Notes from My Conversation with Primus Guaranty

Jun.25.08 | About: Primus Guaranty, (PRSG)

It shaped up to be a very Primus (PRS) weekend here at, because as a follow-up to releasing my stock report on the company, I also had the opportunity today to speak with Nicole Fatica, head of Investor Relations, as well as Chris Gerosa, the company's Treasurer.

I've written a lot about Primus Guaranty over the past couple months because I feel it is a very misunderstood company, and its small size means that it gets very little analyst coverage. Still, Primus is a fast-growing player in the huge market of selling credit default swaps, or credit protection largely written on corporate debt.

My primary areas of interest this time around (I've spoken with Nicole before) were ascertaining the status of the credit markets – which have been pretty locked up due to a lack of counterparty capacity due to the mess with large financial institutions – as well as the direction of Primus' asset management business, and what the company is planning to do with its capital base, which is slightly underleveraged against internal limits and vastly underleveraged against the models of the ratings agencies.

The following are notes from our discussion:

As was indicated on Primus' last conference call, the market for credit default swaps has lacked the liquidity that was present in previous years – Nicole specifically cited the date of Bear Stearns' takeout as when things really locked up. They emphasized that things are fine on Primus' side, but that the books full of bad leveraged loans and mortgage securities at the banks are causing those companies to focus on righting things internally, hence delaying any additional CDS business. While things have opened up slightly, a return to normalcy still seems to be a few quarters out.

In more numerical terms, the CDX index on investment grade debt is a rough approximation of what kind of premiums Primus gets for writing protection. At the end of the first quarter in March, the index was at 135. At the time of Primus' conference call two months later, protection rates had come down substantially to around 80. They currently sit around 110, and have held fairly steady in that range for several days. Because Primus isn't writing lots of new business, that data alone isn't material for modeling future premium streams, although it does help in determining the marks that will be put on Primus' existing swap book at quarter end. While I believe these non-cash changes aren't material to Primus' cash earnings or liquidity, it is something the rest of the investment community looks at – and right now, the marks should be fairly positive and might seem large relative to Primus' size. Still, the cash earnings, or "economic results," are what to focus on.

The next area of interest is Primus' asset management business, which manages a handful of Collateralized Swap Obligations (CSOs) and Collateralized Loan Obligations (CLOs). Overall, revenue from this business is fairly small at about $4.5 million annually, but I like the diversification benefits it could potentially offer as it grows. Chris said that about $4 million of that revenue is attributable to the pair of CLOs under management, and that is the product Primus is targeting because fee revenue there is very good, and would be very scalable because the platform is already in place. A typical CLO might bring in $2 million annually in fees, while only requiring the hiring of one or two additional employees.

A recurring theme was that right now, growth opportunities are somewhat on hold for the company due to market distress, and this holds true for the management of structured finance products as well. Still, Chris said that the company is targeting the addition of two CLOs a year, and although realization of that goal will likely have to wait until 2009, I like that this segment could grow to a multiple of its size in only a couple years.

The final point I was wondering about involved Primus' leverage ratio, and what their current feelings were on raising additional capital. The swap portfolio, relative to the existing capital base, is leveraged at roughly 28x. The stated internal limit for leverage is about 35x, while the ratings agencies would be likely to maintain Primus' AAA/Aaa counterparty rating up to about 45x. In other words, there is plenty of "dry powder" for Primus to write additional business when the market begins to seek additional CDS protection.

Back in mid-2007, there was talk by Primus about raising additional capital to more quickly grow the business. Some small problems in the credit markets since have prevented that happening at an advantageous price. With the current capital base being underleveraged, and the market not offering a fair deal on capital raises, any additional issuance would likely be debt, and isn't likely to happen for at least another year.

One follow-up I asked Nicole was whether or not Primus has the ability (given its operating structure) to buy back stock; the company certainly has the excess capital cushion that it could do so if the desire were there. In my opinion, this would be the most effective way to take advantage of the combination of lack of counterparty demand and unused leverage; additionally, the stock looks so inexpensive relative to value that Primus would effectively be buying back its swap premium stream at about 40 cents on the dollar.

It would take a lot of intellectual honesty to give up dreams of raising additional capital and greatly expanding Primus' swap portfolio, but I'm hopeful that Primus' management will pursue all steps that create shareholder value. A buyback would be a powerful signal that Primus believes the market is overestimating the risk of its swap portfolio, and will creatively leverage up when conditions are advantageous.

Disclosure: I recently bought shares of PRS.