MBIA - Misunderstood And Dramatically Undervalued

| About: MBIA Inc. (MBI)

Summary

On May 9th, MBIA produced another quarter of value enhancement on a per-share basis.

Adjusted book value increased by another 7%, or $2.05 per share, since year end due to accretive stock buybacks.

MBIA ended the first quarter of 2016 with a book value per share of $26.42 and an adjusted book value per share of $31.74.

Once Puerto Rico is resolved, I believe National could potentially be in line for an upgrade in its credit rating.

MBIA's (NYSE:MBI) common stock offers an extremely compelling opportunity to potentially double your money over a three-year period. At the end of the article, I will also show a basic strategy to generate an attractive return in about eight months with even less risk. MBIA has two separate operating companies, but only one really contributes to the value of the company, as they are legally separated. National is the municipal arm of MBIA and holds the vast majority of the company's net asset value. The only real troublesome area for National right now is the political grab-bag that is Puerto Rico. Uncertainty into the final outcome for the Caribbean Island has depressed MBIA's common stock to levels that are tough to fathom when you look at the financial statements. In addition, a recent analyst report pertaining to MBIA Insurance Corp.'s exposure to Zohar really shows a lack of understanding into the legal separation that MBIA executed years ago, which protects National and in turn the common stock of MBI.

On May 9th, MBIA produced another quarter of value enhancement on a per-share basis. Operating income declined from $0.18 per share in the first quarter of 2015 to $0.12 per share in the first quarter of 2016. This decline was due to lower premiums earned and $15MM in unfavorable variance in loss and loss expense due to Puerto Rico. Adjusted book value increased by another 7%, or $2.05 per share, since year end due to accretive stock buybacks. National's reported income was $37MM and it ended the quarter with $3.4 billion in statutory capital and $4.7 billion in claims paying resources. It is important to note that MBIA has been able to buy back stock because its financial strength continues to improve. National's insured portfolio reduced by another $11 billion in the first quarter and now stands at about $150 billion of gross par outstanding. National ended the quarter with a leverage ratio gross par to statutory capital of 44 to 1, down from 48 to 1 at year-end 2015. Management estimates that National has about $1.5 billion of excess capital as measured against Standard & Poor's AAA capital standards. Once Puerto Rico is resolved, I believe National could potentially be in line for an upgrade in its credit rating.

National insured $158MM of par in the first quarter, which was equal to the amount of insurance written in the fourth quarter of last year. This is a positive because the first quarter is usually the slowest, and this year's results were four times better than the same quarter last year. With that said, National has a lot of work to do for new business production to reach satisfactory levels. Resolution to Puerto Rico and any increase in interest rates would be very beneficial. The bond insurance industry penetration for the first quarter of 2016 was 5.9% of total in its par issuance compared to 5.8% for the first quarter of 2015. Of the insurance market that for National is BBB to A-rated credits, the insured penetration was 14.1%, which was also up from the first quarter. The overall outlook for the industry is quite positive as investors realize the huge benefits that the insurance provides in times of distress. MBIA spent almost $400MM to repurchase 55MM shares during 2015 and the first quarter of 2016. All of these buybacks have been done at massive discounts to both intrinsic and operating book value, making them highly accretive. As long as the stock trades so cheaply, stock buybacks represent the best opportunity for MBIA to build per-share value.

Approximately 95% of the $3.9 billion of gross par of Puerto Rico debt insured by National consists of four credits. PREPA is the largest of those credits with $1.4 billion in gross par outstanding, and material progress has been made with the restructuring agreement, where bondholders would take a 15% haircut, but the bond insurers would not, because they would instead insure the securitized newly issued bonds so that they can be of investment-grade quality. MBIA has insured two HTA credits where it has $715MM of gross par outstanding as of March 31st. These credits have fully funded debt service reserve funds, which are sufficient to cover MBIA's insured obligations for at least the next two payments in July of this year and January of next year. This means that the parties should have until July of 2017 to work out a resolution. Just like with PREPA, the HTA has strong revenues associated with it, so a similar restructuring could be accomplished. Puerto Rico needs the bond insurance companies to get access to capital, unless the government truly does want to stand by and provide credit. This seems quite undesirable for the U.S. government to do, so it would be far more constructive for Puerto Rico if it would actually attempt to obtain a mutually acceptable resolution instead of taking the scorched earth policy, which has hugely hurt the Puerto Rican people and economy.

The second largest exposure is to Puerto Rico's General Obligation bonds where MBIA has $985MM of gross par outstanding as of March 31st. This debt has the highest priority of repayment under the Puerto Rico constitution. Keep in mind that the only way the clawback clause can be invoked is if additional revenues are needed for payment on the GO bonds. To not pay this debt would really put the island in hot water from a legal standpoint. The other large exposure is roughly $1 billion of senior-lien COFINA bonds which are repaid from sales taxes collected on the island. Despite the pathetic record the government of Puerto Rico is in actually collecting this tax, there is still more than enough available to pay the future debt service, which doesn't begin to mature until 2040. The secured nature of these bonds has been confirmed by Puerto Rican officials and should stand up to any tests that come. With likely action coming from Congress in the next few weeks, as well as a potential Supreme Court decision on the Recovery Act, 2016 will be a year when we get a lot more clarity around Puerto Rico. While fixing the island's economy is going to take much longer, this clarity should be a catalyst for MBIA.

While the MBIA Insurance Corp., which is legally separated from National, could be under pressure from a liquidity standpoint due to the troubled Zohar I and Zohar II credits, ultimately MBIA believes that it should eventually recover 100% on the claims that it has paid so far. There is $776MM of gross outstanding on the Zohar II notes, which are scheduled to mature in January of 2017. The company is actively looking to create liquidity that will enable it to satisfy claims as they come due. I believe that this can be achieved through the sale of the UK unit to Assured Guaranty (NYSE:AGO) at a discount to statutory capital. The U.K. subsidiary of MBIA has statutory capital of $375MM and a GAAP book value of approximately $465MM. Assured Guaranty has bought some of the Zohar bonds and also has a swap on the counterparty, so we believe that the two companies can work together to come to a value-enhancing solution for both monolines. Assured Guaranty has also been very active in acquiring legacy insured portfolios of companies that are no longer active in writing new insurance, and the MBIA U.K. unit would be a great fit. A cash payment of $300MM or more would go a long way towards building liquidity to deal with Zohar II. If a deal cannot be made, MBIA Insurance Corp. could potentially go into rehabilitation, which would not have much of an impact on the value of the common stock of MBIA, or its subsidiary National where all the value is. MBIA Corp. has statutory capital of $844M as of the end of the first quarter and it has $278MM of liquid assets.

MBIA ended the first quarter of 2016 with a book value per share of $26.42 and an adjusted book value per share of $31.74. It is important to note that in MBIA's adjusted book value calculation, the effects of MBIA Insurance Corp. are excluded except the portion of its NOLs, which are to be used by the holding company. Shares outstanding declined from 152 million at year end to 137MM at the end of the first quarter. Even if MBIA is off in its reserves by $1 billion regarding Puerto Rico, the after-tax impact per share would be just over $5. It is tough to justify a current price below $7 per share when that is the case. National has considerable excess capital that ultimately can be repatriated to shareholders via stock buybacks or dividends. While some compare MBIA to a liquidating trust, I believe there is a very good chance that National will begin writing a lot more business in the next two years or so. The reality is that even if it doesn't write new business, as the insured book amortizes, the company can return far more cash to shareholders over the next 3-4 years than the price that the common stock trades for today. This is a highly attractive opportunity in an expensive market.

One strategy that can be used to generate an attractive rate of return on what I consider to be a very low risk investment is to sell put options. This takes advantage of the extreme volatility in the stock price of MBI despite the fact that the business itself can be somewhat boring in that losses are relatively infrequent. One can sell 10 January, 2017, $6 puts for $0.95 per contract. This generates $950 on a maximum risk of $5,050. Assuming MBI expires at a price above $6, the return in 250 days is a whopping 18.8%, or 27.64% on an annualized basis. Your worst-case scenario would be owning 1,000 shares of MBIA at a breakeven of $5.05. This would equate to a laughable 16% of adjusted book value, and you'd have all of the upside or downside from there.

Disclosure: I am/we are long MBI, 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.