Description

Recommendation

•  Buy Radian Group (RDN) stock at $20.74/sh (~6.4x normal earnings, sub-1x trailing BV) for conservative base case 1-year returns of 33%, with a realistic blue skies case yielding returns 75%+

Company Description

• RDN provides private mortgage insurance (PMI) to home buyers in the US (also has a small fee-based services business.) Per their charters, the GSEs are unable to purchase mortgages that have LTVs above 80% unless the lender provides a form of credit enhancement, the most common of which is PMI; at a high level, PMI allows homebuyers to make a down payment of less than 20% of the value of a home at purchase. RDN receives premiums from the borrower and provides mortgage default protection on a percentage (typically 25%) of the unpaid loan principal, delinquent interest, and expenses associated with a default and subsequent foreclosure or sale of the property. MI usage skews toward first-time homebuyers (average insured loan of $230k, low-90%s LTV at origination)

Situation Overview

• Since the onset of the Covid pandemic, Mortgage Insurer (MI) equities, and in particular RDN have meaningfully sold off (down around 20% from the pre-Covid highs.) The market has been concerned around the impact of rising unemployment on MI insurance portfolios, especially as delinquencies and forbearance rates began to rise
• RDN sold off in tandem with other credit-sensitive stocks early in the pandemic. However, as the economic and consumer credit outlook has improved, RDN has lagged the recovery:
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• Despite the relative weakness in RDN, we see a healthy set-up in the housing market. The entry-level residential real estate market is particularly solid, given historically tight inventory balances and strong demand. This is reflected in homebuilder stocks (see: DHI up ~50% since the beginning of 2020) and positive HPA through 2020 (December median national home listing price grew by 13.4% YoY per realtor.com):
• ACGL 2020 Investor Day
• This dynamic is important, as the trend in home prices is the single largest determinant of claims experience. Increasing home prices gives the borrower a multitude of options to avoid foreclosure, including a sale of the property. As an example, competitor NMIH estimated at its recent investor day that in a scenario with +10% HPA on a 95% LTV mortgage, claims severity would equate to just 9% of risk in force (for reference, in a -10% HPA scenario, they estimated severity of 68%)
• Anecdotally, the pandemic has stoked housing demand (arguably better than pre-pandemic trends), especially among first-time homebuyers; the “value” of a home has never been higher with shelter at home orders and increased working from home. Coupled with the tight inventory backdrop, we are bullish on this positive trend continuing, especially at the entry-level (where the MIs have the most exposure)

Why does the opportunity exist?

• Poor track record in 2008 recession – The MIs struggled during the 2008 Financial Crisis (RDN reported several years of loss ratios in the 200%+ range from 2008-11.) However, RDN and the industry is fundamentally different today than in 2007. A combination of much tighter mortgage underwriting, new risk-based capital requirements for the MIs, more rational competition, and the greater use of reinsurance to protect capital in downside scenarios has desrisked these businesses. We expect RDN to weather the economic dislocation from Covid with fairly limited claims experience which should highlight the resiliency of its book
• Complex sector – We believe the market does not fully understand the tail risk benefit to these reinsurance structures and or correctly bracket the potential range of cumulative losses in a stress scenario. At their 2019 investor day, RDN calculated a stress scenario (10% unemployment / 26% HPA decline) would result in a loss ratio under 70% / $1.1bn of cumulative earnings off their book. Our bottoms-up loss modeling analysis has corroborated this claim
• Niche space within broader equity market – Despite the volatility in the MI names, we believe they are relatively underfollowed (especially compared to larger sectors, like cards.) The total market cap of the pure-play MIs is just $15bn; we believe many don’t view the sector as “worth the time”
• Economy questions, housing – While the economy and housing has held up so far, we’ve heard concerns around a “second wave” of layoffs; whereas the “first wave” largely impacted blue collar workers (largely renters), some fear this “second wave” could have a larger impact on white collar homeowners. We view the resilience of the housing market and the quality of RDN’s book as sufficient to weather any incremental headwinds here with effective vaccines/economic reopening on the horizon

Price target (1-year forward)

• Base case - $27.50 (+33%). We project normalized earnings of $3.23/sh in 2022 assuming a gradual recovery in the economy, with the delinquency rate ticking down to ~3% over the next 24 months. We believe that a name like RDN should trade for ~10x P/E through the cycle (though we could argue the benefits of reinsurance / quality of the book should justify a multiple in the low teens); to reflect some potential lingering uncertainty around the direction of the economy, we apply a 15% haircut to arrive at an 8.5x target P/E multiple
• Realistic blue skies case - $36.50 (+76%). We see substantial excess capital generated over the coming years. Assuming half this excess capital is used to repurchase shares, we project normalized earnings of $3.65/sh. We apply our undiscounted 10x fair value multiple to this figure

Catalyst

• 1) favorable credit/reserve development given positive HPA 2) curing delinquencies as mortgages near the end of their forbearance programs 3) improved capital return outlook 4) potential FHA price cut concerns being proved out as a small earnings impact 5) potential industry consolidation M&A 6) RIF growth given purchase origination outlooka