing inability to isolate LTC business and pay dividends from insurance subsidiaries to holding company
If merger is not completed:
Ability to isolate LTC business and initiate Life and FA dividends to holdco
Continued increase in interest rates improving Life, FA and LTC business
Continued growth of MI business and initiation of dividend payment to holdco
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