|Shares Out. (in M):||498||P/E||3.4||3.4|
|Market Cap (in $M):||1,400||P/FCF||0||0|
|Net Debt (in $M):||3,200||EBIT||0||0|
|Borrow Cost:||Available 0-15% cost|
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Thesis: GNW is in trouble, has unrealistic assumptions on its LTC book and will likely have to take over $2.0 billlion in additional reserves essentially wiping its business taking it down to $0.00
*there are a lot of things to discuss with GNW and its a complicated story but the two main ones are its HoldCo liquidity and ability pay the 2018 bonds, and the assumptions on its LTC business which is what I'd like to concentrate this write up on. There are a myriad of other potential discussions but if those two things are realistically will drive the stock price up or down. *
GNW is a company undergoing simultaneous stress in multiple businesses and a stretched liquidity profile. As such, it makes sense to answer both questions at the same time because each segment’s valuation and sensitivity to factors will impact GNWs liquidity. First it is important to consider where GNW stands in mid-April 2016. The way to think about it as it has 3 “main” segments: Mortgage Insurance (US, Canada, Australia); Life Insurance: which is really the Long Term Care (LTC) since its exiting writing new universal and variable life policies; and run off blocks. While the first one is fairly straight forward (in a normal, non-residential collapse, economies) to value and as a source of liquidity given the clean books, public equity valuations and known dividends the latter 2 are black boxes with major sensitivities to factors out of GNWs control and may need many more billions in reserve contributions which may drive GNW into bankruptcy. Of course its all about probabilities of each scenario and GNW is working hard on a “good bank bad bank” separation to highlight the value of its MI businesses as well as pay off $1-$2 billion in holding company debt. This may or may not work so its important to examine what happens to valuation and liquidity in each scenario. I would say that
The Balance Sheet (assuming no LTC charges)
The Cash: As of March 2016 GNW has approximately $1050 in cash on the balance sheet of which $90 is restricted cash ($1374 on 12/31/2016 less $321 for $298 of face value of 2016 notes redeemed in January 2016).*
*The life block transaction completed in January 2016 is estimated to generate in excess of $200 million of tax benefits to the holding company in the third quarter of 2016, however this will go toward the LTC reorg capital strengthening”
Additionally, GNW has a $300 million revolving credit facility (untapped) which expires Sept 26, 2016.
Theoretical available cash liquidity today is $1,550 million
The Non-Operating (Insurance) Liabilities:
Debt: $4,270 million* (additionally there is approximately a $400 million Accounts Receivable Securitization facility as an off balance sheet financing vehicle). On March 4th, 2016 GNW sent out and received consent solicitation (presumably to buy back the bonds early given their goal of reducing leverage by $1 to $2 billion).
Additional Non Operating Liabilities:
· Genworth Holdings has a Tax Matters Agreement with GE, our former parent company, which represents an obligation of Genworth Holdings to GE. The balance of this obligation was $188 million as of December 31, 2015.
· On March 11, 2016 the company announced a 1Q16 securities lawsuit payment of $69 million dollars
The Cash Flow:
Pretty basic math. First on holding company expenses: The company pays $235 million in interest a year. Additionally, it has approximately $50 to $100 million in corporate level expenses. Its trying to reduce that number but I suspect there will always be issues that pop up that will keep it at this level. If it pays off the 2018s it will save itself ~$40 million a year.
One of the issues with GNW is that despite a multitude of businesses it is only able to receive dividends from Australia and Canadian MI businesses. The US MI business is still in the capital strengthening phase an is unlikely to generate dividends until 2017. For 2016, in an ongoing assumption is that the holding company will receive between $100 and $150 million as its only source of income. In the 10k statement on liquidity (included below) the company says it expects to be able to receive $140 million without any regulatory issues.
So in the COMPANY’s base case assumption 6.2018 should look like this:
· Beginning pro forma cash on 3/2016: $1050 million
· Annual run rate of expenses: -$340 million *2.5 years until 6.2018 = $850 million
· Dividends from International subsidiaries: +$125 to $150 million * 2.5 until 6.2018 = +$350 million
· Securities settlement: -$70 million
· US MI beginning to pay dividends in 2017/2018 = +$100 million
· Life block transaction in 3Q2016: +$230 million
· LTC Capital Infusion for Reorg: -$200 million
· End cash: $610 million
· Pay off $600 million in 2018 bonds leaves cash of $10 million. This is unrealistic as they would need to have at least $450 million on hand per their own goals of 1.5x annual expenses.
If you want to be even more positive, you can assume the company can take out $50mm in cash expenses a year so $100 million more which they said would happen with the suspending of Life sales. You can also assume that they can go out and buy 2018 bonds early at $550 million (currently trading at 93) and save themselves approximately $80 million in cash interest expenses. This would leave you with $200 -$250 million in cash.
So this is very important: THIS ANALYSIS ASSUMES A) No more LTC charges/more capital needed B) No reserve releases from run off life blocks.
So at the end of this base case analysis we’re left with the company needing $250 to $420 million dollars more. I would recommend reading Appendix 1 at the end of write up on the company’s risk disclosures on liquidity. Lets examine how it can get there or if things can get worse by looking at it from a segment by segment analysis.
Mortgage Insurance Segment (33% of Equity)
International (per share value of $2.80; range of $1.90 to $$3.70)
The easiest way for GNW to be shore up short term liquidity would be to sell down, whole or partially, its two public stakes in its Australian and Canadian subsidiaries. First on valuation:
Genworth Mortgage Insurance Australia:
· Shares outstanding: 595 million
· Price: 2.33 Australian Dollars per Share (range since IPO in 2014 2.08 – 3.44).
· Exchange Rate: 1 Australian Dollar = .77 US dollar (Down from 1 to 1 rate on stronger dollar and commodity weakness)
· Book Value for GNWs stake: ~$600 million
· Market Cap: $1100 million of which GNW owns 52% or $580 million (.95x book value)
Genworth Mortgage Insurance Canada:
· Shares outstanding: 91.8 million
· Price: 32.27 Canadian Dollars per Share (range 52 weeks 22.14 – 36.30).
· Exchange Rate: 1 Canadian Dollar = .78 US dollar (Also down from 1 to 1 rate on stronger dollar and commodity weakness)
· Book Value for GNWs stake: ~$1,140 million
· Market Cap: $2310 million of which GNW owns 42% or $970 million (.85x book value) *(excludes stake held by US Mortgage business)
So from the liquidity analysis purposes GNW owns ~1550 million of stock in international MI businesses which will pay $140 million (per 10k) in 2016 or 9.0% dividend yield. The book value to GNW is $1740 meaning the Cash Return on Equity is 8.0%. So the easiest way for GNW to meet its 2018 bonds liquidity is to sell $350 million of stock in its international businesses or 25% and in return giving up $35 million in dividend income. Not the best solution but the easiest one.
Canada and Australia have much different book exposures than US given their economies experience during the financial crisis in that their vintage books are much better. For context their delinquency ratios are 40 to 50 basis points versus US delinquency ratios of 500 to 1500 basis points, see chart below). Nevertheless they experienced a commodity based boom, and are both hurting given the slump in energy prices and their economies dependence on it. As such the may be facing some loss pressure, though still nowhere close to the US 2008-2009 version and can trade down as low as .6x book value. On the upside, if they continue to generate high single digit, low double digit ROEs they should be able to trade above book value 1.2x.
Domestic MI (per share value of $5.00; range of $2.00 to $7.50)
As one of the two survivors of the financial crisis GNWs US MI business could be considered the jewel of the empire. The second easiest way for the company to raise money is to IPO all or part of the US MI business. Many market participants believe that this is the only way the company could survive longer term and weather its liquidity needs going forward. Over the last few years US MI has been in the capital rebuilding phase and as such has not paid out any dividends and is not expected to do so in 2016. 2017 may see under $50 million.
4Q15 earnings call Q&A
2015 was a capital buffer rebuilding year for US MI. The company needed to be compliant with Private Mortgage Insurers Eligibility Requirements (PMIERs) which meant the company needed $780 million of PMIERS related capital actions. It met the requirement via reinsurance contracts (lower premium and net income by 5-10%, but lower loss ratios) of $500 million, capital contributions and sale of European MI ($55 million in 2016, not part of cash/liquidity consideration since its going straight back to MI). The company’s book value is approximately $1.7 billion and a normalized run rate of income could be as high as $300 million by 2017, in line with their peers earning 13-15% ROEs (GNWs US MI 2015 ROE was close to 12%). As such the company is right in the middle of its peers on performance metrics (except ESNT which was formed after the crisis and does not have to deal with pre-2008 vintage books of its competitors)
On valuation and sensitivities: GNW’s US MI book value is approximately $1.7 billion. By year end 2016 which is the earliest the company may finally decide to monetize its assets the book value should be at least $1.9 billion. In the base case, the US housing market stays strong, company keeps earning double digit ROEs and should probably trade at 1.2x-1.4x book value or $2.5 billion or $5.00 per share. On the upside it can go as high as 2.0x book value and be worth as much as $7.50 per share.
The downside is a little bit trickier for me to estimate. I have a personal psychological barrier in that I was invested in PMI, the industry leader, from 2006 all the way down to $1.00 in 2009 right before it filed for bankruptcy. I visited the company 4x in 2007-2008 and on the surface things looked survivable. They had very conservative assumptions and it didn’t seem that bad. And yet, here we are. So, the worst case could be zero. However, since both of these guys survived the crisis, most of the vintage stuff has been rolling off and the new books are much stronger in credit quality than in the past. So I think a realistic .4x-.5x book value (during crisis they traded at .1x to .3x) or approximately $2.00 per share is a good downside assessment.
Please also note that the company’s structure is more complicated in that US MI owns 15% of GNW Canada implying AN ADDITIONAL $0.65 cents in value (range of $0.50 to $1.00)
Life Insurance Segment (67% of Equity)
The 2 segments involved here, run off life insurance and long term care (LTC) are notoriously impossible to value and represent an incredible challenge for GNW going forward. Given that the MI businesses are worth close to $4 billion and GNW has a book value of $12.9 billion and yet is trading at $1.4 billion it is clear that the market is assigning a huge negative value to these businesses of over $11 billion dollars. It is important to understand what is embedded, what is management’s plan and what could happen.
First, on 4Q15 management announced that is exiting the life insurance segment, the book will be in run off and could be used for sale/reinsurance/dividends which is management’s number one plan for shoring up liquidity for 2018. It also announced the re-org of the LTC segment. My personal opinion is there is no way the insurance regulators allow the company to unstack its subsidiaries and separate the good bank from the bad bank. They don't have an incentive to do so, to create risk for their constitutients. The company is bulish on this but I am just having a really hard time seeing state regulators allowing this to happen and IF THEY DO ALLOW IT WILL REQUIRE A LOT MORE THAN THE $200 MILLION they just put in.
US Life Insurance and Fixed Annuity (per share value of $2.50, range from $1.00 to $4.00)
GNW suspended sales of its life insurance and annuity products essentially putting the book in run off. Through restructuring, reinsurance and sales of its life blocks it plans on shoring up its HoldCo liquidity by pulling capital from this segment. The company has approximately $3.9 billion dollars of equity in this business and (excluding the 4Q15 GAAP write off of $184 million) earns approximately $200-$210 million a year or 5-6% ROEs, including the fixed annuity business. The U.S. insurance business did not remit any dividends to the holding company from 2008 to 2011 but was able to pay $226 million of special dividends in 2012 because of asset sales and reinsurance deals. In 2013, it paid $200 million of ordinary dividends. There were no dividend payments in 2014 and 2015. The company actually has a NEGATIVE $70 million surplus which needs to be capitalized and thus there are zero expectations for holding company liquidity contributions from potential dividends in the near future. However, if the reorg transaction is completed and the GLIC and GLAIC segments (life insurance is GLAIC) are unstacked this segment could become a source of liquidity by selling the run off block or through re-insurance transactions. It appears the market (or myself) is giving very little credit to this happening.
Valuation: Life Insurance and annuity businesses are notoriously low margin, highly regulated businesses that have suffered under years of low interest rates which look like they are here to stay for much longer. As such this business should not worth all that much. At a $200 million earnings run rate/5% ROE this business should not be worth more than 6x earnings/.35x book value in any asset sale transaction and frankly it would be amazing if GNW can pull out a $1 billion+ valuation. The industry leaders, MET and PRU that earn double digit ROEs are trading close to .7x P/TBV and VOYA that has a similar black box run-off book but has a great asset management business is trading closer to .45 Book Value. So assigning 6x earnings and .35x BV multiple results in $2.50 per share. Downside Case of 2.5x Earnings results in $1.00 per share and at 10x earnings and .5x BV would result in $4.00 per share. The GS analysis based on current deal multiples vs ROE implies this can go as high as .66x Book Value and that Asian conglomerates are very interested in US Life blocks so this is obviously a risk to the upside in the short case.
10-k Sensitivity Factors in Assumptions
So before we jump into the black box of LTC lets recap or liquidity and valuation scenarios:
· The company needs $250mm to $400mm in additional liquidity by 6/2018 to pay off approximately $600 million in 2018 bonds coming due. While it plans on getting that money via asset sales and reinsurance in the US Life insurance segment with a successful restructuring and unstacking of its life and LTC businesses it can also get liquidate some of its international MI holdings or (as the market hopes) IPO a part of its US MI segment. Either one of those options would give up long term liquidity via dividends for short term liquidity needs by selling stakes in 10-14% cash ROE businesses to pay off 6.5% coupon bonds.
· The Sum Of Parts Value for International MI ($2.80), US MI ($7.50), Canada MI as part of US MI ($0.60) and US Life Insurance ($2.50) is $13.40. The downside Sum of Parts for those segments is $5.40 and upside is $16.20.
Long Term Care Insurance Segment (per share valuation of -$4.00, range of -$10.00 to $1.00)
The key factor in LTC is figuring out whether it has positive value, zero value, or negative value. If LTC further deteriorates and requires additional capital infusions to strengthen the $20 billion in reseves, there should be a strong argument for it to have a negative value. If instead it is capital sufficient but the prospects of getting any dividends out is too far into the future and too uncertain, then the value to equity holders is essentially zero. The best case is management succeeds in restoring profitability and the unit has positive value. I believe this segment will require future capital infusions and a lot more liquidity needs from the company than their current rosy base case which will require separation and unstacking of the LTC business from the HoldCo.
Before discussing the reasons why I believe so, I’d recommend reading the company’s statement on how it gets to $2.5 to $3.0 billion in profit assumptions.
GNW’s 10k on LTC business:
"Future policy benefits
The liability for future policy benefits is equal to the present value of future benefits and expenses, less the present value of expected future net premiums based on assumptions including investment returns, health care experience (including type of care and cost of care), policyholder persistency or lapses (i.e., the probability that a policy or contract will remain in-force from one period to the next), insured mortality (i.e., life expectancy or longevity), insured morbidity (i.e., frequency and severity of claim, including claim termination rates and benefit utilization rates) and expenses. In our long-term care insurance business, our assumptions also include anticipated future premium increases from future in-force rate actions (including anticipated actions that have not yet received regulatory approval). The liability for future policy benefits is reviewed at least annually as a part of our loss recognition testing using current assumptions based on the manner of acquiring, servicing and measuring the profitability of the insurance contracts. Loss recognition testing is generally performed at the line of business level, with acquired blocks and certain reinsured blocks tested separately. Changes in how we manage certain polices could require separate loss recognition testing and could result in future charges to income.
Long-term care insurance block, excluding our acquired block (*this is a small block, while still material, not the biggest issue facing LTC)
We perform loss recognition testing for the liability for future policy benefits for our long-term care insurance products in the aggregate, excluding our acquired block of long-term care insurance, which is tested separately. In 2014, the results of our loss recognition testing on our long-term care insurance block, excluding the acquired block, indicated that our DAC was recoverable and reserves were sufficient, with a margin of approximately $2.3 billion as of December 31, 2014. The results of our 2014 loss recognition test were driven by changes to assumptions and methodologies primarily impacting claim termination rates, most significantly in later-duration claims, and benefit utilization rates. Claim termination rates refer to the expected rates at which claims end. Benefit utilization rates estimate how much of the available policy benefits are expected to be used. Changes to our claim termination rates and benefit utilization rates in our long-term care insurance business decreased our margin by approximately $5.4 billion in 2014. We also included an assumption for future anticipated rate actions which increased our margin by approximately $4.9 billion in 2014.
"In the fourth quarter of 2014, we began including future rate actions in our loss recognition testing in addition to those rate actions that had already been filed and approved or awaiting regulatory approval. Our assumption for future anticipated rate actions is based on our best estimate of the rate increases we expect given our claims cost expectations and uses our historical experience from rate increase approvals. In addition, we reviewed other assumptions, particularly related to claim frequency, lapse rates, morbidity, mortality improvement and expenses, and updated these assumptions as appropriate, which had a modestly favorable impact on our margin in the aggregate.
In 2015, the results of our loss recognition testing on our long-term care insurance block, excluding the acquired block, indicated that our DAC was recoverable and reserves were sufficient, with a margin of approximately $2.5 billion to $3.0 billion as of December 31, 2015."
Our loss recognition testing margin increased in 2015 mainly due to the updated assumptions and methodologies implemented during 2014 and from higher anticipated premiums driven mostly by our anticipated future in-force rate actions. The assumption for future anticipated rate actions increased our margin by approximately $6.0 billion, an increase of approximately $1.1 billion from 2014.
We assume a static discount rate that is in line with our current portfolio yield. Our discount rate assumption for our long-term care insurance block, excluding the acquired block, was 5.24% in 2015 and 5.23% in 2014"
So basically it all comes down to whether these assumptions are realistic and I believe they are not for the following reasons:
Reason 1: The company assumes it’s going to get 25%+ annual rate increases with 70-80%+ approval success rates. While I am sure the company can get rate increases at some point the regulators are going to balk at continuing to give it such high increases. Goldman Sachs did an interesting analysis that the probability of getting rate increases decreases to 50% and below 18% rate growth on the third successive filing increase request. Additionally, the industry approval rate in the last few years has been 10-15% while the company assumes an approval rate of 70 – 80%. Given the long term tail nature of this business and how many fillings they will need I believe the law of numbers is against them. Even a 10% decrease in approvals will result in $600 million in charges. There is a large disconnect between industry data and the company assumptions. If they were to be at industry averages it would result in over $3 billion in charges/capital strengthening.
Reason 2: The company’s discount rate is very high. The company assumes its portfolio yield as its discount rate of 5.25% (noting that its life insurance segment’s yield is 4.97%). The company has 22% of its portfolio coming due in the next 5 years while the US Treasury yield dropped more than 50 basis points (though rebounded) this year. I believe there is significant risk to profits given that its yield is over 5.24%.
I am not the only one with this concern. This was brought up on the last earnings call. I was not impressed with this answer. Say what you want about sell side, but Jimmy Bhullar is a great analyst so he gets to the heart of the matter.
I believe that the company’s assumptions on new rate increases and portfolio yields are too aggressive and it will need to take an additional $2.0+ billion in charges (and likely capital infusion) to strengthen this business regardless of what happens with the reorganization.
· Rating downgrades are a wild card and have already resulted in loss of business:
· The company’s RBC ratio fell below 400% to 393% in the “midnight Friday night filing of its 10k” where it disclosed its NY sub had $355 million deficit in reserves, $160 million more than previously anticipated. This wont impact any dividends but just shows the further deterioration of the LTC business
The company had a material weakness in 2014 (which is why it took over a $1 billion in LTC charges between 2014 and 2015). The weakness seems to have been resolved but there is an ongoing review of the pre 1995 block and leaving a potential for more massive write offs on the benefits side. This also obviously strains management credibility on the issue of assumptions under pinning the reserves.
Appendix 1: Company’s disclosure on liquidity in 10k in risk disclosures and liquidity discussions:
Our internal sources of liquidity may be insufficient to meet our needs and our access to capital may be limited or unavailable. Under such conditions, we may seek additional capital but may be unable to obtain it. We need liquidity to pay our operating expenses, interest on our debt, maturing debt obligations and to meet any statutory capital requirements of our subsidiaries. Genworth Holdings currently has approximately $3.8 billion of outstanding debt that matures between 2018 and 2066, including $0.6 billion that matures in 2018, $0.4 billion that matures in 2020 and $1.1 billion that matures in 2021.
Our existing cash resources are not sufficient to repay all outstanding debt as it becomes due, and therefore we will be required to rely on a combination of potential liquidity sources to repay or refinance debt as it becomes due, including existing and future cash resources, new borrowings and/or other potential sources of liquidity such as issuing additional equity or asset sales. Market conditions and a variety of other factors may make it difficult or impracticable to generate additional liquidity on favorable terms or at all. Any failure to repay or refinance our debt as it becomes due would have a material adverse effect on our business, financial condition and results of operations.
To the extent we seek additional borrowings to satisfy our liquidity needs, the availability of additional borrowings depends on a variety of factors such as market conditions, the general availability of credit, the overall availability of credit to the financial services industry, and our credit ratings and credit capacity. If we were required to raise additional debt today, we do not believe we would be able to raise borrowings on acceptable terms or at all, based on current market conditions and our credit ratings and financial condition. There is no guarantee that any of these factors will improve in the future when we would seek additional borrowings. Disruptions, volatility and uncertainty in the financial markets and downgrades in our credit ratings may force us to delay raising capital, issue shorter term securities than would be optimal, bear an unattractive cost of capital or be unable to raise capital at any price.
GNW 2015 10-k on liquidity:
“During the years ended December 31, 2015, 2014 and 2013, Genworth Holdings received cash dividends from its subsidiaries of $522 million, $630 million and $497 million, respectively. Genworth Holdings’ international subsidiaries paid dividends of $522 million, $630 million and $317 million during the years ended December 31, 2015, 2014 and 2013, respectively. Dividends from our international subsidiaries in 2015 included $173 million of proceeds from the sale of additional shares in our Australian mortgage insurance business in May 2015 and approximately $50 million of the remaining proceeds were distributed to Genworth Holdings through payments made under tax sharing agreements in the third quarter of 2015.
Dividends from our international subsidiaries in 2014 included approximately $500 million from the net proceeds of the IPO of our Australian mortgage insurance business. There were no dividends paid to Genworth Holdings by its domestic subsidiaries during the years ended December 31, 2015 or 2014. Genworth Holdings’ domestic subsidiaries paid dividends of $180 million during the year ended December 31, 2013. We expect our international subsidiaries to be the sole source of cash dividends paid to us in 2016 as we continue to strengthen the capital position of our U.S. mortgage insurance and U.S. life insurance businesses.
Based on estimated statutory results as of December 31, 2015, in accordance with applicable dividend restrictions, our subsidiaries could pay dividends of approximately $140 million to us in 2016 without obtaining regulatory approval. However, our insurance subsidiaries may not pay dividends to us in 2016 at this level if they need to retain capital for growth and to meet capital requirements.
Our international insurance subsidiaries paid dividends of $640 million, $630 million and $317 million during the years ended December 31, 2015, 2014 and 2013, respectively. Our domestic insurance subsidiaries paid dividends of $41 million (none of which were deemed “extraordinary”), $108 million (none of which were deemed “extraordinary”) and $418 million (none of which were deemed “extraordinary”), respectively, during the years ended December 31, 2015, 2014 and 2013.”
Risks to thesis:
I think I laid up the things that the company needs to achieve. To generate cash to pay off 2018 bonds and to make sure all the assumptions it made are going right for it. Thats a tall order but achievable. Any big transaction, such as sale of life block, progress on de-stacking insurance subs, etc will probably result in a short squeeze, etc.
- Additional reserve charges on LTC book
- Low cash generation from subs to parent
- Regulators denying the LTC re-org
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