In this note we provide an update on the proposed acquisition of Genworth Financial, Inc. (‘Genworth’) by China Oceanwide Holding Group (‘Oceanwide’) which was announced in October 2016 and approved by shareholders in March 2017.
The transaction is facing uncertainty due to rising geopolitical tension between US and China. Approval from regulators has been delayed and the deadline for the merger agreement has been pushed back to November 2017 from August 2017. This uncertainty is reflected in the current share price of USD3.41 and is at a 37% discount to the deal price of USD5.43 per share.
If successfully closed, we see upside for the 2021 bonds, as the new Genworth would have been recapitalised whilst preserving the underlying strengths of the residual businesses. However, should the deal not proceed to final close, Genworth will face a challenging predicament that will compromise its business profile. Given this, at the current mid-price of $96 and a YTW of 8.81%, we think that the bonds are expensive and there is likely to be a better entry price in future.
Genworth provides long term care (‘LTC’) and mortgage insurance (‘MI’) products and services throughout the US, Canada and Australia. The market leader in LTC, in early 2016, the group announced it would cease the sale of Life and Annuity products (excluding LTC) following persistently weak sales and longer payouts as life expectancy increased. This effectively placed that business into run off and positioned the US MI business as the main driver of value for Genworth where mortgage insurance continues to generate strong revenue growth.
In October 2016, Oceanwide offered a lifeline to Genworth, announcing an all cash USD2.7bn takeover bid (USD5.43 per share) plus an additional cash injection into Genworth to meet the 2018 maturities and facilitate USD700m cash injection into the life insurance businesses. Oceanwide is a privately owned Chinese company which is majority owned by Mr Lu Zhiqiang, who in 2016, Forbes ranked as the thirtieth richest person in China, with a net worth estimated to be USD5.2bn.
China Oceanwide acquisition update
Elevated event risk
The current state of affairs between US and China may prove to be a dampener for the proposed acquisition of Genworth by Oceanwide. Geopolitical tensions along with personnel changes at the key regulators are delaying the transaction.
The deal is subject to numerous regulatory approvals including US, China, Canada, Australia and Mexico. It is widely expected that approval by the Chinese authorities should be forthcoming given the transaction will allow Oceanwide to develop a LTC insurance business in China which is lucrative with its large proportion of aging population. The head of the Chinese insurance regulator recently departed and the position is yet to be filled which is adding to regulatory delays. We note though that in the event that China declines the deal, Oceanwide is required to pay Genworth a break fee of USD210m.
Canada and Australia are expected to approve the transaction as it does not adversely affect the management or capitalisation of the entities they regulate.
On 13 July 2017, Genworth and Oceanwide withdrew and refiled their submissions to the Committee on Foreign Investment in the United States (CFIUS) for the second time to allow the CFIUS more time to review and discuss the proposed transaction. CFIUS is responsible for reviewing foreign direct investment entering the US for national security concerns. While it is not unusual for companies to have to refile with CFIUS, it is unknown whether the delay is caused by specific details in the transaction, personnel changes at CFIUS or political pressure relating to China. However the CFIUS does not disclose details regarding specific transactions in order to protect the parties involved.
The second CFIUS refiling by Genworth and Oceanwide commenced a new review period which could take up to 75 days to complete. The merger agreement deadline, therefore, has been extended from 31 August 2017 to 30 November 2017. Both Genworth and Oceanwide have reiterated that they remain committed to the transaction.
Genworth has received approval from the insurance bodies in Delaware and Virginia for reinsurance and recapture transactions required as a condition to the purchase of Genworth Life and Annuity Insurance Company (‘GLAIC’) by Genworh Holdings, Inc. (‘Holdco’/’Issuer’) from Genworth Life Insurance Company (‘GLIC’). With this hurdle cleared, Genworth still has to convince the regulators to allow the transfer to Holdco for no more than USD700m, which is one of the closing conditions of the transaction. Transfer of GLAIC to the Holdco will unlock an additional source of dividend capital for Genworth.
As noted previously, should this transaction fail to close, then Genworth is likely to explore asset sales to finance and resize the business.
Share price reflecting uncertainty
On 29 August 2017, Genworth shares closed at USD3.41, a 37% discount to acquisition price of USD5.43 per share reflecting the scepticism of the market regarding the transaction.
What happens if it is a ‘No Deal’
The Oceanwide transaction includes USD600m set aside to specifically address the 2018 debt maturity in May 2018. Genworth holds sufficient liquid assets on hand to meet the maturity in 2018; holdco cash and liquid assets were $860m at 30 June 2017 and management aims to hold cash of 1.5x annual debt service plus $350m buffer at quarter ends. However, we believe that liquidity will be constrained going forward.
Post 2018, liquidity and debt repayment capacity is likely to be challenging if the deal does not close. Issuing new bonds with current credit ratings and liquidity profile will be an expensive and a difficult exercise. Management have noted that asset sales, including potential sales of Canadian and Australian mortgage insurance and/or partial sale of the US mortgage insurance units are all possibilities.
Genworth owns 57% of Genworth Canada and 52% of Genworth Australia. Based on current price, Genworth’s share of the Canadian and Australian mortgage insurance units is worth USD1.5bn and USD610m respectively. Bonds issued out of the Australian mortgage insurance unit do not have a change of control clause and so any sale by Genworth of its offshore operations will not trigger early repayment.
Failure to close will slow down US Life restructuring plan
Genworth targets to meaningfully separate and isolate the US Life segment from its long term care business given low sales and revenue from the US Life segment. Separating the businesses will also allow Genworth to unlock dividends to send to holdco. Separation of these businesses is a pre condition of the transaction. Should the deal not close then the separation of businesses will slow down as the $175m cash Genworth has put aside for this will be required for liquidity purposes. As the Life business is effectively in run off, it is unlikely Genworth will be able to receive a good purchase price should it decide to sell the arm.
2Q17 results (quarter ended 30 June 2017)
Genworth reported strong 2Q17 earnings that beat analyst expectations, helped by strong US and Canada MI and LTC businesses. Net income for the quarter was USD202m, up 17% from 2Q16, and includes USD51m of net investment gains.
US MI reported adjusted operating income of USD91m (2Q16: USD61m) and loss ratio of just 2% (2Q16: 24%). The loss ratio benefitted from USD10m favourable reserve adjustment; including the impact of the reserve adjustment, the loss ratio would still have been low at 10%.
Canada MI also had a strong quarter with operating income of USD41m compared to USD38m in 2Q16. The loss ratio fell from 20% a year ago to 4% due to lower new delinquencies and strong cure activity reflecting strength in the housing market. Australian MI operating income was USD12m compared to USD15m in 2Q16 and the loss ratio was relatively unchanged at 34% compared to 36% reported in the prior year with commodity dependant regions of Queensland and WA underperforming.
LTC operating income of USD33m (2Q16: USD37m) benefitted from higher premiums and higher reserve releases. Life insurance operating income was USD1m compared to USD31m a year ago and reflected higher lapses and accelerated amortisation of deferred acquisition costs.
Capital ratios were strong across all regions. The holding company had USD858m cash and liquid assets at the end of the quarter.
As noted above, if the deal is successfully closed, we see upside for the 2021 bonds as the new Genworth would have been recapitalised whilst preserving the underlying strengths of the residual businesses.
However, should the deal not proceed, investors with appropriate risk appetites may look to opportunistically reinvest in the bonds at potentially lower prices and wait for the debt to be paid from the monetisation of assets.
At the current valuation we believe the bonds are expensive and there is likely to be a better entry price in future. There is a high degree of geopolitical risk and event risk attached with the Oceanwide transaction and investors should expect volatility in the price of the bonds until clarity is gained on the merger.
Note: Prices accurate as at 24 August 2017 but subject to change; indicative only
Sources: FIIG Securities, Bloomberg