Assured Guaranty - Putting Puerto Rico In Perspective

| About: Assured Guaranty (AGO)

Summary

Despite AGO’s incredible financial strength and strong management, short-term market participants have been selling the stock off to levels far beyond intrinsic value.

AGO’s stock seems to trade primarily on news from the manic Puerto Rican government and its scorched earth negotiating tactics.

Ultimately, whether it happens in Chapter 9 or is renegotiated mutually, the deal with PREPA will get done and I doubt the bond insurance companies will lose anything.

As the carnage of January 2016 continues, stocks that were already cheap have gotten a lot less expensive. In a panic, the selloff often is dramatically greater than any fundamental impact on intrinsic value, thereby creating opportunities for attractive investments. I've long been bullish on Assured Guaranty (NYSE:AGO), having started investing in the name about seven years ago. Quarter by quarter, the company improves its competitive and financial positions while also creating shareholder value with strategic stock buybacks. Kroll recently confirmed its AA+ rating even assuming multiple defaults with Puerto Rico. Despite this incredible financial strength and strong management, short-term market participants have been selling the stock off to levels so far beyond intrinsic value that it is mathematically hard to equate. Long-term investors should add, or at worst hold on to, their positions in the stock, as the recovery should be quite strong when the market environment normalizes and when the situation in Puerto Rico becomes clearer.

On January 25th, AGO closed at $22.46 per share. As of the end of the third quarter of 2015, AGO had 142.9MM shares outstanding, or a market capitalization of $3.2095 billion. For that price, the investor is getting operating shareholders' equity of $5.984 billion or $41.87 per share. This is the closest approximation to liquidation value for the company and doesn't factor in the unearned premium reserve, minus expected losses like adjusted book value does. Book value is $5.819 billion, or $40.72 per share. This is a less reliable number just due to the archaic accounting of credit default swaps, but the numbers aren't very different anymore. On an adjusted book value basis, AGO has $8.571 billion of equity, or $59.97 per share.

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Source: AGO Third-Quarter Financial Supplement

Despite this sterling financial strength and unquestioned market leadership in the municipal bond insurance industry, AGO's stock seems to trade primarily on news from the manic Puerto Rican government and its scorched-earth negotiating tactics. Monday's drop in the stock was in part a reflection of the fact that the previously agreed to negotiation on restructuring PREPA was not consummated, via Puerto Rico passing the required legislation on time. This agreement called for a 15% reduction in debt for PREPA, which would have saved the entity roughly $800MM in debt service obligations over the next five years, which could be used to modernize its facility. The bond insurance companies were going to provide liquidity through the purchase of some debt and surety bonds, which would allow the newly issued bonds, reflecting the 15% haircut, to achieve an investment-grade rating. By doing this, the bond insurance companies were not going to take any haircut themselves on their much maligned exposure to PREPA. The bond insurers are a pivotal element to Puerto Rico maintaining access to capital and you can imagine a similar template on other debt.

When this deal passed, I thought two things: First is, it makes a ton of sense for everybody involved and highlights the important role that bond insurance companies play in debt restructurings. Secondly, it was too perfect of a deal to comply with the disgraceful tactics of Puerto Rican politicians. While clearly, reducing the debt and modernizing the facility is in the best interests of the people of Puerto Rico, it inconveniently provides a framework in which Puerto Rico's debt problems could get worked out without retroactively getting access to Chapter 9. Amazingly, Democrats and some Republicans have been willing to entertain providing Chapter 9 access without audited financial statements provided by the Commonwealth. This is despite the fact that Puerto Rico's own government admits to extreme levels of corruption and inefficiency that has been going on for decades. Being that it is an election year and many Puerto Ricans that have migrated to the U.S. are able to vote, politicians seem to be putting the rule of law on the back burner to further their partisan objectives. Ultimately, whether it happens in Chapter 9 or is renegotiated mutually, the deal with PREPA will get done, and I doubt the bond insurance companies will lose anything. PREPA hasn't raised its base electricity rate since the late 1980s and would be required to do so as part of the deal. PREPA's energy input is crude oil, which in case you haven't heard is trading below $30, generating a windfall for the Commonwealth. Often politicians mention that Puerto Rico's prices are higher than the mainland while declining to mention that the island's prices are far below most of its Caribbean peers. The decline in energy prices makes an increase in the base rate much more palatable. If PREPA doesn't want to play nice, a receivership would likely raise the rates, but I'm sure Puerto Rican politicians will be kicking and screaming the whole time as has been the modus operandi.

When looking at AGO's exposure to Puerto Rico, it is important to remember a few things. One is that much of the exposure is revenue bonds, which have certain protections in the Chapter 9 process. This will likely result in very moderate severities, if any in some circumstances, especially since the bond insurers can assure access to capital and liquidity. Secondly, any payments would be made over the span of 30 years in most cases. Thirdly, the bond insurers cannot be forced to accelerate payments; this reduces the present value of the exposures dramatically, even when using the more conservative total debt service exposure, as opposed to net par. Outside of the revenue bonds, most of AGO's exposure is to General Obligation bonds that have the highest constitutional protections, even before government salaries.

Amazingly, this Puerto Rican government that constantly screams at the top of its lungs that it has no money, managed to pay $120MM in Christmas bonuses on December 20th. It is incredibly difficult for Puerto Rico to justify its actions such as claw backs, or seeking Chapter 9 when it is willing to pay these "bonuses". The other significant exposures are subordinated COFINA bonds that are pledged to the Puerto Rico sales tax and have strong protections akin to a revenue bond, although not as high as the first-lien of course. In addition, you've got the Puerto Rico Municipal Finance Agency (MFA) bonds, which are secured by payments of principal and interest on a portfolio of municipal bonds held by the Trustee under the Indenture. The municipal bonds are general obligations of a municipal issuer, secured by ad valorem taxation, without limitation as to the rate or amount, on all property within the respective municipal issuer.

These are obviously very strong bonds that not only are difficult to default on, but the severities should also not be too severe. Now in Puerto Rico's $72 billion plus of debt, there are some weak issuances, which it has started to default on. Not all bonds are created equal so losses on some issuances might be quite high. This provides further protection to the more senior issuances, as a dollar saved on uninsured debt can be used for the more senior claims. Puerto Rico doesn't seem to be as inclined to make cuts to its exorbitant expenditures and government salaries, but that is going to have to be a big part of the equation as well. The biggest improvements would be in efficiency of collections, where the island is particularly behind the eight ball. Now Assured Guaranty doesn't break out its specific reserves for individual issuances or for Puerto Rico as a whole, but the vast majority of its additions to reserves over the last year have pertained to Puerto Rico. Let's just imagine that this company, that has a history of appropriately reserving, has underestimated its likely losses by $1.5 billion. After factoring in a 30% tax rate, the total additional loss beyond current reserves would be about $1.05 billion paid out over about 30 years, and the company generates over $400MM per annum, in investment income. Based on 142.9MM shares outstanding, this would result in a hit to adjusted book value of $7.34. This means that in this highly unlikely scenario, AGO would still have an operating book value around $35 per share and an adjusted book value of $53. Clearly, stock buybacks would still be enormously accretive and could help offset the declines to book value. The company has a fortress balance sheet with virtually no liquidity risk. Its other exposures are rapidly amortizing and all of its capital ratios have improved dramatically over the last several years.

When you look at AGO's balance sheet, the true financial strength becomes easy to identify. As of the end of the third quarter, the investment portfolio was $11.343 billion. There is easily between $400MM-440MM of annual investment income potential that is conservatively invested. The largest liability is the $4.112 billion unearned premium reserve where the company's list of troubled credits outside of Puerto Rico is incredibly strong and de-risked, particularly with the improving housing market. The company has a loss and loss adjustment expense reserve of $1.007 billion, up from $799MM from the end of 2014. AGO also has reinsurance recoverable on unpaid losses of $89MM and salvage and subrogation recoverable of $135MM. As of the end of the third quarter, the company was forecasting net expected losses to be paid on its U.S. Public Finance portfolio, which is roughly half of its $1.307 billion in total expected losses to be paid. Puerto Rico obviously accounts for the vast majority of these projected losses and the company has a history of reserving conservatively.

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On the first week of January, Puerto Rico made most of its debt service payments. 2016 is AGO's biggest year in terms of exposure, which declines significantly sequentially. Total debt service for 2016 is $559MM. Most of Puerto Rico's debt service comes in the form of two annual interest payments (typically January 1 and July 1) and one mid-year principal payment (typically July 1). A rough estimate of the company's January 2016 debt service for Puerto Rico can be obtained by (i) taking the Total Net Debt Service (principal and interest) for 2016, (ii) removing the Total Net Par amortization for 2016 and (iii) dividing that difference evenly. This is not an exact calculation but can give us an approximation.

AGO's exposure has likely been reduced by almost $129MM and then there was also the $34MM in GDB bonds that were paid in the end of 2015. I highly doubt that all of these bonds will default, particularly those that are backed by the Commonwealth. Severities on the revenue bonds should not be too bad. The bond insurers are Puerto Rico's best bet to regain access to capital markets, and generally get paid a premium for assisting with this. The current price of AGO makes no sense whatsoever. For investors that want to take advantage of the volatility in the stock, one might consider selling puts. You can sell the April $22 puts for about $1.40 per contract, which expire in 81 days. This provides a return of 6.8% on your money in 81 days if the stock expires above $22. Your worst-case scenario is you'll end up owning 100 shares at a breakeven of $20.60 per share. From that point on, you have all of the upside and downside on the stock. AGO pays a little over 2% a year as a dividend, and there is room for it to grow from here.

Disclosure: I am/we are long AGO.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.