Genworth Attractive But Not Without Risk

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-Higher risk profile
-Leveraged to weak economy
-Uncertain volume outlook
-Capital return potential
 

By Eva Brocklehurst

Genworth Mortgage Insurance Australia ((GMA)) recently listed on ASX and several brokers have initiated coverage, quietly confident in the long-term outlook for the business while accepting the higher risk nature of the loans covered by this type of insurance.

On a relative basis, as the company caters to the most extreme tail events in the residential mortgage market, brokers expect the stock will trade at a discount to financials with similar return profiles. Macquarie notes Genworth Australia has benefitted from higher premium rates, lower risk products and improved underwriting since the Global Financial Crisis. The micro reforms that have been subsequently undertaken have potential to deliver several years of earnings growth, capital returns and an improving return on equity for the stock. This presents an attractive investment opportunity, in the broker's view.

As the Australian housing market has been resilient over the past 15 years, Genworth largely becomes an undifferentiated leveraged exposure to the tail of the residential market, in terms of either an economy-wide slump, period of higher unemployment and limited income growth, collapsing house prices and/or persistent inflation. The share price could react severely to any of these scenarios. In the meantime, conditions are supportive.

CIMB has a number of concerns. None the least is the structural outlook for the industry. As lenders increasingly retain risk in-house, the company's business mix will shift higher up the loan-to-valuation (LVR) curve. The claims outlook appears supportive and the lower-for-longer interest rate scenario should keep delinquencies suppressed. Having said that, CIMB observes the current investor-led rally in Australian east coast property looks somewhat speculative. Heeding recent warnings on lending standards emanating from the Australian Prudential Regulation Authority (APRA), a mild correction is a near-term risk in the broker's view.

Goldman Sachs considers the business is particularly leveraged to weaker macroeconomic conditions, which could drive lower demand for homes in Australia and lower house prices, higher unemployment and insufficient income to pay mortgages. Nevertheless, in the broker's view, these risks are overstated by the current share price, which implies a significant probability that Australian house prices will experience a sharp fall. Goldman observes the company's insurance margin is very strong – even in the "re-provisioning" year of FY12 the margin was 14% compared with Australian major listed non-life insurers at around 10-15%. APRA standards are stringent and so the broker accepts that, despite high margins, underlying return on equity is quite modest at around 10% in FY13.

CIMB notes a high degree of uncertainty in terms of the volume outlook, with a contraction in new insurance written over the medium term. The broader mortgage approval environment remains strong but is also likely to be at peak levels for this cycle, in the broker's view. Moreover, the market's composition is not particularly supportive, led by investors, as first home buyers have faded from the scene. Major customers, generally the banks, are retaining greater levels of risk and CIMB thinks momentum on this front will build while the credit environment is benign.

Mortgage insurers do have a degree of pricing power and relative pricing is important. Over the past four years, Genworth Australia has re-priced rates, but management does not expect to increase rates in FY14. CIMB assumes no further re-pricing but expects the average premium rate will creep higher, affected by the mix-shift to higher LVR business. Goldman Sachs notes, as the older policies run off and are replaced by new higher returning policies, this should provide a progressive improvement in return on equity, translating to around 9% growth in underlying earnings per annum over the next three years. The broker thinks the stock offers good value and the target of $3.45 implies a 16% total return versus 10% for the broader financials. Goldman initiates with a Buy rating.

Macquarie initiates with an Outperform rating and $3.43 target. The broker believes the company has the potential to return capital through optimising capital efficiency through tier 1 and tier 2 instruments and/or adding reinsurance. Taking a relatively conservative view, Macquarie expects 142c per share could be returned over the next three years, boosting an already high dividend yield, should Genworth Australia move to a more optimal capital structure and include additional reinsurance.

The broker is mindful that capital return scenarios are subject to rating agency and regulatory considerations and constraints. Therefore, current forecasts do not factor in any capital returns as these initiatives are highly uncertain. CIMB suspects that, while yield remains in vogue, the stock will be well supported for its dividend flexibility, but swings in sentiment should provide better buying opportunities. CIMB has a Hold rating and initiates with a target of $3.26.

Lenders mortgage insurance is a specialist line that protects the mortgage provider in the event that a borrower cannot repay their loan. Lenders generally use mortgage insurance for loans originated with an LVR ratio of 80% or greater. The product is called a "long tail" because premiums are earned over an 11-year period, in Genworth Australia's case. The two largest providers in the industry are Genworth and QBE Insurance ((QBE)), having roughly 80% of the market. Historically, the product was used by lenders for capital relief and risk transfer. CIMB notes the future of this type of insurance in Australia will become largely centred on risk transfer. Well over half Genworth Australia's share of the market comes from the major banks.

UBS has also this morning initiated coverage of Genworth, setting a Buy rating and $3.50 target. The broker agrees the stock offers favourable cyclical drivers and will further benefit as the pre-GFC years roll off the insurance book.

The FNArena database now shows tow Buys (or equivalent), two Holds and a Sell. The consensus target price is currently $2.90, suggesting 11% upside.
 

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