Over the long term, stock prices and intrinsic value should ultimately converge. There are some scenarios where a company keeps creating enormous value, but for various reasons, the market doesn't want to recognize it fully. The common stock of Assured Guaranty has been a massive winner since early 2009 when the stock traded below $4. In all that time, I've never felt like the stock was appropriately valued. Surely, the Financial Crisis and bankruptcies of Detroit and Puerto Rico made huge headlines, but for those that did the math, the value was clear to see. As Puerto Rico comes closer to resolution and after a potentially game-changing acquisition, I'm increasingly confident that AGO's best days are ahead of it.
On August 7, AGO reported a very strong second quarter. The company earned $141MM of non-GAAP operating income or $1.38 per share. AGO increased shareholders' equity per share, non-GAAP operating shareholders' equity per share, and non-GAAP adjusted book value per share, reaching new record highs of $67.35, $63.48, and $88.67, respectively. AGO repurchased another 2.5MM common shares at an average price of $43.89 per share, and on August 7, the Board of Directors approved an incremental $300MM in share repurchases.
AGO began its capital management strategy in 2013, and through August 7, 2019, the company has repurchased 100.3MM shares or roughly 52% of its shares outstanding at the beginning of the program for approximately $3 billion. All these buybacks were done at discounts to all book value per share metrics, and any reasonable estimate of intrinsic value, making them highly accretive. The buybacks have increased operating shareholders' equity by $16.86 per share and adjusted book value per share by $29.33.
The company has been able to do that because of the profitable amortization of its insurance portfolio, which was somewhat artificially enlarged due to several acquisitions and has been running down as the rate of new business has been less than the amortization. This creates surplus capital, but reduces unearned premium reserve, along with risk exposure. AGO ended the second quarter with just under 100MM shares outstanding.
Source: AGO Second Quarter Investor Presentation (Same with Subsequent Slides)
The fundamental thing to understand is that writing insurance ties up capital. Because there are only two competitors, pricing has become much more rational in the bond insurance industry. Demand is good, despite record-low interest rates and small credit spreads, however, the target market is smaller than 12 years ago because they can't target AAA securities anymore. When there are attractive opportunities to write insurance, the company does so. If that means growing the book, that is great and should enhance the unearned premium reserves. If there isn't enough profitable business to write, not writing insurance and using surplus capital to buy back stock when it trades at a huge discount to intrinsic value, is a phenomenal decision. One of my criticisms of analysts is that they tend to be rather myopic. For banks, net interest margins are an obsession of analysts. For AGO, the growth of the insurance book and Puerto Rico are paramount issues, and while important, it becomes easy to miss the forest for the trees with that view.
There was some commentary on my last AGO article that the company wouldn't be able to buy back as much stock because earnings were down from peak years. Dividends are calculated via a function of net investment income and earned surplus capital. The slide below shows AGO's various subsidiaries capacity to pay dividends to the holding company. Net income, especially that of a short-term basis isn't a component. Also, net income was up quite substantially in the second quarter from the first quarter anyway, but that has always fluctuated greatly based on reserve provisioning. The ratio of net par outstanding to claims paying resources has declined from 51:1, to 20:1, despite all these buybacks and Puerto Rico payments, so it shouldn't be a shock that the company has the capacity to continue buying back stock. AGO estimates that based on S&P's AAA criteria, the company had $3.2 billion of excess capital as of the end of 2018. The question I'd ask the bears would be, what are your assumptions to begin to see book value per share declining for AGO? Mathematically, I have a tough time building that argument up, especially with the progress being made in Puerto Rico.
New business production was quite reasonable with $54MM of PVP written, despite one of the worst quarters for interest rates and credit spreads, particularly for municipal bonds where demand has been exceptionally strong, given the changes in the tax code. The insured market par penetration rate crept up to 6.9% in the second quarter, while AGO's market share on insured transactions was 60%. These are decent figures, and I believe that the events that have transpired in Puerto Rico have really shown the immense value that bond insurance does provide. Investors that purchased AGO-insured bonds have been paid in full, while everyone else is made to wait on a costly and time-consuming process. The total par volume of new issues sold with insurance rose 13% YoY, and the number of insured transactions was up 38%.
AGO isn't simply tied to U.S. municipal finance and also has operations in structured finance and international public finance. These units provide diversification and growth, which will only be enhanced with the asset management acquisition. AGO has proven to be a good underwriter of risk and now they are starting to broaden their bond insurance reach geographically, which, was a huge business prior to the Financial Crisis. One example in the second quarter was AGO provided a guarantee on a debt refinancing of Spanish solar plants and a Scottish housing associating transaction. Management mentioned that already in the third quarter, the company has added another $65MM of PVP, with significant contributions from each of the product lines.
AGO made one of its most important acquisitions ever in August, with the announcement of its purchase of BlueMountain Capital Management, LLC and its associated entities for $160MM. The transaction is expected to be accretive to EPS and ROE beginning in 2020. BlueMountain manages approximately $19.3 billion in assets under management across CLOs, long duration opportunities funds and hedge funds. At less than 1% of AUM, this deal seems almost absurdly cheap. BlueMountain has had a few troubles recently, but this seems like a good strategic fit. The firm has a great deal of experience evaluating credit and managing investments. Hopefully, they can help introduce AGO's insurance to additional transactions, while AGO might be able to introduce BlueMountain to attractive investments. AGO will be investing $500MM into BlueMountain funds within three years of closing, which should be beneficial to investment income. S&P recently updated the bond insurance investment portfolio capital charges to the same as what stands for P&C, Life and other insurance companies. This is good news in that before, any investment rated below A required a 100% capital charge.
The acquisition will be funded through loans from the insurance subsidiaries at a market interest rate and will be held by a holding company in the United States. The loans will likely be paid off over 10 years, with the excess free cash flow generated from the asset management business, creating future new investment opportunities. Structuring it this way is very intelligent in that AGO's dividend capacity from its subsidiaries is partially calculated from its investment income, so this should provide enhancement to that capacity, as opposed to tying up resources. AGO is under-leveraged, so it must find opportunities to deploy capital, and this is an opportunity with immense upside potential. Asset management is a capital-light, fee-generating business, that would provide great diversification to its bond insurance operations.
Progress has been made in relation to Puerto Rico despite massive corruption and a truly inept Oversight Board, that allowed Governor Ricard Rossello to squander hundreds of millions, if not billions, on uneconomic contracts to friends and partisans. In February of 2019, COFINA was restructured, giving AGO a roughly 60% recovery on its subordinated debt. In May 2019, there was the announcement of a restructuring agreement on the company's PREPA debt. Recoveries would probably be in the low to mid 70's and have almost certainly already been factored into the company's reserve estimates. Then on August 9th, it was announced that PRASA entered into a loan agreement with the United States of America on a term loan of forty years. The notes are on parity with PRASA's Senior Bonds and other Senior Debt. These notes bear interest at 2% with a maturity of July 1, 2059, and an aggregate principal amount of roughly $403MM. PRASA debt is one of the few issues that has still been paid and this seems to cement that status. Sadly, because of the Oversight Board's incompetence and the corruption from the politicians, Puerto Rico's best chance to access capital is via guarantees from the U.S. government.
The biggest issues remaining for Puerto Rico in relation to Assured Guaranty are the GO bonds and the HTA bonds. There are strong revenues associated with the HTA, but the money has been clawed back. The only legal reason for that money to be clawed back is to pay GO debt, which hasn't been happening either of course. The GO bonds constitutionally become before all other expenses. I think we will see settlements on both and believe recoveries will be pretty much in line with current reserves, give or take a few hundred million. AGO proved to be significantly over-reserved for its structured finance losses, which has been a tailwind against the additional reserves being incurred for Puerto Rico. Just this quarter, $118MM in recoveries on RMBS, outweighed a substantial additional reserve for Puerto Rico. When all is said and done, I wouldn't be shocked to see a similar thing playing out and recoveries being more favorable than most would anticipate.
At a recent price of $44.88, AGO trades at 50.6% of adjusted book value per share. Even if you assumed an additional $500MM in PR losses (I'll bet the under), you are only really talking about $3 per share after tax from an adjusted book value per share of $88.67, much of which would be offset by normalized earnings and accretive buybacks. If Puerto Rico and its restructuring was a thing of the past, with the uncertainty removed, the future would look that much brighter for the company and the stock. Such a substantial discount to all book value metrics, would be much harder to justify. I believe AGO is a $60-70 stock, that has the potential to grow far beyond that. Management has truly done an exceptional job, and I don't say that lightly. Since coming public in 2004, CEO Dominic Frederico has run the show the whole time. At a young 65, my hope is that he continues to head the company for many years to come. Shareholders' seem poised to benefit either way.
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.