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Morningstar | Tightening Credit Standards, Lower Growth and House Price Falls Prompt a Reduction in Genworth’s FVE

A change in analyst leads to a downgrade to no-moat Genworth’s fair value estimate to AUD 2.55 per share from AUD 2.70. The reduction is prompted by our expectation the recent downturn in the Australian economy, including the systemwide fall in home loan growth to 4.9% in 2018 from 6.8% in 2017 and declining Australian home prices will persist over the near term. This is likely to reduce the level of new insurance written and increase claims. The deterioration in the economy could also lead to lower interest rates, which would reduce the returns on Genworth’s investment portfolio. Tightening lending standards, which we expect to continue, is leading to lower high loan/value ratio, or HLVR, loans and this, combined with the loss of two major customers, are the main reasons for Genworth suffering high-single-digit to double-digit falls in new insurance written, or NIW, each full year since it listed in May 2014. These are also the main reasons net earned premiums, or NEP, have progressively reduced each year, compounded by an actuarial assumption change in 2017.

In the face of these challenges, we think the company has managed its capital well, paying all aftertax profits by way of ordinary and special dividends since listing, and instituting share buybacks while maintaining a strong balance sheet. However, despite an enticing fully franked 2019 dividend yield of 8.6% at our fair value estimate, Australia’s weakening home-loan credit growth, historically high home-loan debt levels, and continuing house price correction prevents us being more positive on the stock.

We expect a 3.6% increase in NEP in 2019, within management’s guidance range of between negative 5% and positive 5%, and a material improvement from the sharp 24.1% fall in 2018. Genworth recognises earned premiums based on actuarial assumptions and a change in these assumptions in 2017 and lower HLVR housing credit growth are the main causes of the steep NEP fall in 2018. Specifically, the actuarial assumption for the average duration period in which revenue is recognised lengthened by about 12 months, because, among other things, longer claim periods emerged from losses in mining-related regions. The negative impact on NEP due to these assumptions has progressively reduced to AUD 23.2 million in the fourth quarter 2018 from AUD 37.3 million in the fourth quarter 2017 and we expect impact to be lower in in 2019 before providing some payback from 2020.

We forecast a loss ratio (net claims incurred/NEP) of 51.5% in 2019, within management’s guidance-range of 45% to 55%. Softening cure rates, in addition to the NEP reduction from the actuarial assumption changes, led to the company’s loss ratio increasing to 51.9% in 2018 from 38.3% in 2017. Australia’s deteriorating economic conditions were also reflected in Genworth’s delinquency rate jumping 7 basis points in 2018 due to higher delinquencies from a low base in New South Wales and a continuing high delinquency rate in Western Australia. We expect incurred claims to increase to about AUD 160 million in 2023 from about AUD 146 million in 2018, but these losses are expected to be fractionalised over moderately higher NEP, mainly due to a payback from the 2017 earnings curve assumption changes from 2020 onwards.

Both the NEP and loss ratio forecasts assumes a continuing decline in systemwide home loan growth. We forecast Australia’s system wide home loans (investor and owner-occupier based on Australian Bureau of Statistics seasonally adjusted data) to increase by a CAGR of 4% in the next five years, compared with a CAGR of 6.3% in the previous five years. A combination of factors are expected to cause the decline, including Australians holding historically high levels of home loan debt, and APRA and lenders continuing to focus on strengthening lending criteria, with RBA liaison research noting the average maximum loan size offered to new borrowers falling by around 20% since 2015. Additionally, we expect the combination of continuing low wages growth and historically high average-dwelling-prices-to-average-annual-disposable-income to contribute to the ongoing decline in home prices which will likely lead to a continuing fall in the demand for credit. Our forecast also expects Genworth to average NIW on 26% of new the home loans issued over the next five years, compared with our estimate of an average of about 30% in the previous five years. The lower proportion of NIW is mainly due to our assumption of a lower percentage of the new home loans being HLVR loans because of ongoing credit tightening and general risk averseness by lenders.

Although we expect subdued Australian economic growth, Genworth’s fair value estimate does not assume a sudden major economic slow-down or a sharp rise in unemployment from current levels. Australia’s real GDP fell to a lower-than-expected annualised rate of 2.3% in December 2018, below the RBA’s forecast of 2.8% and its estimate of Australia’s potential growth rate of 2.75%. Nonetheless, Australia has recently been recording strong employment growth, with the unemployment rate sitting at 5%, the lowest level since 2011 and falling from 6.1% in 2014. The RBA recognises the tension between these two major economic data points and indicates it is currently devoting significant resources in understanding this tension, while also noting recent labour market data has been encouraging. The concern is this tension will be resolved by higher future unemployment. More so than most other businesses, Genworth’s fundamental value is sensitive to Australia’s economic conditions. A plausible scenario of lower GDP, higher unemployment, a reduction in the availability of credit, and further falls in house prices is likely to have the compounding impact of simultaneously reducing Genworth’s NEP and increasing its incurred claims, while also likely leading to lower interest rates, reducing the returns on its investment portfolio.

Regardless, we expect ongoing low interest rates will continue to restrain the return on its investment portfolio. This portfolio not only generates returns for shareholders but also provides backing for unearned premiums and insurance claims. This restricts the level of risk the company can tolerate under its own risk management policies and APRA risk weightings. Consequently, the portfolio predominantly comprises high investment-grade, mainly “A” and higher-rated fixed and floating government and corporate debt and AUD cash. The low-interest rate environment has led to investment returns of below 3% in 2017 and 2018 and we expect sub-3% returns in the next few years.

We also don’t believe Genworth possesses a sustainable competitive advantage and expect it will be unable to generate a ROE above its cost of equity through the economic cycle. Despite its large market share and some barriers to entry from a high level of regulation, we think the negotiating power of its customers and the availability of alternatives to LMI for managing risk plus its sensitivity to Australia’s economy means it doesn’t have a moat. The other major LMI provider in Australia is QBE Lenders' Mortgage Insurance but Genworth’s competitive position from this duopolistic industry structure has been challenged recently when it lost Westpac Bank as a customer of its core HLVR LMI product in 2015 and Macquarie Bank in 2017 both to Bermuda-based Arch Capital Group. The market also includes two wholly-owned subsidiaries of two of Australia’s big four banks which are licensed to provide LMI to their parent. The dominance of Australia’s four major banks in providing home loans in Australia also means Genworth faces significant customer concentration risks. Its major customer, Commonwealth Bank, accounted for 60.1% of Genworth’s gross written premium, or GWP, in 2018 and this contract is up for renewal at the end of 2019.

On a more positive note, we believe the company’s strong balance sheet will allow it to continue its share buyback program, forecasting share buybacks of AUD 100 million per year for the next three years. Lower NIW and the seasoning of older poorer performing loan books is reducing its APRA prescribed capital amount, or PCA. The lower PCA is mainly due to materially lower probable maximum loss, or PML, levels. The PML level is calculated assuming a three-year economic and property downturn at an APRA-determined 1-in-200-year severity level. The PML amount has fallen to AUD 1.7 billion in 2018, from AUD 2.6 billion in 2013. Therefore, despite material falls in statutory profits, it has been able to maintain a strong PCA coverage ratio of a little over 1.9 times at the end of 2017 and 2018, well above its internal target range of 1.32-1.44 times. Excess capital has been returned to shareholders by way of ordinary and special dividends and it bought back AUD 149.1 million worth of shares in 2018.