The recent bankruptcy of Detroit and significant anxieties pertaining to Puerto Rico, have pressured the stocks of municipal bond insurance companies' such as MBIA (MBI) and Assured Guaranty (AGO). These companies have finally recovered from the substantial losses incurred from RMBS and CMBS from the Great Recession, dealt with constant ambiguity from the ratings agencies and now are dealing with the ramifications of municipalities that over-leveraged their resources. There is no doubt that these are significant issues but the pessimism surrounding Assured Guaranty in particular, is obscuring the deep undervaluation that the stock trades at in relation to intrinsic value. If just a few good things start to happen to the company in relation to new issuance volume or Puerto Rico, the stock could quite possibly climb 50% over the next year or two.
On November 11th, Assured Guaranty posted reasonable financial results given the weak operating environment in the municipal bond insurance industry. The company reported operating income for the 3rd quarter of $117MM, or 0$.64 per share, which was down from $166MM and 0$.85 per share from the year before. Through the first 9 months of 2013, AGO has generated $475MM of operating income, or $2.51 per share, which is up from $351MM, or $1.85 per share from the first 3 quarters of 2012. The company is benefitting from lower losses on its insured exposures, but is being hurt by lower scheduled net earned premiums. GAAP accounting is much less relevant for this industry, but GAAP net income in the quarter was $384MM, or $2.09 per share, up from $142MM or $0.73 per share in 2012. The GAAP numbers include some non-economic mark to market movements in credit derivatives, so I'd only really focus on the operating numbers.
New business production continues to be extremely slow for Assured Guaranty, largely due to the record low interest rate environment. The present value of new business production (PVP) was $40MM in the 3rd quarter, which was barely up from $35MM at the same time last year. Encouragingly, $13MM was generated from international infrastructure projects, which management has been flagging as a future source of revenue. The company also guaranteed $273MM of notes backed by small equipment lease and loan contracts originated by LEAF Commercial Capital, which is another positive for the structured finance business. AGO's municipal secondary market business executed 289 secondary market transactions, aggregating $522MM in par insured during the quarter, which was the highest volume this year. While the still slow rate of new business production is a negative, it is important to note that because the existing insured book of business continues to roll off, the capital position of the company continues to improve. This could ultimately lead to higher credit ratings or more capital flexibility in terms of distributions to shareholders. Through November 11, 2013, AGO has repurchased a total of 12.5MM common shares for approximately $264MM at an average price of $21.12 per share. The company has replaced the remaining $51MM authorization with a $400MM authorization, which should be highly accretive based on recent share prices.
The company terminated $1 billion of net part outstanding on policies related to 7 transactions and also purchased over $125MM of wrapped bonds at 60% of par. These activities reduce risk, increase capital adequacy and mitigated future losses in the portfolio, yet the company doesn't seem to get much credit for strong capital management. AGO took control over a lot of the RBMS servicing on some of its riskier exposures and has seen significant improvements in the outcomes as a results, while the delinquency trends have continued to improve. In addition, the company has now made 6 rep and warranty agreements thus far through 2013, which further eliminates uncertainty. There is no doubt that the worst is over in relation to the company's RMBS exposure. It is amazing to note that this company has posted consistent operating profits since its IPO in 2004, despite the worst financial crisis since the Great Depression.
AGO's shareholders' equity at the end of the 3rd quarter was $26.53 per share, which was up from $25.74 per share on December 31, 2012. The more important metric is operating shareholders' equity, which was $33.15 at the end of the 3rd quarter of this year, up from $30.05 on December 31, 2012. Lastly, adjusted book value stood at $49.55, up from a year-end $47.17 per share. With the stock trading at such drastic discounts to these various metrics for liquidation value, it is important to attempt to understand why these discounts might be warranted. The concerns would be that the company would face significant losses from municipal defaults such as Detroit and Puerto Rico. Additionally, new business production has been anemic so there might be an expectation of low returns on equity moving forward.
I believe the market is overly pessimistic because of the fact that in the case of the default in Detroit and the potential default of Puerto Rico, AGO is only responsible for interest and principle payments as they come due over many years. In addition, the company's policies do not permit acceleration of the bonds without its consent. This is very significant given the large par exposures that AGO has to these troublesome municipalities. AGO has $12 billion of consolidated claim paying resources and roughly $400MM of annual income from its investment portfolio, so there is very little doubt that the insured bonds will be paid in full and on time. 85% of AGO's exposure to Detroit is secured by liens on special revenues on water and sewer systems that serve communities extending well beyond the city limits of Detroit. Currently, all Puerto Rico credits that the company insures are current on their debt payments, and none are eligible to file Chapter 11 bankruptcy. The current political administration has taken steps to improve the financial condition, so while there is definitely uncertainty and risk, I don't believe that these exposures are too troublesome for the company. AGO has reached conditional settlement agreements related to its insured exposures in Harrisburg, Jefferson County and Stockton and in each case the company doesn't expect to incur additional reserves.
Based on 182.2MM shares outstanding and a recent price of $21.72, AGO has a market capitalization of roughly $3.96 billion. I believe that we are in a situation where short-term trading might be focused on news pertaining to Detroit and more importantly Puerto Rico, but any sell-offs in the stock offer the company the opportunity to increase book value by buying back stock at a big discount. This ultimately will increase the intrinsic value of the company. When rates rise, demand for bond insurance will increase and AGO's sterling track record should make it the ideal bond insurer to do business with. Currently, the company is over-capitalized so returns on equity are low, but as capital is returned to shareholders' and interest rates increase, bolstering interest income in the investment portfolio, an ROE of 10% seems quite reasonable. I believe that AGO is easily worth at least $30-$35 a share and my intrinsic value estimate will increase through retained earnings and accretive stock buybacks moving forward.