Essent Group Ltd (ESNT) 2017 Q2 法說會逐字稿

Good morning, my name is Chris, and I will be your conference operator today. At this time, I would like to welcome everyone to the Essent Group Ltd. Second Quarter 2017 Earnings Conference Call. (Operator Instructions) Thank you. Chris Curran, Senior Vice President of Investor Relations, you may begin your conference.

Thank you, Chris. Good morning, everyone, and welcome to our call. Joining me today are Mark Casale, Chairman and CEO; and Larry McAlee, Chief Financial Officer. Our press release, which contains Essent's financial results for the second quarter of 2017 was issued earlier today, and is available on our website at essentgroup.com in the Investor section. Our press release also includes non-GAAP financial measures, that may be discussed during today's call. The complete description of these measures and the reconciliation to GAAP may be found in Exhibit L of our press release. Prior to getting started, I would like to remind participants that today's discussions are being recorded and will include the use of forward-looking statements. These statements are based on current expectations, estimates, projections and assumptions that are subject to risks and uncertainties, which may cause actual results to differ materially. For a discussion of these risks, please review the cautionary language regarding forward-looking statements in today's press release, the Risk Factors included in our Form 10-K filed with the SEC on February 16, 2017, and any other reports of registration statements filed with the SEC, which are also available on our website. Now let me turn the call over to Mark.

Thanks, Chris. Good morning, everyone, and thank you for joining us today. I am pleased to report that Essent posted another solid quarter of financial results. Portfolio growth, strong credit performance and ongoing expense leverage continue to drive our high quality and growing earnings. As a franchise that invests in U.S. mortgage credit risk, we are well positioned in growing our insured portfolio and generating strong returns. Our outlook for Essent and our industry remains positive as the MI business is correlated to housing and weighted towards purchase mortgages in first-time homebuyers. We believe that demographics, such as the millennials entering in their peak buying years, are contributing to a strong housing environment. In fact, the largest cohorts of the millennials are between the ages of 25 to 27 years old, while the average age of the first-time homebuyer is approximately 32. This demand, combined with builders increasing supply to first-time homebuyers with price points in the low 200,000s, is good for housing.

Now, let me touch on our results. For the second quarter, we earned $72 million, an increase of 38% compared to $52 million for the second quarter a year ago. On a per diluted share basis, we earned $0.77 for the second quarter of 2017 and generated a 20% return on average equity. In addition, we grew adjusted book value per share 22% to $15.93 compared to $13.08 as of June 30, 2016. Our increase in net income continues to be driven by growth in our insurance in-force, which increased 32% to $95 billion from $72 billion as of June 30, 2016. This growth drove a 26% increase in earned premiums to $127 million compared to $101 million for the second quarter a year ago. We remain pleased with our portfolio's credit performance and improved operating leverage. For the quarter, our combined ratio was 29.6%, while our portfolio had a weighted average FICO of 748 and a default ratio of 41 basis point at June 30. Our balance sheet is strong with $2.2 billion of assets and $1.5 billion of equity at June 30. During the first half of this year, we continue to invest capital to support higher-than-expected growth as our portfolio increased 15% compared to 11% for the same period in 2016. To enhance financial flexibility during the quarter, we amended our credit facility by increasing it to $375 million and extending the term to 2021. At June 30, we had $175 million outstanding on the facility with $200 million in revolving capacity. Looking forward, we expect to continue investing capital to support growth and evaluating strategies that further enhance financial flexibility and strengthen our capital position. In Bermuda, we continue to execute on our 25% affiliate quarter share and investing in GSE risk share transactions. Essent Re has become another platform to invest in U.S. mortgage credit risk, at returns that are accretive to our franchise. At June 30, Essent Re had $538 million of equity and $5.2 billion of mortgage risk.

Turning our attention to the regulatory front. The GSEs have told us that they project PMIERs 2.0 going into effect in the fourth quarter of 2018 after a 180-day notice period. Prior to finalizing, we anticipate that our industry will have an opportunity to review and comment on the updated standards. We look forward to working with the GSEs on the updated PMIERs and continue to believe that strong and transparent standards are a long-term positive for our industry, policyholders and shareholders.

Finally, in Washington, we continue to monitor policy discussions regarding GSE reform and housing finance. It remains our view that the administration and policy makers are supportive of more private capital being used to support mortgage credit risk. Accordingly, we believe that Essent and our industry are well positioned to play a larger role in supporting a robust and well-functioning housing finance system. Now let me turn the call over to Larry.

Thanks, Mark, and good morning, everyone. I will now discuss our results for the quarter in more detail. For the second quarter, we reported net income of $72 million or $0.77 per diluted share. Net income for the quarter increased 38% as compared to $52 million for the second quarter of 2016. Earned premium for the second quarter was $127 million, an increase of 8% over the first quarter of $118 million, and an increase of 26% from $101 million for the second quarter of 2016. The average premium rate for the second quarter was 53 basis points, which was consistent with the first quarter of 2017 and down from 57 basis points for the second quarter of 2016. The decrease in the average premium rate compared to the second quarter of last year is primarily due to a lower level of singles cancellation income. We remain pleased with the credit performance of our insured portfolio, ending the quarter with a default rate of 41 basis points compared to 45 basis points as of March 31, 2017, and 36 basis points as of the end of the second quarter of 2016.

Our provision for the quarter was $1.8 million compared to $3.7 million for the first quarter and $3 million for the second quarter a year ago. The decline on our provision this quarter compared to last quarter continues to be driven by a decrease in the number of new defaults, net of cures, reported during the quarter.

Other underwriting and operating expenses were $35.7 million for the second quarter and our expense ratio was 28.2% compared to $36.3 million and 30.9%, respectively, for the first quarter of 2017. The income tax rate for the second quarter was 27.1%. We expect our effective tax rate for the second half of 2017 to be 27%, not incorporating any impacts of possible federal tax reform. Note that income tax expense for the first quarter of 2017 was reduced by $3 million of excess tax benefits associated with an accounting standards update that was adopted by Essent as of January 1, 2017.

The consolidated balance of cash investments at June 30, 2017, was $1.9 billion. The cash and investment balance at the holding company was $27 million compared to $41 million as of March 31, 2017. As Mark noted earlier, we amended our credit facility during the second quarter to increase the capacity from $200 million to $375 million and extend the maturity to May 2021. During the second quarter, we drew an additional $50 million under our revolving credit facility and used the proceeds to make a capital contribution to Essent Re. We also contributed an additional $10 million to Essent Re for a total of $60 million during the quarter. As of June 30, we have $200 million of undrawn capacity under the revolving credit component of the facility. The weighted average interest rate on the amount drawn under the credit facility as of June 30, 2017, was 3.2%. As of June 30, 2017, the combined U.S. mortgage insurance business statutory capital was $1.3 billion, with a risk-to-capital ratio of 14.9:1 compared to 14.6:1 as of March 31, 2017. Finally, Essent Re had GAAP equity of $538 million, supporting $5.2 billion of net risk in force.

Now let me turn the call back over to Mark.

Thanks, Larry. In closing, Essent had another strong quarter of financial performance. Our goal at Essent remains simple, and that is to build a high credit quality and profitable mortgage insurance portfolio. The Essent team does this every day by delivering best-in-class service to our lender partners and helping them grow their businesses. I am very proud of our team and all their efforts in building such a strong customer-focus franchise.

Now let's turn the call over to your questions. Operator?

(Operator Instructions) Your first question comes from Jack Micenko of SIG.

It looks like the 95 LTV product has increased a bit year-to-year, quarter-to-quarter and the FICOs are holding. So is that the banks maybe reducing overlays? Or do you think that's maybe more education on behalf of the mortgage originators around the availability of that product? What do you think it's driving some of that growth. We've seen it in others in the industry as well.

Jack, it's Mark. It's a pretty simple -- it's really the GSEs have reopened their program going back a couple of years now. And really it's -- so what you're seeing is 2 things in our portfolio. You are seeing the 95s migrate to 97s because of our 3% down versus 5. And you are also seeing some of the borrowers move over from FHFA. So you are seeing a slight increase. I think from our standpoint, we like the risk there. We have reduced coverage at the 97s, and the pricing is pretty good. So like our all-in returns at that product are really no different than any other LTV across the book.

Okay. And then, Larry, it looks like you guys took on some duration in the quarter. Is that sort of you -- the mid-part of the curve is maybe flatter longer? And maybe just talk about your sensitivity to rising rates on that home securities book compared to maybe where it was a year ago?

Sure, Jack. We have no substantial change in our strategy around the investment portfolio. In terms of rising rate, we do believe we're pretty well positioned to manage any increase in rates as it relates the portfolio. The duration is still relatively moderate at about 4. In addition, in terms of the portfolio, it's well laddered. We have about 30% of the portfolio that matures in the next 24 months. So we'd be able to reinvest that at higher rates. And I think maybe most importantly, we continue to generate a lot of cash in the core business. First 6 months of the year, operating cash flow was about $144 million. So we'll obviously have the ability to reinvest to that to the extent that our rates increase in the future as well. So we think the portfolio in the business is pretty well positioned, as it relates to any rise in the interest rates.

Okay. And then just to sneak one more in, the persistency bump sequentially about 190 basis points. Are we pretty much through the sort of the resolution of refi's that we had seen later last year at this point?

It's tough to tell, Jack. I mean, again, I think from a guidance standpoint, we would probably point you more to the kind of 78 and 80. I know it bumped up a little bit above 80 for the quarter. But tough to tell, really, where rates are going and where persistency is going to kind of stop. We tend to be a little bit more conservative in guiding you guys. So 78 to 80 is probably a good range.

Your next question comes from Rick Shane of JPMorgan.

In looking at the operating expenses, it looks like you'd sort of hit a new plateau over the last 3 quarters in the $36 million, $37 million per quarter range. And that was up and sort of plateaued in the $31 million, $32 million range. What is the trend going forward? Should we see this as a longer plateau? Or with the portfolio having continued to grow, should we expect another incremental step up sometime in the next 6 to 12 months?

Rick, it's Mark. I don't know if it's incremental. Remember, we paid premium taxes. So as the portfolio grows, that's a certain kind of percentage where the expenses will grow. We also have kind of nominal wage inflation growth. So yes, I would see slow and steady. I don't think there's going to be any jump ups, so to speak, but we have plateaued. I think we're really starting to see -- kind of grow into our portfolio, so to speak. So we would expect to see further kind of expense ratio reduction down the road. But like I said, I think, it will be more slow and steady.

Your next question comes from Bose George of KBW speak to.

First, just one on the growth. And you guys noted that growth's been higher than expected and the 32% incentive for us looks like it's the fastest level in a couple of years. Just in terms of the growth, can you sort of think about how much of that is -- the outperformance was driven by better industry growth versus better growth than expected at Essent itself?

I think it's really kind of 3 things. The industry growth is strong. And I think that really points to kind of when I said earlier in the script around housing. We follow the fortunes of housing. Housing, we think, is strong. And I think, the demographics were set up for it to remain at really good levels. Second is -- I think, growth within Essent, both on the origination side and also on the persistency side, I think, the increase kind of in persistency has helped. So you combine those 3 things, I think, that's really contributed to kind of a little bit faster-than-expected growth within the portfolio.

That makes sense. And then actually just one on seeding to Essent Re. Do you think it's possible that the level of seeding could exceed 25% in 2018? Or is that probably later than that?

It's tough to put a time line on it. It's something definitely that we have considered in the past and something we are continuing to evaluate. So I would stay tuned on that one.

Okay. Great. And then actually I know you don't like to discuss share, but I'm going to try one, anyway. The -- with all the company's reporting now, and then it looks like you've taken a fair amount of share over the last few quarters. So from a share standpoint, do you think there's any reason we should think that you should lose any share from here? Do you feel like this is a pretty stable share position for you?

Actually, no. I think we're looking forward. I would still be in that 13% to 15% range, Bose. I mean, quarter-to-quarter, it ebbs and flows a little bit. I mean, there's certain -- we've increased utilization with a few of the larger lenders, but -- and we've done that through our history, but it kind of really ebbs and flows. Looking forward, I think, really, 13% to 15% is probably a better guide for you guys. It gives us a little more flexibility, in terms of pricing and credit, and really gets back down to insurance in-force growth. So as long as we continue to grow our insurance in-force in the market at this pretty good size, I still believe 13% to 15% is probably a better long-term range for us.

Your next question comes from Phil Stefano of Deutsche Bank.

Wanted to talk about the reserve setting process. And my expectation is there might be incentives for you early in the business development to maybe have been more conservative in how you set reserves? Has there been any changes to the reserving process as the business has seasoned? Are there different confidence intervals that you book to now maybe versus you may have in 2013? Any thoughts you might have around that?

Phil, it's Larry responding to your question. No substantial changes. Really, no changes in our methodology relative to the reserves. The approach that we currently employ, we've employed for a number of years. We'll update factors each quarter based on historical performance, which we have done consistently, and it is sort of since the inception of the company. So again, our approach to reserves is very consistent from inception of the company.

Okay. And I wanted to ask quickly. It's something I haven't heard come up on the other calls, and Arch has just started to put out a realistic disaster scenario, where I -- it was the mortgage insurance equivalent of PML. Is this a number that you discuss internally? Is it something that the management is aware of, that maybe hasn't been disclosed? And one other things I'm struggling with is, when I think about modeling the path of a storm, I mean, that's something I could probably do and have a pretty good idea of what the loss of cumulation looks like there. But as far as using historical performance during downcycles to apply to the current portfolio, i.e. are there inherent difficulties in doing that when we think about what this number is?

Phil, it's Mark. You haven't followed us for that long, so I'll give you a little bit of a context. We have built the company around setting economic capital models. And it's basically based on kind of the Great Recession stress scenario. And that's really kind of how we form our capital view. It's done internally, it's not shared externally. And it's really the basis for how we originally funded the company and put capital to the company when we were private. That's how we assess capital today. We also, obviously, look at PMIERs and rating agencies as kind of binding constraints that's really kind of the core of the company is how we assess that. And yes, it's really taking the current portfolio every quarter and then stressing that on the Great Recession scenario and then looking kind of doing a simple sources and uses to make sure we have enough capital to pay our claims. So again, it's really the basis of the company, and it's, again, something we don't share. But I think, the RDS scenario is obviously a very sound technique. And I think, I'm sure others in the industry did the same thing.

Your next question comes from Mark DeVries of Barclays.

I had a follow-up question on the expenses. Larry, I think, we saw more operating leverage this quarter than we've seen in a while. Is there anything worth calling out in the quarter?

No, Mark, nothing specific. If you remember the first quarter, and historically in the first quarter, we'll experience a little bit higher level of payroll taxes associated with payment of bonuses, investing of restricted share. So that's something that you'll historically see each quarter. So that isn't as recurring. But as Mark mentioned earlier, there are some variable expenses and premium taxes will increase. But other than that, I think it's continuing to grow the top line and grow premiums and expenses starting to -- leveling out a little bit versus the first quarter.

Okay. Got it. And just a question around the credit trends, I mean, it's no surprise that everything written since 2010 has been very high quality. But it's kind of remarkable how low your default rates remain. I guess, Mark, are you surprised that the default rate still remains so low even as your book seasons here? And anything worth kind of noting about what's keeping them so low?

Yes, we've talked about this in the past. I do caution everyone, the book is still relatively young. And as we continue to grow, book remains young. That being said, Mark, there are a number of factors. And I think they are kind of more secular in nature in terms of where credit is. One is kind of the regulatory guardrails that we mentioned way back on the IPO around QM. They continued to have a positive effect on the industry. Second is really kind of a manufacturing quality that we are seeing at our lenders, I would say, it's excellent. And you put on top of that some of the enhanced QC that's been done by the GSEs and by the MIs. Lastly, and maybe the most important part, is just the credit quality of the portfolio with the average FICO being close to 750. And as I pointed out in the past, that's well above where it was, kind of pre-crisis for the MIs. I think it was closer to 700 to 705. So when you get a 750-type borrower, you're generally going to get lower DTIs, better reserves, more ability to withstand an event in their lives. So I think that's really contributed to it. Going forward, remember, that we are subject to economic swings. So I mean the economic environment has been strong too. I would just say given kind of the strength of the portfolio, we feel the portfolio is better equipped to handle some of those events, maybe than it was -- certainly, than it was in the past.

Okay. And sorry, if I missed this, but Larry, why were the provisions down both Q-over-Q and year-over-year so much? Is there any kind of like reserve adjustment that was made during the quarter?

Yes. The question came up earlier relative to our reserve methodology, very consistent from quarter-to-quarter. Really, it relates to the number and net new defaults. We're experiencing decline in the number of defaults being reported and also an increase in the number of cures.

Your next question comes from Mackenzie Aron of Zelman & Associates.

Mark, I guess, just 2 questions on the volume outlook and what you guys are seeing. First, as we're thinking about the back half and just recognizing that the year-over-year comps get more difficult compared to last year given how robust the purchase and refi trends were last year. Can you give us any sense of how we should be thinking about just modeling out for the remainder of the year? And then also, just curious if when you look at the business that's been -- being delivered over the last quarter or 2. Are you seeing any shift in the mix of borrowers and maybe picking up anything incremental in terms of what have may be been in FHA customer, but because of either lenders' execution or the GSE's 97 programs where you think the MIs are benefiting incrementally from some of that share shift?

Good morning, Mackenzie. I would say, on the NIW question, I don't think we've changed our guidance too much. I do think that, yes, I agree that back half the year will be tougher, down $120 billion, $122 billion for the first half of the year. So I kind of -- we feel comfortable with kind of that 250 to 260 range for the whole year, which again is obviously elevated relative to historical levels and it gets back to, again, kind of housing fundamentals. In terms of kind of taking share away from FHA, I would really just point to the 97. It's clear given our increase in the 97s and some of the programs that the lenders have out there. But we are seeing a little bit of an incremental shift, not a lot of, but a little bit of shift from FHA just on the 97s. Tough to see it in other places.

Your next question comes from Mihir Bhatia of Bank of America.

Most of my questions have been answered. So just 2 hopefully pretty straightforward and quick ones. In terms of your NIW growth this year, it's been pretty good, I think, as has been discussed on the call. I was just wondering are there any particular channels that you are seeing better growth in? Or where you maybe think -- maybe not taking share, but you are seeing more product from what have you compared to last year or the year before this year?

No particular channel. Again, I think it just increased activation and utilization, kind of, what we said. We continued to add clients each quarter as we continue to grow the company. Remember, we are still relatively a young company compared to some of our peers. And then as I said, as we get to know some of them better and get more comfortable with them, we have seen some increased utilization. But tough to pinpoint any one kind of channel, so to speak, of product that we are seeing differences.

Great. And just on your credit, clearly, it's been very good. And I think you've talked about not to read too much into it at this stage, given the young portfolio. But can you talk about maybe some of the things that you would -- that we should be looking for maybe in terms of just when credit will start normalizing. What are some of the early indicators that credit is starting to normalize a little bit at this -- or are you seeing any of that right now? And what should we be looking out for?

Yes, I mean I think in terms of -- I think the portfolio we've explained kind of, I think, for reasons of the credit. Again, looking forward, I think it's going to be really about the economy. So I would look in unemployment. I think there's probably more early indicators of the credit performance. Obviously, if someone loses their job, it's a little bit more difficult for them to make payments. Again, being said, as we mentioned earlier, I think the strength of our portfolio and the FICO will help there. But certainly, we are still prone, and we're subject to economic environmental risks. And I think -- so unemployment would be 1 that I would point to look at.

Your next question comes from Douglas Harter of Crédit Suisse.

The pace of contribution to Essent Re accelerated this quarter. I was wondering if there's kind of anything behind that or just kind of looking to build up capital in the quarter?

Doug, it's Mark. No, it’s really coming from the growth in the affiliate side of the business. The third-party business remains steady. But as the Essent Guaranty continues to grow kind of outside of our expectations, 25% of that goes to Essent Re, and it's really driving the capital needs at Essent Re.

And how do you think about or how close is Essent Re getting to the point where it might be sort of self-sustaining, in terms of capital, as it's earning phase gets high enough?

Yes. As we mentioned in the script, given the growth, I would say, we are still firmly in the capital-consumptive mode, really, across the enterprise. The growth -- we continue to contribute or invest capital in Essent Re, and there's a potential that we would invest capital in Essent Guaranty given where the growth is. So as much as we would like to be kind of in that self-sustaining mode, so to speak, it's the fact that we are growing so quick has actually kept us in the capital-consumptive model, which I think is a very positive sign.

Your next question comes from Geoffrey Dunn of Dowling & Partners.

Mark, can you talk a little bit about capital structure. Obviously, this quarter you've termed out the credit facility increased the capacity there, but you've tended to shy away from debt in the past. And the holding company cash position is getting a bit thin, you are consuming capital. What are your thoughts midterm? Are you looking to term out this debt? Maybe take down some capacity and bring your leverage up to mid-teens? Is equity in your thinking at all? Do you think you need to tap the equity markets or want to? How should we be thinking about capital structure over the next 2, 3 years given the growth trends?

Yes, I mean, given the strength of the growth, as I said in kind of the script, we're going to continue to look to increase our financial flexibility. The line of credit has been terrific. But as I said in the past, it's more of a temporary kind of bridge to more permanent capital. And I think, we've invested or we see the opportunity to continue to invest capital across the enterprise that we will be looking and evaluating strategies to kind of increase our permanent sources of capital. Whether it's debt or equity, again, I think it depends kind of where the markets are and kind of how we view leverage, as you know, but I wouldn't rule out either one.

Okay. And then I think it's generally accepted that the current pricing on BPMI or -- has typically assumed like 20%, 25% ultimate loss ratio. When pricing is set, did it envision the quality of the books that Essent and other companies are putting on with a 750 average FICO and all the other factors?

Yes, I think it does. I mean, I think we still set the pricing that way. Our portfolio has been this way for -- really, since we started. So there's been no changes kind of to the economic, kind of union economic model. Again, these are kind of more through-the-cycle pricing and union economic estimates. So you don't want to price just for the good times. And I think, the industry has really done a good job, especially over the last few years around maintaining that discipline. I mean, again, we're still -- a recession hasn't happened yet, but the likelihood of a recession happening over the next 2 to 4 years, I mean, I would put it at a relatively high level. So you just need to be careful about pricing for today. And again, as we look at pricing, it's always kind of through the cycle, so to speak. So we don't want to just -- and plus we have the PMIERs that we have to assess and look at that. For those capital standards, pricing comes into play with that too. So again, another good evidence that clear and transparent standards really maintains some pricing discipline.

Okay. So -- but this goes back to the previous question. It seems like the normalization is more about economic pressure relative to where we are today, not any kind of product reaped towards 97 or anything like that?

Correct.

There are no further questions at this time. I will now return the call to management for closing comments.

Okay. Thank you, operator. We'd like to thank everyone for participating in today's call, and have a great weekend.

This concludes today's conference call. You may now disconnect.