Recent media speculation of a potential takeover bid for QBE Insurance Group (QBE), dismissed by the company, suggests foreign investors see value in large-cap insurers. Better opportunities exist in undervalued small- and mid-size insurers in niche fields.
There are tentative signs that small business policy premiums are stabilising after a period of declines. That’s good for insurance brokers. Continued strength in property markets helps mortgage insurers that are vulnerable to a spike in loan delinquencies.
Genworth Mortgage Insurance Australia is an example. With 40% market share, Genworth is the country’s leading provider of Lenders Mortgage Insurance (LMI). Banks use LMI on their highest-risk residential mortgages.
For example, a couple that borrows 80% or more of the value of a property from a bank will typically be required to have LMI. That helps the bank manage its credit risk and reduces its exposure to property in the event of a severe downturn.
Mortgage insurers are the worst stocks to hold when property markets tumble, such is their leverage to loan stress and delinquencies. The United States housing crash in 2008 slaughtered that country’s mortgage insurance industry, sending several providers into delinquencies.
A chorus of property bears might warn against investing in Genworth Mortgage Insurance Australia, such is its leverage to Australia’s hot property market. A weakening economy and sharp falls in local property prices, should they occur, would lead to a deterioration in loan delinquencies that lasts longer than expected. Genworth’s earnings and dividends would face immense pressure.
The market has partly factored that view into Genworth. The stock tumbled from a brief peak above $5 in February 2015 to $2.48 a year later. Genworth rallied to $3.50 but cautious commentary in its FY16 result, released last week, drove the price to $2.91.
Chart 1: Genworth Mortgage Insurance Australia
Source: Yahoo Finance
Genworth’s underlying net profit of $212 million for FY16, down almost 20% from a year earlier, was in line with market expectation.
The concern was management’s bearish FY17 guidance and commentary. Genworth expects a 10-15% fall in net earned premium growth and a full-year claims ratio loss of 40-50%.
That’s a significant deterioration from Genworth’s FY16 guidance of a 5% drop in net earned premium growth and a full-year claims ratio of 25-30%. Genworth expects rising mortgage stress and higher loan delinquencies in FY17 in regional economies.
Genworth’s outlook is particularly challenging in the mining states of Queensland and Western Australia, which face higher loan delinquencies, amid the resource sector contraction.
Customer re-contracting risk is another headwind. Some of Genworth’s biggest banking contracts are up for renewal in the first half of this calendar year. A recurring threat is more banks self-insuring against loan defaults or providing alternatives to traditional LMI. Also, the prospect of lower lending volume growth, as big banks lift scrutiny on applicants with lower home deposits, could reduce demand for LMI. Macquarie Group this week said interest-only loan applicants would have to provide information on their weekly spending, to help the bank assess the borrower’s capacity to meet repayments.
Regulatory pressures on bank lending for property is another ongoing challenge for LMI providers, given its potential to slow lending growth and LMI demand.
Modest valuation multiple
The key question, as always, is valuation. Genworth looks undervalued at $2.91. Possibly significantly so, if the property market holds up better than expected. All bets are off if a property slowdown turns into a meltdown, but I do not see that happening.
Make no mistake: parts of the property market are ripe for larger price falls. Investment properties in Brisbane, for example, because of apartment oversupply; higher loan delinquencies for residential property in WA is another concern.
Credit ratings agency, Moody’s, in October said mortgage delinquencies in WA, Tasmania and the Northern Territory hit a three-year high. Several regional towns in mining states are experiencing rising mortgage stress as mining jobs are lost.
But much has happened in the resource sector since October. A commodity price rally, lasting longer that most commentators expected, has buoyed resource-sector sentiment and boosted share prices of many mining stocks and service providers.
More junior explorers are raising capital again to develop tenements or move towards products. That’s good for mining jobs and, in time, mortgage repayments.
It’s too soon to say the worst is over in mining, or that loan delinquencies will not climb higher. Still, rising commodity prices and greater mining activity should alleviate some pressure on loan delinquencies in the resource states. Enough, at least, to suggest Genworth’s FY17 claims loss ratio guidance of up to 50% is too conservative.
The crucial Sydney and Melbourne property markets continue to strengthen, despite never-ending predictions of a price collapse. Yes, property is overpriced in the big capitals. But what matters for Genworth is the ability of borrowers with highly geared loans to meet their repayments.
Record-low interest rates and reasonable employment levels should restrain growth in mortgage stress and loan delinquencies this year. Both will continue to edge higher, but not by enough to justify a sharp de-rating in Genworth’s share price. Interest rates are unlikely to head higher anytime soon and unemployment levels should remain steady. Also, consumer sentiment rebounded in February, showed the latest Melbourne Institute/ Westpac survey. And business confidence soared in January, suggesting the economy is strengthening, reported the National Australia Bank this week.
Yes, plenty of consumers are doing it tough. But much of the media gloom about the economy is looking backward. Forward-looking indicators are improving, not dramatically but enough to suggest predictions of a national property crash are, yet again, overstated.
On balance, the macro outlook for Genworth, while deteriorating, is not as bad as the company’s valuation or bearish outlook commentary implies at the current price.
Capital position supports dividend outlook
Micro factors add to the long-term investment case. Genworth has a strong balance sheet and its required level of regulatory capital declined by $224 million over 12 months. That implies Genworth has excess capital of about 35 cents a share, if it were to reduce capital held to the top of its target range, based on Macquarie numbers.
That has two implications. First, that Genworth is well provisioned should loan delinquencies rise faster than expected in the mining states. And second, that Genworth can maintain an attractive dividend by paying out after-tax profits as ordinary or special dividends in the next year or two.
Morningstar forecasts 23.5 cents in dividends per share in FY17, for an 8.2% yield at the current share price. After full franking, the grossed-up yield is an expected 11.7%. That’s attractive in a low-rate market, provided Genworth holds its forecast dividend.
A decent capital return to shareholders in the next few years, as Genworth releases excess capital, is another possibility. This yield outlook, and Genworth’s ability to maintain its dividend, should attract income-focused investors and support the share price.
At $2.91, Genworth trades on a forecast Price Earnings (PE) multiple of 9 times FY18 – modest for a well-run, well-capitalised company that leads its market.
A consensus of four broking firms, too small to rely on, has a median price target of $3.93, suggesting Genworth is materially undervalued at the current price. Macquarie’s 12-month target is $3.56. Morningstar’s fair value is $3.
I am not as bullish on Genworth as the consensus, but Macquarie’s $3.56 target is plausible. If that occurs, Genworth will deliver a total return (including dividends) of about 30% over 12 months.
However, caution is needed. Genworth’s potential for higher earnings volatility makes it unsuitable for conservative income investors. This is not a stock for the risk averse or those who believe property is ripe for a large correction and mortgage stress will spike.
Investors who can look through the gloom will see a company that is prepared for a larger increase in delinquencies, should it occur. And a valuation that is factoring too much bad news for a property market that keeps defying the bears.
Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at February 14, 2017.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
