Ambac ABK
November 12, 2007 - 2:16am EST by
Coyote05
2007 2008
Price: 26.16 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 2,689 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

 

As a result of the sub-prime melt down, ABK is severely depressed.  It is trading at half of book value, while it normally trades north of 1.5x.  At the current valuation, I view it as a high uncertainty, low risk situation.  This is a high uncertainty situation because, at least to me, their portfolio is a “black box”.  Within this “black box” the company has $8.8b of exposure to sub-prime MBS (less than 1% of the total portfolio).  However, it is practically impossible to assess the level of losses that the company will actually incur, when will they materialize, and to what extent these losses will be greater than the earnings of the rest of the business and thus significantly erode book value.  If you disagree (that is you have factual evidence that would lead one to conclude otherwise), feel free to rate this idea a zero, but please share your insights.

 

Note:  It will probably become evident to the initiated reader that I am not an expert in this sector or possess special insight into this company.  However, the information I have gathered and my analysis suggest that there is a favorable risk/reward in ABK.  If you are interested, I recommend reviewing the investor presentations on the company’s website and listening to the recent investor call to discuss their sub-prime exposure in addition to their filings and other public info.

 

Description

ABK is a mono-line insurer offering financial guarantee.  That is, it guarantees the payment of principal and interest on insured bonds.  ABK is one of the two market leaders (MBIA being the other).  By some measures it is the largest and most profitable.  It is a rated AAA and has a long history of growth and profitable underwriting.  It has a broadly diversified book of business.  Its return on equity has generally been 13% to 16%.  It has consistently increased its dividend and, most recently has repurchased its stock and reduced its share count (as opposed to other companies that despite repurchasing their shares the share count does not decrease.)  Finally, it has a growing international business that accounts for more than 25% of earned premium.

 

Thesis

ABK is a market leader with a long term track record of growth and profitability.  While most likely it will not emerge unscathed, the current valuation provides a substantial margin of safety.  Thus, ABK has limited downside with potentially large (100%+) upside as the financial guarantee market recovers from this episode and continues its long term growth path.

 

Merits

Sub-prime is a small portion (<1%) of their total portfolio.  ABK has a total net par insured of $556b, of which $8.8b sub-prime MBS.  Of the latter amount, $4.0b corresponds to 2004-2007 “vintages” ($0.8b ’04, $1.6b ’05, $1.0b ’06, and $0.6b ’07).  Further, the company does not expect any material claims from its exposure to sub-prime MBS.  Lastly, the company only insures the most senior tranche.

 

ABK recently confirmed that it has $1b-$2b of excess capital (that is capital in excess of what it needs to maintain its AAA rating) depending on which rating agency’s model is used (Moody’s, S&P, or Fitch).  Furthermore, it has also mentioned that even stress-testing the sub-prime portfolio for additional substantial downgrades to the underlying securities (everything down 3 notches, with the bottom ten percent down 10 notches), it would remain overcapitalized by $500m+.  The stress testing also included delinquencies reaching 21%-26%, an assumption characterized by management as far more conservative than those used virtually anywhere on The St.  In addition, the company has mentioned that internally it uses more strict criteria (than the rating agencies) to “mark-to-model” their exposure.  As such, the current book value already provides for potential additional downgrades (by the rating agencies) on their book of business – however, I am not sure that the $500m mentioned above would have this leeway.

 

It does not face a liquidity crisis.  For once, the company has $14.2b worth of claims-paying resources and its financial resources ratio is 63:1.  The company highlights that its contracts do not require collateral.  On the investing side (as opposed to the underwriting side), the company does not have a material exposure to sub-prime securities.  It has a high quality fixed-income investment portfolio, 99% of which is rate A or higher.

 

The company has shown underwriting discipline.  If you look at the company’s participation in the non-agency MBS market, it drops dramatically from 2002 to 2004 and has stayed at very low levels since then.  Furthermore, their sub-prime MBS par outstanding peaked in 2003 at $33.9b, and their total MBS (prime and non-prime) portfolio peaked in 2004.  (Note that ABK has reduced its exposure to sub-prime from $33.9b in 2003 to $8.8b as of 3Q07.)  As most people know, underwriting discipline is critical if an insurer intends to weather a crisis.  ABK has weathered just fine previous major credit crises.

 

The rest of the business continues to grow and prices have firmed up.  Once the sub-prime crisis runs its course, it is likely that the competitive environment will see fewer players and better pricing.  I believe that given the specialized niche nature of the financial guarantee market, it is unlikely that a substantial amount of capital will enter the business after the crisis as it has happened in other insurance sectors (e.g. P&C after 9/11).

 

Risks

I believe the risk of bankruptcy is negligible, except in case of fraud or “a nuclear melt-down”.  Another possibility is that things turn out much worse than expected (e.g., sub-prime delinquencies north of 25% and a simultaneous crisis in another portion of their business), forcing the company to raise “dilutive” capital.  It is hard for me to envision a probable scenario where the company would need to raise “dilutive” capital (for those buying at the current valuation).  First, it has ample liquidity ($14.2b worth of claims-paying resources).  Even if the company had to pay $3.0b worth of claims over the next two/three years, the business keeps generating earnings and cash flow.  Thus, a couple of years from now, on a worse case scenario*, the company would still look rather solid.

 

*This is would be quite a worse case scenario, not your average worse case scenario.  First, consider that the company has paid claims totaling $272 million since 1991.  This is the sum of all claims paid (net of recoveries) since 1991.  Second, this worse case scenario would correspond to an economic crisis where sub-prime delinquencies exceed 25% and there is a simultaneous major crisis affecting structured finance.  Finally, this worse case scenario, excludes a likely government intervention in a crisis of such magnitude.

 

Another risk is that management, and the rating agencies, are in denial – not uncommon when the time of reckoning arrives.  It is possible that those “stress tests” are not really what a stress test should be.  Consequently, their capital position could be much weaker than what their comments and disclosures indicate.  Thus, in a reasonable worse case scenario, the company would be forced to raise capital.  While this would be more than embarrassing for management (and the rating agencies), it would further depress the stock price.

 

It is hard to gauge how realistic are the large number of assumptions that management uses to test the resilience of their portfolio.  One can take some comfort in the fact that three rating agencies will be looking over their shoulders.  However, given the complexity of their book of business, I don’t know how much comfort one can derive from this; especially in light of the sub-par performance of the rating agencies in the sub-prime sector.  In terms of incentives, I am inclined to believe that management has the incentive to be optimistic (i.e., paint a rosy picture).  This is partly because now would not be a particularly good time to raise capital; as the crisis is still unfolding.  On the other hand, the CFO and other senior executives in charge of risk management would want to preserve their credibility as much as possible by being conservative.  However, one could characterize their stress tests as optimistic relative to actual recent downgrades experienced.  A couple of deals were downgraded from AAA to BBB.  While management claims that these were exceptional cases, one has to wonder how many more “exceptional” cases will surface as the crisis unfolds.

 

Bottom line, while I think that there is a decent margin of safety and large long-term upside, I would not be surprised if the stock experiences new lows in the near term.

 

Catalyst

Unfortunately, I do not see a clear catalyst.  As the sub-prime crisis play out, management could signal improved fundamentals by resuming/increasing share repurchases or increasing the dividend.  Investors will also, to the extent disclosed, learn about actual claims paid.

Catalyst

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    Description

     

    As a result of the sub-prime melt down, ABK is severely depressed.  It is trading at half of book value, while it normally trades north of 1.5x.  At the current valuation, I view it as a high uncertainty, low risk situation.  This is a high uncertainty situation because, at least to me, their portfolio is a “black box”.  Within this “black box” the company has $8.8b of exposure to sub-prime MBS (less than 1% of the total portfolio).  However, it is practically impossible to assess the level of losses that the company will actually incur, when will they materialize, and to what extent these losses will be greater than the earnings of the rest of the business and thus significantly erode book value.  If you disagree (that is you have factual evidence that would lead one to conclude otherwise), feel free to rate this idea a zero, but please share your insights.

     

    Note:  It will probably become evident to the initiated reader that I am not an expert in this sector or possess special insight into this company.  However, the information I have gathered and my analysis suggest that there is a favorable risk/reward in ABK.  If you are interested, I recommend reviewing the investor presentations on the company’s website and listening to the recent investor call to discuss their sub-prime exposure in addition to their filings and other public info.

     

    Description

    ABK is a mono-line insurer offering financial guarantee.  That is, it guarantees the payment of principal and interest on insured bonds.  ABK is one of the two market leaders (MBIA being the other).  By some measures it is the largest and most profitable.  It is a rated AAA and has a long history of growth and profitable underwriting.  It has a broadly diversified book of business.  Its return on equity has generally been 13% to 16%.  It has consistently increased its dividend and, most recently has repurchased its stock and reduced its share count (as opposed to other companies that despite repurchasing their shares the share count does not decrease.)  Finally, it has a growing international business that accounts for more than 25% of earned premium.

     

    Thesis

    ABK is a market leader with a long term track record of growth and profitability.  While most likely it will not emerge unscathed, the current valuation provides a substantial margin of safety.  Thus, ABK has limited downside with potentially large (100%+) upside as the financial guarantee market recovers from this episode and continues its long term growth path.

     

    Merits

    Sub-prime is a small portion (<1%) of their total portfolio.  ABK has a total net par insured of $556b, of which $8.8b sub-prime MBS.  Of the latter amount, $4.0b corresponds to 2004-2007 “vintages” ($0.8b ’04, $1.6b ’05, $1.0b ’06, and $0.6b ’07).  Further, the company does not expect any material claims from its exposure to sub-prime MBS.  Lastly, the company only insures the most senior tranche.

     

    ABK recently confirmed that it has $1b-$2b of excess capital (that is capital in excess of what it needs to maintain its AAA rating) depending on which rating agency’s model is used (Moody’s, S&P, or Fitch).  Furthermore, it has also mentioned that even stress-testing the sub-prime portfolio for additional substantial downgrades to the underlying securities (everything down 3 notches, with the bottom ten percent down 10 notches), it would remain overcapitalized by $500m+.  The stress testing also included delinquencies reaching 21%-26%, an assumption characterized by management as far more conservative than those used virtually anywhere on The St.  In addition, the company has mentioned that internally it uses more strict criteria (than the rating agencies) to “mark-to-model” their exposure.  As such, the current book value already provides for potential additional downgrades (by the rating agencies) on their book of business – however, I am not sure that the $500m mentioned above would have this leeway.

     

    It does not face a liquidity crisis.  For once, the company has $14.2b worth of claims-paying resources and its financial resources ratio is 63:1.  The company highlights that its contracts do not require collateral.  On the investing side (as opposed to the underwriting side), the company does not have a material exposure to sub-prime securities.  It has a high quality fixed-income investment portfolio, 99% of which is rate A or higher.

     

    The company has shown underwriting discipline.  If you look at the company’s participation in the non-agency MBS market, it drops dramatically from 2002 to 2004 and has stayed at very low levels since then.  Furthermore, their sub-prime MBS par outstanding peaked in 2003 at $33.9b, and their total MBS (prime and non-prime) portfolio peaked in 2004.  (Note that ABK has reduced its exposure to sub-prime from $33.9b in 2003 to $8.8b as of 3Q07.)  As most people know, underwriting discipline is critical if an insurer intends to weather a crisis.  ABK has weathered just fine previous major credit crises.

     

    The rest of the business continues to grow and prices have firmed up.  Once the sub-prime crisis runs its course, it is likely that the competitive environment will see fewer players and better pricing.  I believe that given the specialized niche nature of the financial guarantee market, it is unlikely that a substantial amount of capital will enter the business after the crisis as it has happened in other insurance sectors (e.g. P&C after 9/11).

     

    Risks

    I believe the risk of bankruptcy is negligible, except in case of fraud or “a nuclear melt-down”.  Another possibility is that things turn out much worse than expected (e.g., sub-prime delinquencies north of 25% and a simultaneous crisis in another portion of their business), forcing the company to raise “dilutive” capital.  It is hard for me to envision a probable scenario where the company would need to raise “dilutive” capital (for those buying at the current valuation).  First, it has ample liquidity ($14.2b worth of claims-paying resources).  Even if the company had to pay $3.0b worth of claims over the next two/three years, the business keeps generating earnings and cash flow.  Thus, a couple of years from now, on a worse case scenario*, the company would still look rather solid.

     

    *This is would be quite a worse case scenario, not your average worse case scenario.  First, consider that the company has paid claims totaling $272 million since 1991.  This is the sum of all claims paid (net of recoveries) since 1991.  Second, this worse case scenario would correspond to an economic crisis where sub-prime delinquencies exceed 25% and there is a simultaneous major crisis affecting structured finance.  Finally, this worse case scenario, excludes a likely government intervention in a crisis of such magnitude.

     

    Another risk is that management, and the rating agencies, are in denial – not uncommon when the time of reckoning arrives.  It is possible that those “stress tests” are not really what a stress test should be.  Consequently, their capital position could be much weaker than what their comments and disclosures indicate.  Thus, in a reasonable worse case scenario, the company would be forced to raise capital.  While this would be more than embarrassing for management (and the rating agencies), it would further depress the stock price.

     

    It is hard to gauge how realistic are the large number of assumptions that management uses to test the resilience of their portfolio.  One can take some comfort in the fact that three rating agencies will be looking over their shoulders.  However, given the complexity of their book of business, I don’t know how much comfort one can derive from this; especially in light of the sub-par performance of the rating agencies in the sub-prime sector.  In terms of incentives, I am inclined to believe that management has the incentive to be optimistic (i.e., paint a rosy picture).  This is partly because now would not be a particularly good time to raise capital; as the crisis is still unfolding.  On the other hand, the CFO and other senior executives in charge of risk management would want to preserve their credibility as much as possible by being conservative.  However, one could characterize their stress tests as optimistic relative to actual recent downgrades experienced.  A couple of deals were downgraded from AAA to BBB.  While management claims that these were exceptional cases, one has to wonder how many more “exceptional” cases will surface as the crisis unfolds.

     

    Bottom line, while I think that there is a decent margin of safety and large long-term upside, I would not be surprised if the stock experiences new lows in the near term.

     

    Catalyst

    Unfortunately, I do not see a clear catalyst.  As the sub-prime crisis play out, management could signal improved fundamentals by resuming/increasing share repurchases or increasing the dividend.  Investors will also, to the extent disclosed, learn about actual claims paid.

    Catalyst

    Messages


    SubjectComments
    Entry11/12/2007 11:09 AM
    Memberdavid101
    Vanleo,

    Thanks for writing up Ambac. The comments and details on underwriting discipline are key. I also highly recommend anyone considering Ambac to listen to their most recent conference call in response to the Morgan Stanley report; it is available as a webcast on their company web site. They highlight how comparing them to Merrill Lynch misses important points, like how any loss payments they make are for periodic princiapal and interest payments, not the entire principal balance. It is also worth noting that insiders have been buying.

    David

    SubjectABK's rating downgrade risk
    Entry11/13/2007 01:57 PM
    Membercarbone959
    It is being said that the insurers' AAA rating is a matter of life and death. Do you think this true and, if so, what makes you confident that ABK's insurance subs will stay AAA?

    Subjectackman
    Entry11/28/2007 11:57 AM
    Memberrii136
    Did anyone attend Ackman's presentation today, or know if the presentation is available anywhere online like his last one was? Curious to hear thoughts/summary from anyone who attended. Thanks.

    rii

    Subjectdownloaded Ackman's spreadshee
    Entry02/01/2008 11:30 AM
    Memberscrooge833
    So I downloaded Bill's spreadsheet. I have one question.


    Does anyone know how to recalculate after changing the assumptions?

    SubjectRe: Ackman's spreadsheet
    Entry02/04/2008 10:55 AM
    Memberdoggy835
    His spreadsheets are hardwired to spit out Chapter 11 no matter what assumptions you use :-)
    Seriously, I only have his presentations. If you can point me to the spreadsheet I'll see if I can get it to recalc.

    SubjectRe: Ackman's spreadsheet
    Entry02/04/2008 10:56 AM
    Memberdoggy835
    His spreadsheets are hardwired to spit out Chapter 11 no matter what assumptions you use :-)
    Seriously, I only have his presentations. If you can point me to the spreadsheet I'll see if I can get it to recalc.

    SubjectRe: Ackman's spreadsheet
    Entry02/04/2008 10:56 AM
    Memberdoggy835
    His spreadsheets are hardwired to spit out Chapter 11 no matter what assumptions you use :-)
    Seriously, I only have his presentations. If you can point me to the spreadsheet I'll see if I can get it to recalc.

    SubjectRE:Sorry
    Entry02/04/2008 10:58 AM
    Memberdoggy835
    Sorry for the multiple replies. This new BBS software has some interesting, um, features.
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