Assured Guaranty is a Bermuda-based financial guaranty insurer that trades rather cheaply at 88% of book and 8.9X estimated 2005 EPS. AGO has been unjustly associated with the issues currently happening at the likes of MBIA and AIG. Underneath all this is a potential catalyst that could propel the business forward, while it retains its niche as being THE top financial guaranty reinsurer.
History: AGO was IPO’ed from ACE Limited in 2004. As part of their IPO, they restructured themselves. They exited the mortgage guaranty insurance business, stopped writing single name corporate derivatives and stopped covering equity pieces of structured finance deals. They also shifted to writing more insurance. In 2003, 90% of the primary business written was CDS but only 25% in 2004. Their bread-and-butter business, though, is financial guaranty reinsurance that represents 2/3 of their revenues.
What is financial guaranty (FG) insurance? It provides credit enhancement to an underlying debt security. AGO concentrates on two areas, namely, public finance, which covers a variety of bonds and obligations for state and local governments, and structured finance, which covers various collateralized obligations. AGO’s credit enhancements can be traditional insurance that covers an obligation no matter the owner or a credit derivative swap (CDS) that is tradable and covers the holder. Whether a deal uses insurance or CDS is up to the customer, but AGO now prefers bidding on insurance deals. While a CDS basically achieves the same result as insurance, the mark-to-market accounting treatment for CDS adds volatility to the income statement and the balance sheet.
Why did ACE let AGO go? The answer is capital. It was likely that ACE would have needed to add more capital to maintain the necessary agency ratings. So they had a choice to add more capital to AGO in order to run-in place, or allocate the capital to grow the other insurance lines. They opted for growth, and sold 66% of AGO to the public.
ACE still holds its 34.2% position, which is now carried on their books as an investment. Other large owners are Boston Partners at 5.5%, Wellington at 5.2% and Cambiar at 5.1%. As of 12/31/04, total institutional ownership was 64.9%, which when combined with the ACE ownership, makes the stock somewhat illiquid despite the $1.36 billion market cap.
As a public entity, AGO has focused on expanding the primary insurance business, particularly in the public finance space, as well as growing business in Europe where they have expanded staff. Post IPO, they are actually overcapitalized and management’s intent is to put the capital to work. Obviously, they would rather deploy their capital after an upgrade, rather than before.
Comps: The major, publicly traded insurers focused on financial guaranty are ABK, MBI, MTG, PMI, RDN and TGIC. Two other competitors, FSA and FGIC, are part of other companies. However, MTG, PMI, RDN and TGIC are focused on the mortgage sector within FG. Thus, ABK and MBI are the closest comps, and are the top two writers of the $3 billion FG market. On the primary business, ABK and MBI are AGO’s closest competitors, and yet, customers for their reinsurance. MBI represents 18% of AGO’s reinsurance book, while ABK is 10%. Here is how the key metrics stack up:
Metric AGO ABK MBI
05 P/E 8.9 9.4 9.2
P/B 0.88 1.40 1.08
Thus, AGO trades at a 4% P/E discount and a 18% P/B discount to its nearest comp, who happens to be under a regulatory cloud.
Key Catalyst: AGO is seeking to be upgraded from “Aa1” to "Aaa" by Moody's on its direct insurance subsidiary, AGC. Most of the restructuring has been geared towards achieving an upgrade. S&P gave AGC its top rating of “AAA” and last week it garnered Fitch’s top rating of ‘AAA’. The other AGO insurance subs have lower ratings because the business that they write is less ratings sensitive and doesn’t justify locking up additional capital.
Indications are that AGO has the capital, product mix, investment portfolio and underwriting discipline that merit a higher rating. Given the exclusivity of a Moody's "Aaa" rating, the agency is not in a rush to let new members into this club. The CEO, Dominic Frederico, noted that even getting the "under review with negative implication" removed from the rating would help because counterparties price as if their rating was actually lower. An upgrade to "Aaa" would be a big boost in competing for muni deals because the lower rating makes them uncompetitive with regard to ABK and MBI. Muni deals represent 40% of the FG market and AGO's competes only on the scraps representing 1% to 2% of the market. Thus, they are effectively shut out of 38% of the FG market.
The one place that they are not shut out is reinsurance. They are the largest reinsurer of FG business, both in terms of market share and financial size. There are only four other FG reinsurers of note, and none offer the capacity that AGO does. This is good to know because reinsurance is 2/3 of their business.
The company has really tried to be open and transparent to investors. Their web site contains lots of information and their VP of IR, Sabra Purtill, knows the business and responds quickly to questions. For die-hard insurance junkies, their statutory (!) filings are at:
Regulatory: Since the NY A.G. started investigating the insurance industry last October, there has been market concern behind every insurer. AGO is relatively clean. They have no finite-risk, no finite reinsurance, and no retroactive reinsurance. There are no contingent commission worries as they are direct writers.
Earnings Estimates: First Call has 2005 EPS at $2.01 and 2006 EPS at $2.29. A partial multiple expansion to a forward 10 P/E would provide 25% return within the next year. With an upgrade and a more benign credit quality outlook, AGO could trade to a 11-12 P/E multiple range that ABK and MBI have averaged.
- They are not upgraded
- Structured financing deals decrease dramatically
- Increase in credit defaults
- Ratings upgrade from Moody’s
- Growth into other markets
- Margin of safety with valuations
- Core reinsurance business is solid