Puerto Rico Aside, Assured Guaranty Is A Buy

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About: Assured Guaranty Ltd. (AGO), Includes: AMBC, MBI
by: Tim Travis
Summary

AGO is generating substantial excess capital via portfolio amortization.

The stock has an adjusted book value per share of $86.95, yet trades at just over $42.

Cofina is resolved and there is an RSA in place for PREPA with a chance to succeed.  Puerto Rico should be mostly resolved in the next year.

In the age of growth stock glory, there is very little interest in a rather obscure bond insurance company, regardless of an impressive track record of success. I’m probably not smart enough to create a discounted cash flow analysis for Amazon that I had any faith in, with all the moving parts going on in that company, and the already high expectations priced into the stock. I can, however, look at a company like Assured Guaranty (AGO), where the stock trades at a massive discount to any reasonable analysis of liquidation value, and realize it is a compelling buy.

Source: AGO 1st quarter 2019 Equity Presentation

Over the last 15 years that AGO has been public, the company has been profitable on an operating basis each year. This has been despite the bankruptcies of Jefferson County, Detroit and Puerto Rico. There was even that “little” thing called the Financial Crisis that occurred eleven years ago, that the company survived and thrived through. AGO has been able to do this for a variety of reasons, mostly stemming from good management.

The company has a strong underwriting track record. They didn’t get involved heavily in the CDO-squared garbage, or the guaranteed investment contract business, which did-in most of its peers. They have done a good job making accretive acquisitions, which have enhanced its competitive position. The bond insurance business isn’t sexy, but overall it is decent with only one other viable competitor nowadays. Default frequency is very low, and severities have historically been mild.

The biggest negative is that you are dealing with a lot of political agendas, and in today’s environment, everyone loves to blame creditors, as opposed to looking in the mirror at their own fiscal prudence.

Capital accessibility is the lynchpin of economic growth. Companies such as Google and Facebook, wouldn’t be where they are now without the equity capital that they raised. Since municipalities can’t really raise equity, debt is essential to funding their operations. Violating legal contracts and constitutional guarantees might sound cool to corrupt political officials and their followers, but when they try to build a new school or infrastructure project and can’t fund it, the appeal loses its allure. When defaults do occur, the company fights it out in court to protect its rights, while also working with the municipalities for consensual solutions to create a better path forward, like with what happened with Detroit.

Investor Presentation

Over the last roughly 10 years, AGO’s insured net par outstanding has dropped from $646.6 billion, to $237.3 billion. The once troublesome U.S. structured finance exposure has been trimmed to $10.3 billion, from $142.2 billion at the 3rd quarter of 2009. Meanwhile the investment portfolio has grown, and the claims-paying resources is just under $12 billion. The company’s ratio of net par outstanding/claims paying resources of 21:1, speaks to a surplus of capital.

While some might look at the declining insured net par outstanding, I look at it in a much more favorable light, as it means less long-tail risk. If a company has excess capital and doesn’t have new business opportunities that can achieve better returns, than their hurdle rate, capital allocation decisions become that much more important. Fortunately, AGO’s management team has taken advantage of the consistently silly discount to intrinsic value that the stock trades at, to buy back stock aggressively. In combination with retained earnings, all book value per share metrics, have been growing rapidly.

Investor Presentation

Since I started buying the stock over 10 years ago, the stock has generally headed materially higher with some real bouts of volatility. Despite the stock’s fluctuations, the book value per share has grown very consistently. That is a perfect situation for a value investor, as there have been a ton of opportunities to keep buying the stock. After the recent earnings report, there has been some selling off the high’s, which in my opinion, has created another attractive entry-point.

On May 9th, Assured Guaranty announced a decent 1st quarter earnings report, with Non-GAAP operating income of $86MM, or $.82 per share. GAAP net income was $54MM, or $.52 per share. Low interest rates and tight spreads on municipal securities, resulted in PVP of $42MM. The company was able to write business in each of its three divisions, U.S. public finance, international infrastructure and global structured finance. More than half of the A-rated transactions utilized bond insurance despite the market pressures in the quarter, which is Assured’s target market in U.S. public finance. If we see higher rates and wider spreads, Assured has the potential to dramatically increases PVP by 200-300% in my opinion, but it doesn’t need that to be a successful investment. AGO led the municipal bond insurance primary market with 56% of the market share of both par issued and transactions sold.

Net earned premiums were $118MM in the 1st quarter of 2019, compared with $145MM in the 1st quarter of 2018. The 2017 Tax Act had a negative impact on advanced refundings, and muni bond insurance was very slow in 2009 and beyond, so accelerations due to refunding declined to $26MM from $52MM a year ago. For revenues to grow, AGO will need higher interest rates and wider spreads.

Another potential opportunity would be if they were able to get a little more aggressive with their investment portfolio, which will depend on ratings agency models most likely. Acquisitions and reinsurance are other major parts of AGO’s strategy. As the Puerto Rico debt picture clears up, it seems very possible that a reinsurance deal, or an acquisition could occur with National (MBI), or Ambac (AMBC). Both companies are in runoff and would obtain way better capital efficiency if they were to offload their legacy bond insurance portfolios.

Loss and LAE was $46MM in the 1st quarter, compared with a benefit of $18MM in the 1st quarter of 2018. The loss and LAE was primarily related to the Puerto Rico exposures. During the 1st quarter, there was an awful decision by the First Circuit Court of Appeals, allowing revenue bonds to skip payments while in the bankruptcy process, going against precedent and rattling the municipal bond market. In the end, they still owe on the debt, but Assured must factor in all possibilities into its loss reserving.

Shareholders’ equity per share reach a new high at $65.21, while Non-GAAP operating shareholders’ equity per share stood at $62.00 at the end of the 1st quarter. These figures were up from $63.23 and $61.17, respectively, as of the end of 2018. Non-GAAP adjusted book value per share stood at $86.95, versus $86.06 at the end of 2018.

The Puerto Rico saga continues to generate headlines and political hysteria. General fund revenues for the 9 months ending on March 31st, were up 8% above the revised projections in the most recent certified fiscal plan from October 2018. These figures were over 33% above the original projection in June 2018’s fiscal plan. Private sector jobs now exceed the level before Hurricane Maria, according to the Puerto Rico Economic Development Bank. The unemployment rate has declined from 10% to 8.8% between March of 2018 and March of 2019.

In early May, AGO joined an amended Restructuring Support Agreement (RSA) for the Puerto Rico Electric Power Authority, along with a group of uninsured PREPA creditors, the Commonwealth and the Oversight Board. The plan would likely result in at least a 20% write-down but Assured can mitigate some of those losses, by attaching its guaranty and wrapping the bonds it receives in the securitization exchange. This could materially improve Assured’s recovery under the transaction. The reality is that creditors have a secured claim on the net revenues of PREPA. Unfortunately, the scene has gotten so politically toxic, that I support this RSA in that it will clear the table a bit and allow everyone to move on to deal with the GO and HTA debt. There is still a lot that needs to happen to get this RSA past the finish line, as other bond insurers are not supporting it yet.

The Oversight Board’s record of disgraceful actions towards creditors continues on a new front, as now they are attempting to have some of the Commonwealth’s G.O. bonds declared invalid. They are even attempting to claw back previously distributed principal and interest from bondholders, on the grounds that the bonds were issued in violation of the constitutional debt limit. Imagine a government issuing debt with a full constitutional guarantee of repayment over all other expenses. Then that same government a few years later, says that they lied on their disclosures, and thus the debt should be invalid. Despite them collecting the billions of dollars from the bonds and not paying debt service, they even want to go after the paltry amounts of debt service that has already been paid. Make no mistake, this Oversight Board is an absolute disgrace and has wasted hundreds of millions on consultants and legal fees, with little success to point to.

These tactics are clearly an effort to obtain a more favorable settlement on the GO debt, as they would have no chance in court. While AGO could go along with this charade, as their exposure to these issuances is far less than the rest of their GO exposure, they are correctly taking the moral high ground and fighting this heinous act. It is a positive that negotiations are occurring and this far in the process, I’m very confident that AGO’s Puerto Rico reserves are near where they should be based on the facts. If things get a little better, I could see them releasing reserves, or if they end up adding, I wouldn’t expect it to be very material at this juncture.

In the 1st quarter, AGO bought back 1.9MM for $79MM, at an average price of $41.62 per share. It is amazing to think that since 2013, the company has repurchased 96.5MM shares. The cumulative effect of these buybacks was a benefit of roughly $15.84 per share in operating shareholders’ equity, and approximately $27.83 in adjusted book value per share. Thus far in the 2nd quarter, the company has repurchased an additional 853,000 shares for a total of $40MM. Management has been very clear about its goal of buying roughly $500MM of stock each year, given the absurd valuation, and the excess capital that the company holds.

Investor Presentation

AGO’s buybacks and retained earnings provide a clear path for continued book value growth. Just six years ago, book value per share was $28.07, and now that figure is over $65. Most of those years the company has been dealing with Puerto Rico. I can’t imagine a scenario where the company doesn’t continue to grow its book value per share. If interest rates go up, the company’s earnings potential would be geometrically higher, on a very low share count.

At a recent price of $42.50 and 102.3MM shares outstanding, AGO’s market capitalization is roughly $4.34 billion. AGO’s adjusted book value is roughly $8.9 billion, where the biggest difference is AGO is given credit for their unearned premiums reserves after taxes. Those reserves are already on the balance sheet and are generating investment income of roughly $400MM a year. Mr. Market is essentially saying that AGO is likely to lose $5.7 billion before tax.

Puerto Rico is heading towards a resolution. Management was way too conservative on its RMBS reserves and I think will show themselves well on this. I understand there are other troubled municipalities like New Jersey, Illinois, Chicago etc. Firstly, states can’t legally declare bankruptcy. Secondly, those are wealthy municipalities with awful spending problems. Puerto Rico was a relatively poor municipality with awful spending problems. AGO’s exposure to these municipalities is amortizing rapidly and with an unemployment rate for the country at 3.6%, things look okay for the near future at least.The bottom line is AGO is an easy buy here. At some point the market will rerate the company to a more proper valuation but even if multiples stay the same, book value per share growth will drive the stock higher.

Disclosure: I am/we are long AGO, AMBC, MBI. 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.

Additional disclosure: I/We also own a collection of Puerto Rico bonds since December of 2017.