A year ago, I thought that Genworth (NYSE:GNW) was a high-risk insurance story that was trading at a substantial discount to its long-term value. With the stock up almost 130% since then, I feel pretty good about that call. Looking at the company again today, though, I'm not nearly as optimistic about the stock. While the stock is still undervalued on a long-range ROE model, the growing challenges in mortgage insurance and long-term care insurance bode poorly for nearer-term value creation.
U.S. Mortgage Insurance Profitable Again … But Will It Last?
One of the relatively few bright spots in Genworth's first quarter results was the return of the U.S. mortgage insurance business to profitability. Prices for insurance have been improving recently, and the U.S. housing market has been looking better. While that was a nice result, I'm sorely concerned that it will not last.
On the whole, I don't think the company has huge legacy issues to worry about, but competition is a different story. Radian (NYSE:RDN) and MGIC (NYSE: MTG) have recapitalized with the intention of writing more business (and near 52-week highs), and the outlook for better rates has led Arch Capital (Nasdaq: ACGL) to get into the business through its acquisition of CMG. With NMI Holdings also writing policies again, the U.S. mortgage insurance market is getting more crowded and I don't see how this is a good thing for Genworth.
Long-Term Care Is Under Pressure
With the exit of MetLife (NYSE:MET), Prudential (NYSE:PRU), and Unum (NYSE:UNM) from the market, Genworth is far and away the largest underwriter in long-term care insurance with more than one-third of the market. Unfortunately, I'm of the opinion that when a well-run insurance company like MetLife decides to get out, it doesn't say a lot of good things about the companies left behind.
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To that end, reserve deficiencies in the LT care market are getting a lot worse. Low interest rates are certainly hurting, but so too is greater than forecast loss severity. Genworth is looking to respond with steep rate increases (as much as 50% over the next three to five years in some cases), but it sounds as though that's only going to allow older blocks to reach breakeven. The company is also looking to start capping benefits, but it's unclear if regulators will sign-off on this and/or whether Genworth will lose business to rivals like CNO Financial (NYSE:CNO) and Manulife (NYSE:MFC).
Life Insurance Pressured
Life insurance is still a meaningful business for Genworth, but this too is not doing particularly well. A lot of the trouble can be tied to the low rate environment, but I think Genworth is also just not as good at underwriting or running a life insurance business as MetLife. Consequently, while higher rates would definitely help the business, I think it's going to be hard for the company to achieve “industry standard” returns over the long term.
The Bottom Line
Genworth isn't nearly as appealing today as it was a year ago. I do believe the company may have to shore up the long-term care business, and I think management may find it harder to pass through the rate increases than they currently believe (though lapse rates have been low, and could stay low on the uncapped policies). What's more, I do believe that increased competition in the mortgage insurance market is going to squeeze the company – if I have to place a bet between Arch Capital and Genworth, I'm betting on Arch Capital winning.
Valuation on Genworth shares is pretty mixed today. Using a long-term return on equity model, I believe Genworth can attain long-term ROEs of 7.5%, and that works out to about $16 per share today. Looking at tangible book relative to returns on equity and assets, though, I think Genworth's industry-low returns merit a sharp discount to tangible book value. In essence, I believe that the company's returns are running close to half the cost of equity, meaning that the company is destroying economic value. Accordingly, looking at a long-term regression analysis of the industry suggests that the appropriate multiple is 0.5x, leading to a $11.60 target/fair value.
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If you belief that stronger housing demand will keep mortgage insurance rates up even in the face of competition, I suppose there's an argument for hanging on to Genworth shares. Between the entry of new mortgage insurance rivals and worsening conditions in long-term care insurance, though, I think Genworth is a better source of funds than a destination for them.