Description

 Judging from the stock performance, low valuation, and headlines, most casual investors might assume that Genworth is primarily a US mortgage insurance (MI) company.

It's not.

It's a diversified life insurer (spun out from GE in 2004 with a history dating back to 1871 and operations in 25 countries). GNW has three primary operating businesses: Retirement & Protection, International, and US Mortgage Insurance. Retirement & Protection consists of life insurance, annuities, wealth management, and long-term care health insurance. International consists of mortgage insurance in Canada and Australia and payment protection in Europe. MI in Canada and Australia are very different businesses from in the US and remain solidly profitable for Genworth.  Payment protection provides for insurance against accident, sickness, and unemployment. In US Mortgage Insurance, Genworth is a top 5 player in a fairly concentrated market.

US mortgage insurance makes up only 10% of GNW's total revenue.  It is almost a rounding error. US MI's impact on the bottom line has obviously been outsized recently and insurance losses can extend far beyond the revenue collected, but the table above is meant to demonstrate that Genworth will very likely be able to ride out the storm hitting the US mortgage insurance industry.

Genworth's Balance Sheet
In addition to the serious problems in its US MI business, Genworth was rocked by escalating mark-to-market (MTM) losses in its $65B investment portfolio. Bankruptcy was priced in last November, with the stock plummeting to 71 cents. The accumulated other comprehensive income on the balance sheet (i.e. net investment losses) went from +$0.7 billion in Q4/07 to -$3.1 billion in Q1/09 in conjunction with substantial realized losses as well. Book value per share fell from $31 at the end of 2007 to $19 at the end of Q1/09. However, the marks have reversed sharply the past two quarters and AOCI actually stood at a positive figure ($23M) at the end of the third quarter, with book value at over $25. This is remarkable. As a general observation of third quarter results and conference calls, it is remarkable how little attention the improved balance sheet of many financial companies has received. Many analysts are complaining about the low earnings (but they're positive!) in the midst of a severe recession.

Retirement & Protection
Annual earnings for this division are down from a pre-crisis run-rate of roughly $750M to $400-500M currently, primarily due to sensitivity to the depressed stock market. While earnings are down, this is a solidly profitable business with sticky assets and customers that should continue to benefit over the long-term from the secular trend of retiring baby-boomers. In the meantime, these earnings have helped to absorb losses in the US MI business, thus insuring GNW's own survival. 

International
Genworth's Canadian mortgage insurance business earned $45M in Q3/09, down from $58M in Q2, largely reflecting the partial IPO. In an effort to shore up its balance sheet and reassure investors, Genworth IPO'd 42.5% of its Canadian insurance business in July, generating $705M in proceeds. This has hurt earnings going forward, but it allowed GNW to avoid any government assistance as well as retire all long-term debt due in 2009 and 2010. Genworth has only one competitor in Canada, the Canadian government, which is a very rational player. This beneficial arrangement is set to continue for the foreseeable future.

Australian MI earnings were up sequentially from $32M to $42M, and have yet to report a loss as well. Genworth has noted in recent presentations that house prices have actually increased in the past quarter in both Australia and Canada, which should prevent any future losses from occurring, even if the recession does drag on. Additionally, the company has recently noted it is getting 20% price increases in 2009 on top of 17% increases in 2008. Given mortgage delinquencies of only 0.42% in Canada and 0.48% in Australia compared to 3.84% in the US, it is clear these businesses are quite different from their US counterpart and very attractive for Genworth. Slide 14 from GNW's recent investor presentation has some great information detailing the differences:  http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9MzUwMjU3fENoaWxkSUQ9MzQzNDI2fFR5cGU9MQ==&t=1. GNW has only one other major competitor in Australia, a favorable competitive dynamic comparable to that in Canada, which should also continue for the foreseeable future.

Payment Protection (i.e insurance for accidents, sickness, job loss similar to what Aflac offers) in Western Europe was a mild concern, but earnings rebounded in Q3 (to $12 from $4M in Q2) on top of strong prices increases. Given the lagging nature of unemployment, it is very possible that claims continue to rise, but it looks as if prices increases and renegotiations have more than offset this.

US Mortgage Insurance
This business has been a disaster for Genworth. It lost $116M in 3Q/09 (including a $62M legal settlement) and will probably lose near $500M for the full year and $510-200M next year. However, at the KBW insurance conference on September 9th, CFO Kelleher noted prospects for the US MI business are bright, with 35% price increases YOY and 20%+ ROEs on new business, even as high as 35%, with better risk parameters. Volumes on this new business are low, however, because of fierce competition from a new competitor-the Federal Housing Administration (FHA), whose market share in US MI has gone from 4% in 2006 to 33% today. The WSJ had a great article today (November 12) on why the FHA's market share is likely unsustainable. Delinquency rates on its 2008 book of loans, already over 15%, are on track to be the worst on record. (By contrast, Genworth's 2008 delinquencies are near 4%.) As the FHA recognizes its substantial losses, it will be forced to step back, creating room for GNW to step up and write a lot more business at highly profitable rates. This could be a huge wave for Genworth.

Surprisingly, none of GNW's major pure-play competitors in this space (MGIC, RDN, and PMI) have gone bankrupt, although TGIC is in regulatory mandated run-off and there are serious concerns about PMI. If PMI does fail or goes into run off, it will not be very long before investors begin to recognize GNW as one of the top 3 players left that has the capital strength to write lots of new attractively priced business with ROEs north of 25%.

Recent Capital Raise
In addition to the Canadian MI IPO, Genworth successfully completed a $622M secondary offering of stock in September-55M shares at $11.27 per share. Both of these transactions were mildly dilutive to future EPS, but have done much to improve GNW's regulatory capital and leverage. While insurance regulatory ratios are even more confusing than bank regulatory ratios to many non-specialists, the TCE ratio (tangible common equity divided by total assets) will improve nicely, from a low of 5.8% in Q1/08 to an estimated 9.7% for Q3/09. It is a solid balance sheet with excess capital and plenty of capacity to absorb losses from the mortgage insurance operations for a few more quarters.

Valuation
GNW currently trades at 45% of its Q3/09 of Q3's $25.42 stated book value and 50% of its $22.80 tangible book value. Genworth still has issues to work through, but it is making money and within a relatively short time-frame (4 or 5 quarters), US mortgage insurance will go from being a huge earnings head-wind to a substantial tail-wind. Companies with positive earnings, stable balance sheets, and strong pricing trends tend not to trade at such sharp discounts to tangible book for very long. With a little luck, GNW can earn $1.00+ of EPS in 2010 and $2 in 2011. With the stock at $11, there is still considerable upside.

Catalyst

Mortgage insurance losses decline sharply and new volumes pick up as FHA pulls back.