In a stock market where truly undervalued and misunderstood opportunities are rare, Assured Guaranty Ltd. (AGO) offers the investor a unique opportunity to earn explosive returns over the next several years. AGO is the best run operator in the municipal bond insurance business, and despite numerous challenges brought about by the Great Recession, the company has been consistently profitable on an operating basis. It boast a very strong balance sheet and a management team, led by CEO Dominic Frederico, that has consistently maintained a strong underwriting discipline, despite the drunken euphoria that existed in the middle part of the last decade, where competitors lost their way in a stupor of poor underwriting on structured finance transactions. We last profiled Assured Guaranty in August of this year, and while business has progressed nicely, there are new developments that have the potential to act as a catalyst for the stock price.
AGO currently trades at around $13.56 per share, and based on 194.7 million shares outstanding, the market capitalization is about $2.64 billion. This is nearly 50% below its book value of $25.53, its more important operating book value of $29.20, and it is only 28% of the company's adjusted book value of $47.09. GAAP measures have very limited value for this company because of fluctuations on CDS spreads that have no economic impact, therefore both operating book value, and operating earnings provide a much more transparent look at the financial situation of the company.
For a business to be trading at such a large discount to its net worth, you'd think that the company was losing money. In actuality, however, AGO has been consistently profitable throughout the last several years, which is something that very few financial firms can say. Management has focused its efforts on successfully collecting on its representation and warranty claims against some of the big banks such as Bank of America (BAC), buying back insured bonds at discounts when possible, and underwriting attractive new municipal offerings.
Low interest rates, and uncertainty pertaining to Moody's Corporation's (MCO) 8 month long review of AGO for a potential ratings downgrade from AA-, have decreased demand for Assured's financial guarantees, but despite these headwinds, the company has been able to write an adequate amount of new business or present value of new business production (PVP).
Moody's recently announced that after 8 months, it should finish its ratings review of AGO by the first half of November. I truly cannot fathom how the company can be downgraded, as the company has grown its equity, run-off a considerable portion of the portfolio, and focused exclusively on the highest quality of business with very low likely losses associated with them. The company has been able to collect R&W's where other companies have failed, and it has a strong market share in very difficult conditions.
A favorable resolution would enable the company to focus on writing new business and I believe you'd see a large increase in PVP production, as municipalities would no longer be in fear of a quick downgrade on guaranteed securities. New entrants have come into the municipal bond market, which add legitimacy and marketing to the competitive landscape. On the few insured municipal bonds that have defaulted, investors have seen the wonderful value that AGO provides by guaranteeing the interest and principal, in addition to the monitoring and surveillance functions that come with the guarantees. I believe the company should be able to generate a 12-15% ROE over the course of an economic cycle assuming a stable AA- rating.
If the resolution with Moody's results in a downgrade, then I believe you will see some significant changes. Because it is a Bermuda insured insurance company, there are limitations to how much capital it has free to buy back stock, but I do believe that it will buy back as much as possible. I think it is possible that the company would be taken private, where it could then add additional capital to meet any ratings agency requirements. The company could enter new insurance lines such as mortgage, reinsurance, etc., where it wouldn't face the same tax consequences of paying a dividend out of the U.S. based operating companies to the Bermuda holding company. At current prices, nothing is more attractive than reducing the equity base, but the company has had its hands tied behind its back waiting for this pending Moody's decision.
On November 8th, AGO reported 3rd quarter earnings that were very promising. Operating income was $166MM versus $38MM a year ago. This equated to operating EPS of $0.85 per share as opposed to $0.21 last year. The company had $3.189 billion of gross par written, equating to PVP of $35MM, down $16MM YoY. Net earned premiums increased to $239MM, from $231MM in the 3rd quarter of 2011, due primarily to higher refundings, accelerations and terminations. Refundings are generally higher in low interest rate environments as debt issuers refinance at more attractive rates.
Importantly, the company's loss expense was $100MM, compared with $254MM last year at the same time. The decrease was primarily due to lower loss expenses in the U.S. residential mortgage-backed securities sector, offset in part by higher international public finance losses attributable to Spanish sub-sovereign exposures. AGO has a very diverse insured portfolio, that has only strengthened with high quality underwriting, and the reduction that has occurred through accretion and refundings.
Just since March, $38 billion of exposure has runoff, and the company has produced $85MM of PVP, proving the viability of the business model. Of the $35MM of total U.S. public finance PVP, more than $7MM was gained through the secondary market, as investors sought the security that AGO could provide on previously purchased issues that didn't have the benefit of insurance. AGO guaranteed 31% of the transactions sold and 12% of the par, in its underlying single A target market.
During the quarter, Assured guaranteed the senior notes of a $225MM securitization of small equipment loans and leases by Leaf Commercial Capital. The transaction obtained a AAA rating based in part of the backing of Assured Guaranty. I'd expect to see more of these transactions as the securitized markets continue to improve. While these are riskier transaction than AGO's core public finance business, these deals tend to offer nice margins, and AGO's management has a track record of successfully mitigating risks in the worst of circumstances.
The company has been very active in purchasing previously insured bonds at discounts, which is incredibly value accretive. In the 3rd quarter alone, AGO bought $88MM of revenue bonds in five transactions, and the average yield of 7.6% enhances investment returns. The company is actively engaged in litigation with Flagstar Bancorp (FBC) and Credit Suisse (CS), amongst others, and I'd expect the company to be victorious in collecting on its rep and warranty claims.
In conclusion, I'd suggest buying the stock aggressively at current levels. Assured Guaranty is worth upwards of $25 per share, and I believe it has substantial upside from there. The company offers a dividend yield of around 2.35%, so the investor gets paid for waiting. AGO is probably my favorite stock to sell puts on, as the volatility is tremendous, yet in my estimation the risk is very little over the long-term. Currently you can sell the January 2014 $13 puts for $2.80. This means that if AGO closes above $13 at expiration you will make 27% on the maximum risk. Even better, if the stock expires below $13, your breakeven price is $10.20. This would allow for incredible upside potential moving forward.