Essent’s Catalyst Is The End To Economic Uncertainty (ESNT)

Published on the Value Lab 1/6/22

Essent (NYSE:ESNT) is a private mortgage insurer (PMI), which means that it sells insurance in order to reduce LTVs on loans where downpayments are too low for GSE and the standards of most lenders. FICO scores of underlying borrowers are high, and reserves are actually shrinking since being frozen at COVID-19 danger levels, and macro indicators still look good for the company despite a very compressed multiple. The risk for them is claims from mortgage defaults, which are at historically low levels. Reserves should account for this, and there is a margin of safety for the US economy to suffer more before ESNT’s economics get serious affected. There are other latent cyclical elements that could improve the company’s profile too as the economic pressures mount. Overall, ESNT looks too conservatively priced, but we’d rather stay away from businesses that respond so strongly to perceived economic conditions.

Notes on Q3

The quarter was pretty interesting. Insurance in force continued to grow 7% despite pressures on home prices and rising interest rates to crimp borrowers. Borrowers are still taking loans with low downpayments, which was not expected given the position in the economic cycle. Credit qualities remain really good with 746 FICOs, and a IIF portfolio that is backed by the AI EssentEDGE, which tries to pick high quality borrowers with FICOs that undervalue their profile. They continue to close transactions that are limiting claims risk by reinsuring their portfolio – the vast majority of their portfolio is subject to some degree of reinsurance, but the costs of doing so rise while pricing for PMIs lags. Premiums written grow slightly, but the pressure from poorer investment performance is affecting the bottom line with about 10% declines in net income.

Reserves remain in line sequentially more or less, and the declines YoY are substantial as COVID-19 effects have finally been revised, after having been conservatively frozen at crisis levels for some time.

There are beginning to be signs of some delinquencies and defaults as the US economy faces rising pressure from rising rates, but the alarms are not ringing yet. Claim rates are still well below historical levels at below 1%, when historically they’re between 2-3%. There is margins for worsening economic conditions before ESNT’s economics really suffer, and unemployment is the metric that decides ESNT’s performance most of all. Thankfully, job growth continues despite deceleration.

Bottom Line

We think that the ESNT multiple looks low at 4.9x PE. The reasons are of course that investment incomes are under pressure, and it seems that a hard landing scenario is priced in still. We believe more and more strongly in the possibility of a soft landing, but there are other reasons why ESNT may see improvement.

Firstly, returns are at a little above 2% in their investment portfolio, but higher fixed income rates have improved returns to 4% as of the latest quarter. That is the current run rate performance and it could be locked in with duration, which we think would be the right move. As always, fixed income dominates the profile of insurance investment portfolios.

The other thing is that P&C insurance pricing continues to rise. This could draw capacity away from mortgage insurance and help pricing. On pricing, ESNT has also been slower to price up and is gaining market share. They have scope to raise prices, and doing so will improve their economics. Finally, with claims rates being so low, when they rise, and the reserves should account for a return to normal at least so there shouldn’t be a large cost to income, there should be scope to raise prices then as the industry can rationalize them higher.

The company does not look like it’s going to change its dividend profile based on its comments – it will focus on balance sheet – but the earnings yield is very high at over 20%. ESNT is a quality stock, and while a worsening economic picture will affect their stock performance, we don’t think the economy will get bad enough to dramatically revise their risk profile. It’s decent value at this price.