AGO's New Business Production Augurs Well For The Stock

Summary

• AGO has achieved a 295% increase in its most important metric, adjusted book value per share, over the last 15 years.
• Deals in place on the GO and PBA bonds, are likely to be improved, but still offer substantial recoveries, including back interest.
• There seems to be a misconception on the HTA or highway bonds.  AGO is likely within a few hundred million tops, of being fully-reserved for PR, and maybe is overly-reserved.

Assured Guaranty (NYSE:AGO) has achieved a 295% increase in its most important metric, adjusted book value per share, over the last 15 years, since its IPO in 2004. The company has been profitable throughout, despite the Financial Crisis, the bankruptcies of Detroit, Stockton, and of course Puerto Rico. I’ve written about the company many times, including last week, but I wanted to update things to reflect the bond insurer’s most recent results. AGO’s 4^th quarter earnings results show that the company has entered a new phase of growth, which should lead to improved earnings and returns on equity over the next 3-5 years. Enhancing the unearned premium reserve, diversifying the insurance book further into international infrastructure, and generating fee revenue from the investment management business, should ultimately lead to a higher valuation multiple for the stock.

Source: AGO 4^th Quarter Investor Presentation

On February 27^th, Assured Guaranty reported a staggeringly good quarter, mainly due to strong new business development. Net income was $137MM, while adjusted operating income was $87MM. For the full-year, AGO produced adjusted operating income of $391MM, down from $482MM in 2018. Lower earnings were primarily the result of reduced earned premiums, lower investment income, and expenses related to the BlueMountain acquisition. I believe 2021 and beyond is where we should start to see some material earnings growth, as Puerto Rico should be mostly behind it, and the investment management business should start operating at a profit.

The company reached new records in all of its book value per share metrics. Adjusted book value per share ended the year at $96.86, up 13% on the year. Book value per share and operating book value per share stood at $71.18, and $66.96, respectively. Net economic loss development in the 4^th quarter was $13MM. This included $15MM in loss development primarily attributable to Puerto Rico, and a $9MM increase in loss and LAE in various structured finance transactions, partially offset by an $11MM benefit on second-lien RMBS exposures.

For the 5^th time in the last 6 years, AGO repurchased $500MM of its common shares. Keep in mind that throughout this time, their insured leverage ratios have been improving as the runoff of the insured portfolio has greatly exceeded the pace of new business production. It is very likely that we are now at an inflection point, where AGO’s new business production exceeds the runoff, as new business production has accelerated, with $463MM of PVP on the year. This was the best direct production since 2009 and it improves the Claims Paying Resources of the company. AGO has substantial excess capital in its subsidiaries, while also generating close to $400MM in investment income per annum, so the buybacks are likely to continue at extremely accretive prices. To put this in perspective, the company ended the quarter with 93.3MM shares outstanding, and the stock traded at $40.87, so the market capitalization is $3.813 billion. Adjusted book value was $9.035 billion, and book value was $6.639 billion at the end of 2019. If they spent $500MM on stock buybacks at an average price of $45.00, the company would end up having 82.2MM shares outstanding at the end of 2020. Not accounting for any earnings for the year, these buybacks alone would increase adjusted book value per share to nearly $104. If the company earns close to $400MM, that could put the adjusted book value per share number closer to $110 per share.

Key to the growth in new business production are several factors. Firstly, the respect for the insurer’s financial guarantees is so great, that even AA municipalities are using their insurance. Secondly, the company is seeing extraordinary growth in its international infrastructure division. For all of 2019, the company produced $211MM of primary and secondary-market PVP internationally, where they are really the old player. These bonds have very high credit ratings and offer fantastic diversification. Structured Finance also perked up a bit with PVP exceeding $51MM. These are mostly risk management solutions for insurance companies, and also includes aviation and CLO deals.

Economic data coming out of Puerto Rico continues to dramatically exceed the consistently dire expectations of the Federal Oversight Board. As of January 31^st, 2020, Puerto Rico’s Treasury Single Account held a cash balance of $9 billion, compared with less than $8 billion projected in its liquidity plan. Including that account, Puerto Rico reported that at year-end, accounts of the government and its instrumentalities held a staggering aggregate cash balance exceeding $17 billion. That is not half bad for a government and Oversight Board that claims they are completely insolvent. I’m sure banks and credit card companies would have immense compassion if we neglected our mortgages and auto payments, despite sitting on a boatload of cash, but somehow this has been deemed acceptable for this government to do this, at the expense of its own citizens and U.S. taxpayers that invested in the Commonwealth.

Last year, the company resolved its Cofina exposures obtaining about a 60% recovery on its junior claims. In June of 2019, PREPA, the Oversight Board, and the Commonwealth and holders of 90% of PREPA bonds agreed to an RSA on the utility. Bizarrely, the judge has held up this deal and now the new Governor is playing politics objecting to the deal in an election year, but ultimately, I think it gets done. If not, the creditors should be able to appoint a receiver and I think recovery potential would be even higher, but I think this is unlikely.

In February, the FOMB announced a Plan Support Agreement for GO and PBA bonds, without the support of the bond insurers and about half the creditors. Scandalously, the FOMB negotiated with hedge funds that bought their bonds at pennies on the dollar and completely ignored other creditors. They are willing to pay a fee to these same funds to get the deal through the finish line. Obviously, this wasn’t the intention of Promesa, but we are past the point to believing that this Board isn’t highly conflicted and political.

Puerto Rico exposures now constitute less than 2% of the insured portfolio, so most credits are performing very well. Much of the remaining RMBS exposures are now largely investment grade and have been reduced to less than 2% of net par exposure. Below-investment-grade net par outstanding is only 4% of the insured portfolio, which is the lowest in a decade. During 2019, S&P affirmed the AA financial strength rating across all AGO’s insurance subsidiaries. KBRA affirmed AA+ ratings of AM and MAC and affirmed AGC’s AA rating.

Assured Investment Management, which now includes the recent acquisition BlueMountain Capital Management, LLC, is an asset management firm with $17.8 billion in assets under management. This business is highly scalable and allows AGO to earn diversified revenue streams that don’t expose the balance sheet to credit risk. In addition, the company intends to invest $500MM of capital to funds managed by Assured Investment Management, which should be nicely beneficial to investment income for 2020. By year-end, AGO had invested roughly $79MM in three new investment vehicles. Management indicated that they expect investment income to be up YoY, despite the decline in interest rates caused by fears of the Coronavirus pandemic.

For the 4^th quarter, the Investment Management division generated an adjusted operating loss of $2MM, excluding amortization of intangibles and restructuring charges. This was to be expected and they are currently winding down some sizable funds and starting new ones, so 2020 will be a transitional year, getting better in the later quarters. I wouldn’t expect a material financial impact either way in 2020, but longer-term the opportunity is significant. Historically, AGO has done a pretty good job managing costs, and I’d be very surprised if management was content with anything other than operating profits as we get into 2021 and beyond, but that is simply my opinion.

YTD in 2020, the company purchased an additional 840,000 shares for $40MM. That leaves about $460MM of likely 2020 buybacks, and with the recent market crash, those buybacks are going to dramatically enhance book value and earnings per share metrics. The stock has tended to fluctuate between 50-60% of adjusted book value per share, I think largely due to concerns about Puerto Rico. Using that same range and based on current adjusted book value per share, the stock would trade between $48.43, and $58.11. My target price is around $60-$70 and I believe it to be quite conservative. By the end of this year, it is very possible that adjusted book value per share could reach $110.

Lastly and most important, I want to address the conspiracy theorist shorts, led by the likes of David Einhorn. The short thesis has changed over the years, from the company not reserving enough for RMBS during the Financial Crisis, to being too aggressive in its R&W estimates stemming from that, and to not enough reserves for Puerto Rico. AGO has had the same management throughout, and their reserves ended up being dramatically overly-conservative for RMBS and R&W recoveries. While these exposures have mostly runoff to where the exposure is minimal, the company has been able to release reserves that have mitigated much of the losses due to Puerto Rico.

It doesn’t take a genius to see the improvements in the housing market, or to understand that there is excess spread on owned mortgage-backed securities that pay higher rates. Instead, the short thesis is that they are “conspiring” to release RMBS reserves to cover for Puerto Rico, even though any material adjustment on the negative side would be incredibly easy to spot given the small level of RMBS left in the insured portfolio. Einhorn specifically, made a big deal about the mark to market prices that Puerto Rico bonds were trading at after Hurricane Katrina. This was the same argument made during the Financial Crisis on RMBS securities, that ended up leading to them being one of the best asset classes around. Similarly, Puerto Rico bonds have rallied immensely. The GO’s for instance, have risen by roughly 400% since the lows, while the percentages were even greater for Cofina. PREPA doubled, and HTA went up by around 500%, depending on the issuances. GO and PBA recoveries based on the PSA, would likely be in the high $.80’s to low $.90’s of total claims, when all is said and done, due to the recouping of paid interest and the high coupons on new bonds. These bonds would likely be able to be sold at a premium, due to their relative attractiveness. For those scoring at home, PRASA and MFA continue to pay and that shouldn’t change.

Einhorn talks about AGO’s buybacks being too aggressive because they have exceeded last year’s net income, which to me is a rather short-sighted argument. The insured portfolio has declined at a more rapid rate than new business has been produced. This has led to a massive improvement in the insured leverage ratios, thus, creating excess capital. Insurance regulators have dividend policies based on these capital metrics, and/or investment income. AGO’s strength in those departments, while still reserving for Puerto Rico and other exposures, is what has enabled the company to buy back stock and they should continue to be able to do so.

Source: Adobe Document Cloud

Nearly all the variability on Puerto Rico claims based on current info pertains to the HTA exposures, where AGO’s exposure is sizable. HTA bonds are backed by revenue sources such as tolls and an excise tax on gasoline. The FOMB wants to pay 3% on the HTA bonds that are subject to the clawback, which is only a portion of them. Firstly, that is just an offer, which would have to be revised dramatically higher to get consensual support. In Detroit, the first offer was in the $.03-$.05 range, yet they ended up reaching a settlement at between $.70-$.78. Secondly, it only applies to the amount subject to the clawback. Thirdly, the clawback can legally only be used to pay GO debt, which has not happened. As you can see, there are substantial revenues available after expenses to service debt.

Many of the HTA bonds trade at 40 cents or so, despite these ridiculous offers. If the FOMB tried to push something like this through, the Commonwealth would be subjected to years and years more of litigation. There just really is no logical incentive to do that, and it is highly doubtful that various courts would accept this trouncing of the law. Lastly, don’t forget that AGO has a tremendous amount more information than we do as to the private negotiations. They can’t say anything, but they do reserve based on all the available information they have, and then probably weight the outcomes. Puerto Rico’s Fiscal Agency and Financial Advisory Authority detailed some potential economic terms, which are listed above. I don’t know how things will end up, but I’d guess prices are likely to be around 40-50 cents on the low-end.

Einhorn says that AGO’s valuation doesn’t matter because he doesn’t trust their reserves. Plug in your number of additional reserves then. If AGO was under-reserved by $1 billion dollars (highly unlikely), the after-tax impact would be $800MM, or roughly $8.60 per share. Adjusted book value per share by year-end would still be around $102, and Puerto Rico would be a bad memory. Long-term investors have an excellent buying opportunity with AGO shares trading in the low $40’s, as just a .6 multiple on adjusted book value per share, should get you nearly a 50% return.

Analyst’s 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.