Market Musings - December 21, 2017
We continue our blog series: Market Musings, Volume 1, Edition 17, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present Genworth's Plan B.
We have a medium-sized position in Genworth Financial (ticker GNW), which in October 2016 signed an agreement to be acquired by China Oceanwide for $5.43/share in cash (see merger PR here). We previously posted our analysis of the likelihood of completion of this merger (see here). GNW's management is still attempting to obtain regulatory approvals for the China Oceanwide deal, well over year after the deal was first announced. In late November, they provided the following status update (source):
The overriding goal of those in GNW's C-suite should be to avoid (at all costs) ending up like Rite Aid (ticker RAD). Similar to GNW, RAD had a binding merger agreement with Walgreens (ticker WBA) to be taken out at $9/share in cash. Unfortunately for RAD shareholders, management had no real backup plan in the event the WBA merger fell through, which of course happened in June of this year when the FTC blocked the deal. Without a viable Plan B, RAD's management had to improvise the following transaction (source here):
The new deal clearly did not satisfy stampeding exiting arbs, who have sent RAD shares down ~75% since the beginning of this year, when rumors that the FTC was opposed to the transaction first began circulating:
Clearly, the only way to succeed in negotiating is by doing so from strength. This means having options, since having a viable Plan B allows one to simply walk away if Plan A proves unpalatable or not feasible (and therefore the counterparty cannot dictate the terms of a transaction). With respect to RAD, the company's massive debt burden meant that it had few attractive alternatives in the event the WBA acquisition fell apart.
In GNW's case, the market has voted with its pocketbook and sold the company's stock down to the low $3.20s recently, meaning that the spread between the merger and market prices has reached an astounding 40%. Why so large? Company management has totally failed to communicate to the market that it retains options other than the China Oceanwide merger--and naturally the market leaps to the conclusion that therefore none exist. Inexplicably, at the recent annual shareholder meeting GNW's CEO McInerney even went to the extent of actively talking down the company's stock price and undermining GNW's negotiating position (source):
David Robinson [shareholder]: On the liquidation value, if life and long-term care was zero, do you not see, I mean you have done the calculations, is there not a liquidation value in the $5 to $6 range that we can go ahead and move forward on rather than trying to pursue this deal with Oceanwide? I mean, can you not just liquidate the mortgage insurance businesses $3.5 billion it looks like for USMI, which is not a rich premium relative to the market today. You see what the value is in Canada and Australia and you zero out long-term care and life and can you not liquidate and get more than $5.43?
Tom McInerney [CEO]: Mr. Robinson, I think that’s a difficult question to answer. I would say that I think the values that you have for USMI and I think that’s at the high end of the range, but in any event, there is no question that [while selling] the U.S. mortgage insurance business, the Canadian business and the Australian business would produce significant cash, almost all of that cash would be needed to pay off the debt, because to pay off the debt with that cash you would have to pay out the debt at premiums and therefore you would be left with very little cash left from selling all of those strong producing businesses. Also the Canadian and Australian businesses, the Catch 22 in selling that is today we have debt service payments of over $200 million a year and those are the two entities that pay the debt service. So, that’s also a challenge, because you had by selling all of those you would eliminate all of the cash paying, dividend paying capacity of the company. And so I think the shareholders will be left with very little cash at the end of that and the life and long-term care insurance businesses which are dependent as I said on $6 billion to $8 billion, $7 billion is our current estimate of future premium increases.
So, if we are able to achieve those premium increases, then perhaps the value of that businesses are zero, but if we are not able to achieve those premium increases, then the life in the LTC business probably has a negative value. And I think if you look at our stock price today, because I think the market itself is doing a similar analysis to what you are doing, Mr. Robinson. And I think what their conclusion is this is the liquidation value of the MI subsidiaries, then you pay off of [the debt] and here is [what] you are left with. And I think the share price today at $3.40 or thereabouts and that has some value in it for the fact that the deal may close at $5.43. So, I do think...that [if] this deal doesn’t close, even despite the other plans which would include selling some of the businesses, you would likely end up with a price lower than where the stock price is today. So, I believe very strongly I think it’s the view of the board based on the input of all of our outside advisors that $5.43 from Oceanwide still is the best deal for shareholders, because it provides a certain value or cash and eliminates the downside risk of our inability if that should occur of getting the future premium increases.
David Robinson [shareholder]: The deficit of long-term care, I mean, we still don’t go below zero, I mean, we are not going to owe, it can go bankrupt, but the shareholder is not going to go in rears just on that deficit. Is that not correct? I mean, can you not walk away and if you cashed out and I don’t know how big a premium you are talking about on paying back to debt holders?
Tom McInerney [CEO]: But again, I would say Mr. Robinson very difficult to answer that question. All of our businesses are highly regulated by state insurance departments as well as other entities. And so to the extent that there was a issue with our long-term care business and an insolvency of that business there it is unclear from a legal perspective what all the regulators who control USMI – will regulate USMI, the Australian subsidiary, the Canadian subsidiary, our life and annuity subsidiary, which is the Virginia and our New York subsidiary what they will do. So, it’s very unclear that you could just walk away from the LTC business and that insolvency that’s up to courts and all of that. So again I think from a shareholders perspective to take the risk all of that is a lot more downside risk than the certainty of this deal at $5.43 per share.
Why would the CEO go to such lengths to knock down the idea of a Plan B for GNW? Why does he try to scare shareholders into believing that GNW could be torpedoed by its LTC liabilities, despite the fact that the holding company no longer is required to support the LTC insurance subsidiary (for which, see further below)? Why is he so illogically insistent that the China Oceanwide deal is the one and only option that will save GNW shareholders from the abyss? Probably because he's incentivized to do so. First, below are the huge payouts for the CEO and other senior management in the event the merger with China Oceanwide goes through (source):
Second, CEO McInerney was promised the role of CEO of the company resulting from the China Oceanwide deal, which is expected to expand LTC operations to the China market. In effect, not only will McInerney receive millions of dollars directly as a result of the closing of the transaction, he will also preside over the expanding insurance empire which is expected to take form post-merger (and one can only assume he will be compensated accordingly). So the Oceanwide deal is clearly a win-win scenario for Mr. McInerney, even if it's not for GNW shareholders. No wonder he's trying to talk down the idea of a Plan B!
Of course, when the interests of a CEO and those of the shareholders conflict, it is the job of the board of directors to step in and defend the shareholders, to whom they owe fiduciary duties. Board members owe no duty of loyalty to the CEO. If they fail in this role, they should be removed by way of a proxy contest. Thus far the GNW BoD appears to be asleep at the switch, allowing CEO McInerney to dictate everything despite his obvious conflicts of interest. Unfortunately, it seems that GNW's directors care more about the gravy train of easy paychecks for part-time work that accompany their directorships than their duty to require the CEO prioritize shareholder interests.
In our view, despite McInerney's protestations, GNW retains plenty of viable Plan B options if the China Oceanwide deal were to fall through. Among them could be the following:
(1) Rights offering and/or China Oceanwide strategic investment in GNW equity (which could include a JV in China for LTC) to pay down the $600MM Note maturity in May 2018;
(2) IPO of the U.S. MI business, with proceeds to pay down the $600MM Note maturity;
(3) Sale of shares of the Canadian and/or Australian MI businesses to pay down the $600MM Note maturity;
(4) Separation of the MI business from the Life/LTC business, so that the market would be forced to value each separately (and GNW would get credit for the sum of its parts). GNW could issue tracking stocks or do spinoffs. In this respect, note that the GNW's BLAIC capital maintenance agreement expired in October 2016, therefore there is no longer any obligation that the holding company use funds from other insurance subsidiaries to support LTC (source):
(5) Longer term: look to de-stack Life & LTC via a separate transaction--if not possible, simply let them run off. Regulators and policyholders will be better off if de-stacking is allowed (assuming this occurs in connection with an equity infusion into LTC).
DISCLOSURE: Long GNW and RAD.