Change afoot at Genworth?

Company faces new pressures after departure of its founding CEO

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Print this page by Tim Loughran

For now, it’s Martin Klein’s job to boost investor confidence in Genworth Financial Inc., the Henrico County-based Fortune 500 company best-known for its mortgage, life and long-term-care insurance products.

The task won’t be easy. In mid-July, Genworth shares had declined more than 85 percent from their 2007 high of $37 and were down 40 percent in the past 12 months.
Klein, a Wall Street veteran (formerly of Lehmann Brothers and Barclay’s Capital), was hired as chief financial officer by Genworth’s founding chairman and chief executive officer, Michael Fraizer,  last year.

In May, he assumed the additional titles of acting president and interim CEO when Fraizer abruptly resigned. At the same time, lead director James S. Riepe took over as nonexecutive chairman of the board.

“Fundamentally, all management changes create some uncertainty and disruption,” said JP Morgan Chase senior analyst Jimmy Bhullar in assessing the new leadership, adding, ironically, “Wall Street generally does not like managers from Wall Street. Investors prefer top managers to have considerable operational experience in the industry.”

While Klein deals with skeptical investors, his bigger challenge will be to determine whether Genworth remains in its current form or jettisons some business units through sales or spinoffs. The clock is ticking. According to sources, the company has told investors and analysts it plans to make a decision within the next few months.

A reshaping of Genworth’s businesses would be the latest chapter in its repeated efforts to escape the effects of the housing bust and financial crisis of 2008-09.

A victim of what’s been called the world’s deepest economic slump since the 1930s, Genworth had losses of $572 million in 2008 and $460 million in 2009. The company posted $142 million in net income during 2010, but last year profits declined to $122 million, a drop of 14 percent.

In 2012, first-quarter net income decreased by 20 percent — to $47 million from $59 million — compared with the first three months of 2011, in part because of unexpected losses in Genworth’s Australian mortgage insurance unit.  (Second-quarter earnings released on July 31 were $76 million, or 16 cents per diluted share, compared with a loss of $136 million, or 28 cents per diluted share.)

Ratings change
In June, Moody’s Investor Service announced that it had cut its financial strength rating of Genworth’s U.S. Life Insurance division and would review for a possible downgrade its ratings of the parent company and its U.S. mortgage insurance business. In the parent company’s case, a one-notch downgrade of its senior unsecured debt would change its status from “investment grade” to “junk.”

In response, Klein told shareholders in an open letter that he and other Genworth executives were disappointed with Moody’s downgrade and promised “we will continue to improve the financial strength and operating performance of these businesses.” The holding company has cash and highly liquid securities totaling $1.4 billion, a level that Klein said is well above its target of maintaining cash balances of at least twice its annual debt service expenses.

In the same letter, Klein said the company’s executives and board of directors were working to strengthen its capital structure and “realign our business portfolio.” Those four words raised fresh hopes that Genworth soon might sell or spin off its money-losing U.S. mortgage insurance operations, a move many impatient shareholders have long advocated.

During the company’s annual shareholders’ meeting in May, according to news reports, Riepe said the company was working with outside advisers in an “intense review” of the company’s business operations and assets. (“The review of the strategy is complete,” Klein said in a conference call with investors on Aug. 1. However, he said the company “will not discuss specific transactions until the appropriate time.”)

In addition, Boston-based hedge fund Highfields Capital Management, which owns 5.2 percent of Genworth’s outstanding shares, said in a Securities and Exchange Commission filing in late June that it was talking with the company’s management about its “global mortgage insurance assets, its U.S. mortgage insurance assets and its retirement and protection businesses,” adding that its discussions would include “possible sale or spin of assets.”

Klein and Riepe declined interview requests from Virginia Business to discuss their plans. Company officials, however, have told investors and analysts that, possibly as early as September, they plan to reveal the businesses it will keep or sell and announce the hiring of a permanent CEO.

Genworth spokesman Al Orendorff said the company had not released any such timetable.

Citing analysts Mark Palmer of BTIG and Steven Schwartz of Raymond James, Dow Jones Newswires reported in late June that Genworth might consider selling the majority stake it still owns of its Canadian subsidiary, some or all of its Australian mortgage insurance unit as well as its U.S. wealth management division.

Dow Jones said, however, that Genworth might not want to sell its U.S. mortgage insurance unit — the root of most of the company’s recent troubles. 

First, the mortgage insurance operation already is operating under a waiver from the North Carolina Department of Insurance because its capital did not meet a key benchmark, the news service reported. If the state regulator opposed plans to sell the mortgage insurance business, it could revoke the waiver, preventing the unit from selling new policies. (Klein reported during the August conference call that the company had received an 18-month waiver extension from North Carolina regulators through July 31, 2014.)

Secondly, the parent company risks losing $1.76 billion in valuable future tax benefits it has accrued from its previous mortgage insurance losses if it sells that business, the news service reported. “If they separate the mortgage insurance out, they lose a lot of tax benefits,” Schwartz told Dow Jones. “That has always been the issue. It hasn’t changed just because they got a new CEO.”

On top of those concerns, Genworth expects the U.S. mortgage insurance business finally to become profitable next year. “The Moody’s review for downgrade may bring all these decisions to a head,” Palmer said in an interview with Virginia Business. “The difficult thing from the company’s perspective is that the U.S. mortgage insurance business is now trending the right way. You’ve seen some improvement there. It would be a tough thing to cut off that business when its trajectory is improving.”

(During the August conference call, Klein said options for spinning off or selling the mortgage unit “may not be viable at this time due to potential capital required to execute the transaction.”)

Back from the brink in 2009
Fraizer (who also declined to be interviewed for this story) engineered the spinoff of Genworth from GE Capital in 2004. When the company sold its first shares on Wall Street, the economy was booming after the slump that followed the September 2001 terrorist attacks in New York City and Washington, D.C.  Interest rates were low, consumers felt flush, and Genworth’s products were in demand as home sales soared and baby boomers began their retirement planning in earnest. 

Four years later, however, the real estate bubble burst, financial assets began to crumble, and the wheels came off the economy. Genworth’s fortunes turned sharply south. Unemployment rates not seen in decades caused near-record numbers of foreclosures in the United States and many of the international markets where Genworth does business, requiring the company to pay hundreds of millions of dollars in mortgage insurance claims in 2008 and 2009.

In the normally recession-proof Richmond area, where more than 1,200 of Genworth’s 6,400 employees work, three major employers disappeared in 2009:  Fortune 500 electronics retailer Circuit City, Fortune 1,000 title insurance giant Land America and the computer chipmaker Qimonda.  Some feared that Genworth would join them.

Fraizer won praise for leading the company’s comeback in 2009 and 2010 from a “near-death”experience. The company raised more than $700 million in emergency cash when it sold a 44 percent stake in its Canadian subsidiary. It also sold $600 million in new shares of the parent company while repaying more than $660 million in short-term debt.

The company’s stock, which fell as low as 84 cents a share during the worst of the financial crisis, made a partial recovery. In 2010, for example, when the stock had risen to about $17, Bloomberg Businessweek magazine and other media outlets dubbed it the S&P 500 Index’s “Comeback of the Year.” But by July last year, the stock price had slipped below $10 a share.

The Australian IPO
In the past two years, the company has restructured its divisions, sold some ancillary businesses to focus more energy on its largest operations and added cash to protect against additional mortgage insurance losses.

In addition, Genworth earlier this year was finalizing plans for an initial public offering of a minority stake in its Australian mortgage insurance unit as it had with its Canadian subsidiary three years ago. While increasing Genworth’s capital, some of the IPO’s proceeds also would be used to repurchase shares from investors.

A number of Genworth shareholders — pinched in recent years by a see-sawing stock market and consistently low returns on bonds and other fixed-income financial assets — previously had lobbied management to use some of its cash to pay dividends or repurchase shares. (Genworth paid its last cash dividend in October 2008.)

Genworth executives said that rating agencies like Moody’s, Fitch and Standard & Poor’s had advised against such moves. They favored a long-term strategy, setting aside as much extra cash as possible to promptly repay bonds and loans and to cover possible losses in case mortgage insurance claims continued to rise. The IPO would give the company the opportunity to buy back shares without dipping into its cash reserves.

During his last quarterly conference call with investors in February, Fraizer discussed the timing for the IPO. “We still anticipate a second-quarter 2012 execution,” he said. “We have not encountered any regulatory or market conditions that would change that timing.”

In late March at the JPMorgan Insurance Conference in New York, Klein told investors that mortgage insurance operations in Canada and Australia were expected “to remain solid,” according to Bloomberg News.

But about three weeks later, on April 17, Genworth postponed the IPO until early 2013. The company said it expected to report “elevated loss experience” in Australia for the first quarter as later-stage mortgage delinquencies processed by lenders resulted in a higher rate of insurance claims and bigger claim payments. Company officials later explained that, while the overall mortgage insurance business in Australia remained strong, an unexpected spike in claims and average claim payments during March led the company to conduct an extensive review of its inventory of later-stage delinquencies. As a result of that probe, the company increased its loss reserves by $82 million, creating an operating loss of $21 million for the unit for the first quarter.

Postponement of the IPO angered many investors awaiting the repurchase of their stock, and Genworth shares plummeted 24 percent, from $7.70 to $5.87. The selloff apparently stemmed from some investors’ simmering frustration. “They had hoped management could extract more value from the company’s various businesses, and there was a desire to see greater return of capital,” said Palmer, the BTIG analyst. 

The company announced Fraizer’s resignation two weeks later. “I’m kind of stunned by [the CEO’s departure],” Andrew Kligerman, a stock analyst at UBS Securities, told The Wall Street Journal. “Genworth has experienced incessant negative pressures for the last four-plus years, and I think it must have been enough for Mike Fraizer at this stage.”

“The Genworth team has accomplished much as we built the business and since the company went public in 2004,” Fraizer said in a statement. “After navigating through the recent financial and housing crisis, and as the company transitions to the next generation, I believe this is the right time for me to move on to other opportunities.”

Klein and Riepe praised his stewardship of the company in a difficult environment. “Under Mike›s tenure as CEO, he has nurtured a commitment for making a difference for the people who rely on us most: our customers, policyholders, employees, communities and industry,” Klein said during a May conference call with investors. “This has helped set a strong foundation to build from.”

In that conference call, his first as interim CEO, Klein reached out to the company’s largest investors. “I appreciate your frustration and as part of our leadership transition, we will actively review and seek to improve our processes, to avoid such frustration in the future,” he said.

In line with that promise, he kept expectations low, announcing that Genworth would be “unlikely” to repurchase shares any time this year.

In addition to Highfields Capital Management, the company’s major shareholders at the end of the March included Fidelity Management and Research; Legg Mason Capital Management LLC; Dodge & Cox of San Francisco; BlackRock Institutional Trust Co. N.A.; Thornburgh Investment Management of Santa Fe, N.M; the Vanguard Group Inc. and State Street Global Advisors.

While company executives expect some volatility in Australia’s results in coming months, they believe the mortgage insurance business there will be profitable this year, according to the conference call. They also noted that, overshadowed by results in Australia, operating losses in the U.S. mortgage insurance unit were $43 million in the first quarter, down from $96 million the previous quarter and $83 million during the same quarter last year. (In the second quarter, the Australian mortgage insurance unit had an operating profit of $44 million while the operating loss at the U.S. unit declined to $25 million.)

Analysts’ forecasts
At press time, JP Morgan Chase stock analyst Jimmy Bhullar maintained his “neutral” rating on Genworth shares, even as he projected a possible rise to $9 a share by the end of 2012.

 At the end of the first quarter, Genworth calculated its book value per share (or assets minus liabilities) at almost $30. The stock’s recent trading range of $5 to $6 made it among the cheapest for all publicly traded insurance companies or financial services companies selling products similar to Genworth’s, according to Dow Jones Newswires. 

“The stock is very attractive on valuation, if it was not we would be even more cautious,” said Bhullar. On the down side, “the U.S. market should recover, but we don’t know how long that will take, or if Australia’s weakness continues,” he said. “They don’t have a great franchise in many of their product lines … It’s not a growth story.”

More optimistic is analyst Ed Shields of Sander O’Neill + Partners in Chicago, who has a “buy” rating on Genworth. He projects Genworth shares could reach $9.50 each by this time next year.

“Home prices appear to be stabilizing. House sales are happening. There continue to be more and more short sales, rather than outright foreclosures,” he said. “There are some glimmers of positive developments.”

“The biggest issues facing the company have more to do with the amount of capital that’s trapped at the company,” he said. “It’s money they can’t put to work. Normally they could buy back shares, but they are not in a position to do so. Whenever they have any excess capital, the most immediate use is to shore-up those [loss] reserves. What if there’s a double-dip recession, followed by another round of unemployment? It’s sort of a vicious cycle.” 

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