jebmo’s posthaven

Investing is all about paying a much lower price for a security than the value that you are receiving in return. While this seems sensible enough, many people ask why are certain securities undervalued in the first place? Usually they are undervalued due to short-term concerns that mask the obvious disconnect between price and value. When people are concerned that a stock might drop from $36 to $33, they may miss out on it appreciating to $50, as the valuation ultimately should approximate intrinsic value and business fundamentals. The common stock of Assured Guaranty (NYSE:AGO) is once again on sale to anyone willing to look past the toxic mess of Puerto Rico and instead focus on the actual value of the enterprise, which has been growing rapidly despite Puerto Rican problems.

Source: AGO 2016 10-K

What is an industry-leading insurance company's common stock worth with a GAAP and non-GAAP book value of $50.82 and $49.89 per share, respectively? These figures have grown from $25.74 and $28.08 as of year-end 2012. Adjusted book value per share stood at $66.46 as of the end of 2016 compared to $44.84 at the end of 2012. Assured Guaranty guarantees payments on bonds at the time that they are due and in return is paid a premium. These premiums are invested generating investment income. AGO's net par outstanding has dropped from $518.772 billion at the end of 2012 to $296.318 billion at the end of 2016. Meanwhile, claims-paying resources have only dropped from $12.328 billion to $11.7 billion during the same time period. The riskier and more capital-intensive Structured Finance exposure has dropped from $93.303 billion to $25.139 billion, mainly due to amortization and remediations.

In 2016, AGO showed continued improvement in generating new business with the total present value of new business production (PVP) reaching $214MM, which was the highest figure in the last five years, up 20% YoY. This performance occurred despite some of the lowest interest rates we have seen historically, which reduces demand for bond insurance. As rates go higher, and we have already seen two rate hikes over the last few months, demand should pick up even further. In 2016, AGO insured more par issued than the rest of the industry combined while collecting six times the premiums written by the nearest competitor. Despite insured par being down less than 2% from 2015, PVP was up by 30% in U.S. public finance, because of disciplined pricing principles and the respect for the value of the insurance provided. Assured is really the only bond insurer able to handle the largest transactions, and in 2016, the company guaranteed 18 U.S. public finance transactions where it provided over $100MM of bond insurance for a total of $2.8 billion. These were among the 57 municipal transactions issued with $50MM or more with the company's insurance. Assured is also unique in that is has the capability to insure international infrastructure and structured finance deals. These deals are lumpier in nature than U.S. public finance, but they are high margin and add diversification to the insured portfolio.

Because Assured is not writing enough new business to fully offset the natural amortization of the insured portfolio, the company continues to generate excess capital. As of 12-31-2015, AGO estimated that it had $2.6 billion of excess capital above the AAA requirement under the S&P capital adequacy model. Despite completing $306MM in share repurchases in 2016, management believes that this number has increased YoY. Since the beginning of 2013, AGO has repurchased approximately 72.2MM common shares, or roughly 37% of shares outstanding. In November of 2016, the board of directors approved another $250MM in share repurchases. In the first quarter of 2017, the board approved an additional $300MM, which brought the remaining repurchase authorization to $407MM as of 2-23-17. Share repurchases will be partially funded by $300MM that the AGM subsidiary upstreamed to the holding company level after receiving regulatory approval to redeem shares of AGM's common stock held by its holding company. Even after releasing the AGM capital, and also paying $184MM in net claims in 2016 to protect holders of defaulting Puerto Rico-related bonds, AGO's group statutory capital increased $231MM during the year and insured leverage ratios declined.

In addition to stock buybacks, another key pillar of AGO's shareholder value creation strategy is acquisitions. In prior years, the company bought FSA and Radian Guaranty, which were both enormously accretive. In 2016, AGO completed the acquisition of CIFG, which added approximately $310MM to its statutory capital, in addition to $4.2 billion of net insurance exposure, with the related unearned premiums. In January of 2017, AGO closed on the acquisition of MBIA UK, which should add a similar amount of statutory capital and will certainly be very accretive to earnings and book value metrics.

Loss mitigation is another essential element in AGO's strategy. Many of the Puerto Rican debt exposures have defaulted, and AGO has made $226MM in claim payments through February of 2017 thus far. The company and other creditors have begun lawsuits to remedy violations by the Puerto Rican government of its obligations to creditors. In 2016, the U.S. government passed the PROMESA legislation, which establishes an Oversight Board to supervise Puerto Rico's financial affairs and debt negotiations, and it has created a process for both consensual and non-consensual restructurings. Importantly, PROMESA requires the respect for existing constitutional and statutory priorities and contractual liens, which is essential to maintain the rule of law and preserve the contractual rights of creditors and other stakeholders.

Source: AGO Fourth-Quarter Financial Supplement

AGO, other bond insurers, and creditors have already made efforts to work with the government to reduce debt and assist with liquidity. A perfect example is the restructuring agreement with PREPA, where all constituents agreed on terms, but now the new Puerto Rican governor and the Fiscal Control Board are throwing this deal into contention. This change of heart along with the recently approved budget, which allows non-essential government services to be paid prior to creditors, despite this being flagrantly contradictory to the constitution and bond agreements, has thrown gasoline on the Puerto Rican fire. Creditors are fighting back, and I'd expect to either see consensual settlements or the island is going to face a litany of lawsuits, which seem to have very strong cases against how the government is treating creditors.

While there is undeniably tremendous uncertainty, AGO has a strong track record in navigating these types of difficult situations to reach outcomes that are better than what was projected at the outset of negotiations. This is largely due to the company's willingness to defend its legal rights and also leverage the immense value that is provided through enabling the island to access credit markets via the company's bond insurance. Critically, S&P, Moody's and Kroll have all concluded that AGO has the financial strength to manage the potential losses under severely stressed Puerto Rico scenarios while retaining current ratings.

AGO has just under $5 billion of total net par outstanding in Puerto Rican debt. The company has been adding reserves each quarter for about the last two years. The full impact has been negated slightly by the fact that RMBS loss reserves have declined due to more favorable developments. I estimate that AGO has around $1 billion reserved for Puerto Rico thus far. $724MM of the exposure is to PREPA where if the initial RSA were to hold, AGO wouldn't lose anything. If the deal falls apart, they may need to add to reserves, but Puerto Rico may also lose the ability to access credit markets, which will be an essential element to any successful economic recovery. PREPA has had massive liquidity issues, which have only been assuaged by forbearance and loans provided by creditors including the bond insurance companies. AGO has a history of being conservatively reserved, and much of the rumors percolating right now are simply that. What actually matters is what deals are finally agreed upon and approved. Importantly, AGO cannot be accelerated, so payments are only made when due. This allows the company to keep generating its $400MM plus of investment income, which can handle any payments that must be made. Even in the virtually impossible case that AGO is under-reserved by $1 billion, the impact would be manageable. Based on 131MM shares outstanding, the pretax loss would be $7.63 per share. The after-tax hit assuming a 30% tax rate would be roughly $5.34. Expect AGO to earn at least half that in the first quarter of 2017 alone as the impact of the MBIA UK acquisition is reflected on the balance sheet, so no matter what happens, AGO is going to be fine.

This gets us to AGO's valuation. While the stock performed exceptionally well last year and the beginning of 2017, it has pulled back recently as Puerto Rico has been in the news to a recent price of $36.64. This is only 73.5% of operating book value and a paltry 55% of adjusted book value per share. Both these metrics should be up materially after the first quarter even though I do believe the company will probably add another $100MM or so to Puerto Rican reserves. AGO is aggressively on the lookout for acquisitions and it structures these to be very accretive. There is no sense in Syncora (OTCPK:SYCRF) for example having a Financial Guaranty business at this point. AGO can buy it off the company to provide much needed cash, which would help the company invest in a business to monetize its very large net operating losses. You can say the same thing for the majority of the legacy bond insurers that are still out there. Also, the recent selloff has provided a great opportunity for aggressive stock buybacks, which are also enormously accretive. Look for AGO to keep compounding book value in spite of Puerto Rico, and when we get resolution there, the stock should rocket higher as the rest of credit book is in outstanding condition. I believe the company should be trading in the mid-$40s, but should compound intrinsic value by 10-15% per annum over the next three years. This could put intrinsic value around $60 within a three-year period.

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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.

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