Description

Argo Group International Holdings, Ltd. ("Argo", or "the Company") is a Bermuda-based insurance holding company which owns and operates a group of specialty insurance and reinsurance companies. 

Situation overview

Argo’s stock has sold off significantly more than peers since 2/19/20 (S&P peak / pre-COVID) with the underperformance attributable to a series of events preceding and including COVID related losses:

At Friday’s closing price of $34, ARGO is down 46% since 2/19/20 and is down 56% from its all-time high of $78 reached in April 2019.  

Thesis

Argo presents an opportunity to ride shotgun with Voce, who isheavily incentivized to drive the stock price past its disclosedcost basis of approximately $55 per share (61% above last close), at a ~40% discount to what they paid.  A variety of scenario alternatives exist to create value, each with compelling upside:

Business summary

Argo Group is an international underwriter of specialty insurance and reinsurance products in the property and casualty market.

U.S. business overview

Argo’s best asset is its U.S. platform.  It writes both admitted and non-admitted business and focuses on niche products where their in-house underwriting expertise can maintain a market-leadership position.  On a 1Q 2020 LTM basis, the U.S. business broke down as 57% liability, 18% professional lines, 15% property and 10% other specialty products, and roughly an even 50/50 split between admitted and non-admitted business. 

Property and casualty insurance is bound in either the standard (or “admitted”) or the excess and surplus (“E&S”) / “non-admitted” market.  The standard market is much larger (94% of total U.S. P&C gross written premiums) but less profitable (102%+ average combined ratio in the last 15 years) than the non-admitted market. The E&S market tends to be more profitable (96% average combined ratio in the last 15 years) than the standard market as of the result of freedom of rate (no regulatory approval needed for price increases) and form (no regulatory approval for policy terms and conditions).

Argo’s excess and surplus platform, Colony Specialty writes the non-admitted business and includes contract, transportation, casualty, environmental and specialty property products.  The E&S business is primarily distributed through relationships with independent wholesale brokers (AmWINS, RT Specialty, etc.) and managing general agencies focused on niche classes of non-admitted business.  

The admitted business is spread across a group of specialty platforms including Argo Pro (customer service focused D&O and E&O specialty platform), Argo Insurance (offers insurance and risk management services to grocery, restaurants and other specialty retail industries), Rockwood Casualty (designs custom workers comp and other programs for businesses in the mining sector), U.S. Specialty Programs (offers specialized commercial niche programs customized to meet the specific insurance needs of targeted businesses), Inland Marine (offers insurance coverage in the U.S. for builders risk, motor-truck cargo, equipment, and other miscellaneous marine risks), Argo Surety (provides surety solutions to businesses that must satisfy various eligibility conditions in order to conduct commerce).  The admitted business is primarily distributed through independent retail agents and brokers, with occasionally some of the professional liability and surety products may be sourced from wholesale relationships.

U.S. business performance summary

The U.S. business has historically “kept the lights on” at Argo, performing near the top quartile of underwriting results against other specialty peers, including KNSL, PLMR, ACGL, RLI, SIGI, AFG, WRB, MKL, THG, JRVR, HALL, GBLI, PROSand PTVCB.  Argo U.S.’s 5-year combined ratio of 90.5% ranks 4th, only after less mature market-darlings KNSL (77.8%), PLMR (85.4%) and steady-performing ACGL (87.1%).  Another mature, steady-performer, RLI follows Argo’s U.S. business in 5th at 91.4%.  Argo U.S.’s 10.5% 5-year ROE performance of the business also shows well, landing in the top 6 of the same peer group, behind PLMR (17.2%), KNSL (14.8%), AFG (12.2%), RLI (12.0%) and SIGI (11.9%), but well above the median of 8.8%.

The U.S. business, besides 2019, experienced at least 1.0 points of favorable reserve development in each year since 2015. Its accident year ex-Cat loss ratio in 2019 drifted upward by 0.7 points reflecting an increased level of property losses and loss experience in certain liability lines.  Net unfavorable prior year development for 2019 was $15.7mm (1.4 points) and related primarily to unfavorable development on E&S, as well as in property lines.

International business overview

The international business is another story – it has been a poor performer dragging the Company’s returns over the same historical period.  This business writes insurance and reinsurance worldwide through the broker market.  Primary coverages include specialty property insurance (37% of GPW), property catastrophe reinsurance (30%), primary/excess casualty(16%) and professional liability insurance (16%). 

International is made up of a multi-class Lloyd’s Syndicate platform, a Bermuda (re)insurance platform and primary businesses in Continental Europe and Brazil, and besides Lloyd’s, is primarily distributed through the independent retail and wholesale broking markets.

The Lloyd’s Syndicate Platform includes two syndicates (1200 and 1910).  Syndicate 1200 specializes in underwriting worldwide property, specialty and non-U.S. liability insurance under the ArgoGlobal brand.  Syndicate 1910 is the underwriting business of Ariel Re, acquired in 2017 for $235mm; writes a broad range of reinsurance through offices in Bermuda, London, Hong Kong and Brussels. The syndicates are managed by the Argo Managing Agency and trade under the Lloyd’s of London capital and licensing framework.

Bermuda (Re)insurance writes a range of coverages for global clients including property, general and products liability, directors and officer’s liability, errors and omissions liability and employment practices liability.

International Specialty includes the operations in Europe and Brazil. ArgoGlobal SE, based in Malta, underwrites professional liability, surety, and property and casualty business in continental Europe. ArgoGlobal Assicurazioni is a specialty underwriter of property, marine, accident & health and liability insurance in the European market with a focus on Italy and Southern Europe. Argo Seguros based in Sao Paolo, Brazil provides a broad range of commercial property, casualty and specialty coverages; primary lines of business are cargo and marine, property, and engineering and financial lines.

International business performance summary

The international business has historically dragged returns at Argo, as the worst performer in its class of international / reinsurance peers over the last five years.  On a combined ratio basis, the international business 105.8% 5-year CR trails RNR (91.0%), RE (96.0%), Y (98.0%), SG (100.1%) and AXS (101.2%), and is far below the peer median of 98.0%. Argo International’s -1.6% 5-year ROE performance of the business is also poor, ranking as the penultimate name in the group, behind RE (8.9%), RNR (5.0%), AXS (4.0%), Y (4.0%) and ahead of SG (-4.8%), and also well below the peer median of 4.0%.  If compared to the U.S. specialty peers, it would rank even worse.

Argo has experienced a variety of underwriting issues with this business. Weak underwriting performance has primarily been driven by deterioration in 2019 accident year ex-cat loss ratio related to property, liability and marine lines. Net unfavorable prior year development for 2019 was $110.4mm (18.1 points), primarily concentrated in liability and professional lines. 2019 catastrophe losses were $19.2mm (3.2 percentage points) related to Hurricane Dorian, Typhoons Hagibis and Faxai, U.S. storms, and included losses from flooding. Charges in Bermuda stem from public utility business in the casualty division, which Argo previously exited, as well as updated estimates on several other casualty and professional claims based on new information received in the last three quarters of 2019. 

Run-off (discontinued operations included in consolidated results)

Argo’s Run-off lines segment includes results for certain discontinued lines of business, including those lines that were previously recorded in the Company’s Risk Management segment.  Run-off also includes other liability reserves, which include exposure to claims for asbestos and environmental liabilities written in past years.  The company’s Risk management business sale to Paragon Insurance Holdings (an MGA) was announced in February 2020.  The run-off liabilities are associated with discontinued lines previously written by insurance subsidiaries, such as those arising from liability policies dating back to the 1960s, 1970s and into the 1980s.  Majority of the business operations within the run-off lines is focused on the management of claims and other administrative functions.

The Run-off segment has had unfavorable reserve development every year since 2012, resulting in cumulative underwriting losses of ~$157mm.  Each year since 2012, a negative earnings impact of $10-40mm and negative combined ratio impact of 1.0-3.0 points has been included in Argo consolidated earnings from the run-off lines.

Activist Campaign

Timeline

Beginning in January 2019, Voce Capital (led by J. Daniel Plants) privately approached Argo‘s management regarding its underperformance.  In February, Voce filed a 13D disclosing 5.6% stake and Argo retaliated by announcing the appointment of two new directors friendly to CEO Mark Watson.  Later in February, Voce sent letter to shareholders making a case for Board change and notified Argo of its’ intention to replace 4 directors with 4 Voce nominees. In early March, Voce presented a 5-person slate of directors for election to the Board.  Subsequently in March, Argo formed an independent special nominating committee toconsider Voce’s proposals and make a recommendation to the Board.

In late April and early May, after Argo’s formation of the special committee, Voce very publicly accused Argo of providing CEO Mark Watson with lavish accommodations, not disclosing property ownership to shareholders and later published flight logs, noting that some destinations do not house Argo offices.  Later, a detailed 130-page investor presentation slamming Watson was published.  

Both the letters and presentation included some very memorable allegations: “We believe the G5 is Mr. Watson’s personal chariot, whisking him and his entourage around the world in pursuit of his kaleidoscope of hobbies and interests, which sometimes includes Argo business, but often do not…Chauffeured him to France 11 times, which Mr. Watson seems particularly fond of, despite Argo’s miniscule business there, as he’s visited Paris, Provence, Saint Malo and other destinations (and this total excludes the annual Nice Monte Carlo industry conference)... Schlepped him to South Florida 23 times, mostly to Miami and surrounding areas, where his 52 foot yacht, “Spookie,” is harbored and frequently races.”

Later in May, Voce withdrew its 5 nominations after 2 of 5 departments of insurance (IL, VA) withdrew their approvals that allowed Voce to solicit support for its nominees just prior to the 5/24 annual meeting. As a result, all management nominees were elected. In August, Argo announced they had linked executive compensation to 3-year ROE and BV/share metrics, plus increased management stock outstanding guidelines to better align interested with creating shareholder value.

In October, in a rather surprising turn of events, Argo disclosed it had received a SEC subpoena and that its directors were "conducting a review of governance and compensation matters.“ By early November, Watson officially “retired” and Argo announced he would remain on the Board and serve as adviser until year-end 2019. Kevin Rehnberg, CEO of the U.S. business and chief administrative officer, took over as CEO on an interim basis, effective immediately.

Just before Thanksgiving, Voce filed a Preliminary Consent Statement to solicit consents to call a special meeting with the intention to replace five directors, and in mid-December, Argo announced retirement of five Board members, four of whichwere the same that Voce targeted for removal in March.

Immediately after Watson’s departure, on 12/31/19, Argo entered into a cooperation agreement with Voce.  In February2020, Argo appointed existing independent director Tom Bradley its new Chairman and formalized Kevin Rehnberg’s interim status as permanent CEO.  Additionally, Argo and Voce jointly identified two director candidates later in February. In late March and April, Voce filed amended 13Ds, increasing its stake from 5.8% to 7.4%, looks to be cooperating with management, as there have been no new materials developments since COVID began.

Incentives

As of its latest 13D filing, Voce owns 3.022 million shares of ARGO and is its largest active shareholder.  The position was accumulated since 4Q ‘18 and publicly disclosed on 2/4/19, culminating with its last disclosed purchase on 4/17/20.  Assuming the VWAP for the shares purchased in 4Q ’18 (637 thousand shares) prior to the February 2019 filing and the other publicly-disclosed details of the larger trades, it appears that Voce’s cost basis for the position is approximately $55 per share.

Also, this appears to be Voce’s largest position in its portfolio, by far, according to its most recent 13F filing.  Approximately 78% of Voce’s disclosed holdings are in ARGO.  They are now heavily incentivized to make this work with the directors and management they have helped hand-pick following the campaign and the cooperation agreement, and it shows based on the commentary from both sides following the cooperation agreement in early 2020:

Tom Bradley, Governance Committee Chair (at the time), Argo: “We... value [Voce’s] input as we continue to enhance our Board composition and governance practices ...we are pleased to welcome Carol to the Board. Her strong leadership and executive experience in the insurance and investment management industries will help drive continued value creation for our shareholders.”

J. Daniel Plants, Voce Capital: “The appointment of Carol McFate to the Board, the addition of two other independent directors selected with Voce’s input, and the Company’s ongoing governance improvements, are substantive and positive developments that give us confidence in the new course that Argo has charted.”

Post-cooperation agreement issues driving the share price downward

A.M Best ratings downgrade 

In late February, A.M. Best downgraded the long-term issuer credit rating of Argo Group International Holdings Ltd. and Argo Group U.S. Inc. to bbb -and downgraded Argo Re Ltd.‘s financial strength rating from A to A- and long-term issuer credit rating from A to A-. A “negative outlook“ was assigned to all ratings citing repeated and significant reserve development, particularly in the International segment, and reflecting weakening balance sheet strength, including potential for additional reserve development.

An A.M. Best downgrade is challenging for any insurance business as it is impacts marketing products through its various distribution channels.  None of the U.S. subsidiaries’ financial strength was downgraded which is a positive from a marketing perspective.  The downgrade is challenging for International segment, as makes sourcing reinsurance premium to the A- Bermuda entity more difficult, forcing Argo to send more premium to Lloyd’s at a higher cost.

4Q 2019 and 1Q 2020 results

Two challenging quarters in succession show the divide between U.S. and International business fundamentals.  4Q 2019’s poor earnings (pre pre-announced) included $77 million of reserve development (18 combined ratio points) split $ 41, 26 and 10 million between international, U.S. and runoff respectively. One-off expense items included $16 million goodwill impairment related to Italian operations, $18mm for losses and impairment of long-lived assets (aircraft, real estate) and $8 million of expense for board review of governance and compensation.  Core results included weaker than expected growth and underwriting (both driven by International), and Q4 results obscured by “kitchen sink” approach to one-time items.

1Q 2020 was a mixed quarter with strong U.S. results showing strong growth and margins driven by investments in digitization. International results were marred by $19 million of COVID related losses on event cancellation and business interruption policies covering pandemic, with further COVID related losses expected in 2Q.  Expenses were elevated by increased Lloyd’s participation, resulting from A.M. Best downgrade. Investment income improved with shorter duration portfolio less affected by yield pressure but does not include mark-to-market on alternatives portfolio which will appear in 2Q 2020 results given reporting lag.

COVID-19 impact

Total COVID exposure reported was with 1Q results.  In general, it was not outsized relative to peers on a consolidated basis but relatively high in the International business.  International impact was material: COVID losses added 14 points to the combined ratio with Street analysts forecasting a further $15 million loss cumulatively given high exposure to property coverage (nearly one-third) in international business.

COVID exposure is very limited in U.S. book with virus exclusions on most business interruption policies.  COVID added 2.5 points to the combined ratio to the U.S. book, but going forward limited impact is expected as less than half of property policies have business interruption coverage and large majority of business interruption has virus exclusions.

As discussed on VIC previously, the interational BI market will likely be more susceptible to COVID-claims as they develop going forward since policy wordings are not standardized like the ISO form in the U.S. which excludes pandemics from insurable losses.

Investment strengths  

Positioned in desirable markets

The E&S market continues to experience better underwriting results, stronger growth and favorable premium trends compared to the broader P&C market.  Consistent across earnings calls and other industry reporting in the sector, E&S pricing was strong in 2019 and rate increases have continued into 2020 with the sector now in a true hard market.  As the risk appetite of the standard market wanes on certain lines of business as a result of COVID-19, E&S carriers can absorb these risks, but on their terms and pricing.  Strategic expansion in the specialty industry continues to be a sound investment as evidenced by outsized returns of the non-admitted market over the last 20 years.

Argo’s U.S. Specialty business is positioned to capitalize on these positive trends.  Argo’s niche business units attract and retain clients in the world’s most predominant specialty insurance market.  Argo’s U.S. business outperformed specialty peer median on the 5-year average combined ratio by 420bps.  Their Colony Specialty E&S franchise is a top 10 U.S. E&S player, which is a rare commodity in an attractive market segment.

Strong growth in both U.S. and International businesses

Posting an 11.5% consolidated GWP CAGR, Argo is growing well above the U.S. specialty peer (listed above) median CAGR of 9.3% since 2015.  The U.S. business is driving the growth in GWP, with a CAGR of 12.2%. The international business is also contributing strong growth (8.2% CAGR), despite its issues with underwriting and reserving.  The international business continues to be a strong and well-known franchise in the worldwide P&C market and would be attractive to new entrants or those looking to gain market share.

Part of this growth has been driven in all markets by Argo’s ongoing digital transformation.  Argo has embraced a “digital-first carrier” mentality to both strengthen operations and enhance carrier relationships.  Partners are supported with strong technology offerings, and creation and adoption of cutting-edge digital tools and focus on product optimization drives improved risk selection, efficiency and scale.

Through the adoption of its digital transformation, Argo has experienced a 43% improvement in GWP per employee over the past five years.  By implementing cutting-edge operational strategies, Argo can capture the full benefit of its strong growthand market positioning.

Refocus on core business and expenses by new management

In recent months, Argo has refocused its platform to emphasize its high-performing core businesses.  The U.S. business’ 5-year average operating ROE exceeds specialty peer median by 140bps. Argo is concurrently pursuing significant cost-saving strategies, which include: (a) exit of Asian operations and most hull businesses within Syndicate 1200, (b) sale of Trident Public Risk Solutions to Paragon, (c) rationalized corporate expenses (exited aircraft lease, sold select corporate real estate, elimination of regional underwriting office for Latin America), and (d) significantly reduced marketing and sponsorship contracts from Mark Watson era. Recent expense actions will reduce non-underwriting expenses by approximately 10% or $20 million and represents the first step in efforts to simplify organization.

Outcomes of strategic alternatives available to new management

The alternatives available to new CEO Rehnberg are all attractive from a value creation standpoint, and generally fall into three areas.  (a) Refocusing the business on core U.S. Specialty: a sale of Argo’s international business even at a significant discount to book value would result in a U.S. specialty insurer with a mid-teens ROE profile, (b) take-private: partnering with a long-term capital provider to take the company private would allow new management to fix the business without the pressure of quarterly reporting, and (c) status quo: executing new management’s expense plan, raising capital via sidecar or other structure would allow Argo to capitalize on market hardening, earn fee income and not dilute existing shareholders, and potentially acquire another U.S. specialty asset to further improve Argo’s premium mix to investors.

Each of these areas yields plausible scenario outcomes, which are discussed below in the “Scenario analysis / valuation” section and form the basis for the upside in the stock.

Key Risks

Poor performance in the international business

Argo’s international business lags peers and the U.S. business on a combined ratio, ROE, and GPW growth basis. The negative operating earnings and ROE contribution of the International business hinders strong performance of U.S. segment.  As discussed above, weak underwriting performance has been driven by deterioration in 2019 accident year ex-cat loss ratio related to property, liability and marine lines, net unfavorable prior year development for 2019, primarily concentrated in liability and professional lines, and 2019 catastrophe losses related to Hurricane Dorian, Typhoons Hagibis and Faxai, U.S. storms, and included losses from flooding.  Furthermore, future charges related to COVID-19 are expected in the international segment as well as potential unrelated charges given prior performance.  Additionally, the recent A.M. Best downgrade will increase reinsurance costs for the International segment going forward for an undefined period until the A rating is restored.

Reserve charges in the run-off segment

It is very likely new reserve charges will emerge from the run-off segment on an ongoing basis.  Although Trident has since been sold to Paragon (mentioned above), other lines of business still at Argo will drive the charges going forward. The Run-off segment has had unfavorable reserve development every year since 2012, resulting in cumulative underwriting losses of ~$157million. 2019’s fourth quarter review of run-off reserves resulted in an increase of $10mm in reserves for the year, in line with historical ranges of $10 – 40 million per year and 1-3 points of consolidated combined ratio impact.

Inability for new management to reduce expense ratio

Argo’s corporate and other underwriting expenses have historically exceeded its U.S. Specialty peer group (mentioned above) by anywhere from 400 – 700 bps since 2015.  Upon entering the stock, Voce advocated for a series of immediate expense reductions, which it argued could enable Argo to bolster its ROE by 460 bps. Voce’s analysis indicated that reducing Argo’s investment expenses in line with peers could yield $16mm in savings while reigning in corporate expenses—including corporate aircraft, housing and sponsorships—could achieve an additional $20mm in cost savings.

The high expense ratio is also partially attributable to one-time expenses including, (a) continued investments in technology to drive its digital transformation, (b) costs associated with a reduction in workforce, (c) allowance for doubtful accounts related to Argo’s European business unit and (d) other adjustments to underwriting expenses.

If none of the strategic alternatives play out and Argo is not able to get its expenses under control, this remains a very large overhang to consolidated performance.

Social inflation

Argo, like any other liability insurer, is subject to “social inflation” a phenomenon that has been increasing jury trial awards settling liability claims.  Broadly speaking, social inflation refers to the views, opinions and reactions of consumers interacting with institutions.  The acute perception of economic disparity in the U.S., a deep-seated institutional distrust and the perception of the value of an injury all translateinto the expected value of claim outcomes.  The recent events of the COVID pandemic and race-related protests will only accelerate this trend.

The challenge for liability underwriters, actuaries and others trying to quantify social inflation’s impact, is its non-linear trajectory. When a verdict is reached that is unprecedented or even very high, a new value is established for the next case and potentially other claims in a carrier’s inventory. The worst-caseoutcome is a risk portfolio that is potentially sub-optimally positioned or priced.

For Argo, this may manifest itself across the liability portion of its U.S. and International business.  The good news is that Argo is diversified across lines that do not experience social inflation, like property and property cat reinsurance.

Scenario analysis / Valuation

Argo trades today at ~0.7x book value and ~10x 2021E EPS.  Its closest U.S. Specialty peers (WRB, RLI, SIGI, KNSL, JRVR, PLMR and PROS) trade at a median of ~1.9x book value and~20x 2021E EPS.  A few catalyst alternatives are explored below that could close the value gap over the next 12-36 months:

Upside scenario 1 – Reposition Argo as a U.S. Specialty carrier by selling International business

Separating the International business from the U.S. operations would yield a U.S.-focused specialty carrier with a mid-teens ROE.  On a consolidated basis, 2021E Street forecasts for Argo is to write $1.9 billion of net premiums and $126 million of after-tax operating earnings, with equity of $1.9 billion and debt of $454 million (pro forma for the July 2020 issuance of preferred shares to extinguish their outstanding bank term loan).  Removing the International business would result in a U.S.-focused entity projected to write $1.3 billion of net premiums in 2021 and earn $146 million of after-tax operating earnings, with $1.1 billion of equity and $313 million.  

The new entity implies a 2021E ROE of ~13%, which is above the peer median of its closest U.S. specialty peers of 12%. This assumes the following: (a) earnings impact includes the five-year average International combined ratio of 105.8, and cost savings of 30% of $59 million of corporate expenses (in line with premiums contribution), (b) corporate and run-off results remain with the Company, (c) balance sheet and income statement items are roll-forward consensus estimates, and (d) segmental equity is allocated per percentages in 2019 10-K, and segmental debt remains constant, besides the paydown of the $125 million corporate level bank term loan in July.

To put the value creation of this transaction in context, assuming a 1.9x book value multiple on the U.S. RemainCo (based on the peer median, which appears to be conservative based on the ROE profile of the new company), the RemainCo’s implied valuation would be $2.1 billion or $63 per share.  Argo’s current market cap is $1.2 billion ($34 per share), which implies a negative value of ~$0.9 billion (-$29 per share) for the international business.  With continued strong performance relative to the group, there likely would be upside from this level as well.

The obvious risk here is finding a buyer for a business that the market currently is valuing negatively. Viability of the International business as a standalone platform is certainly up for debate and interest from buyers may be limited to international segments businesses of other U.S. carriers (ACGL, AXIS, Canopius / Sompo).  Putting International into run-off and selling to financial buyers (Catalina / Apollo, Enstar, Fortitude Re, Riverstone / Fairfax, Premia) also remains an option.  Despite the problems the International business has caused for Argo, it does have two very attractive Lloyd’s assets which represent over two-thirds of the premium written, and the platform has franchise value. Additionally, top line has been strong at 8.2% gross premiums written growth annually since 2015.

While this scenario may be difficult to execute, from Voce‘s perspective it offers an avenue to accretion through multiple re-rating above its $55 cost basis and gives them optionality to continue working with management to drive earnings growth and a share price beyond $63 in the periods following the sale.  Timing would likely be 18-24+ months to realize this scenario including a sale process and requisite regulatory approvals, and possibly longer given uncertainty around various factors, including COVID and its related litigation potential in the international P&C market.

Upside scenario 2 — Sale of Argo Consolidated to strategic or financial buyer

A sale to a strategic buyer would likely create shareholder value as well but risks the disruption of a sale process on new management’s focused plan to re-position the business if a sale is not achieved.  Strategic buyers for Argo include many of its peers, discussed above, as well as larger strategics like AIG, CB, Sompo, CINF, Fairfax, Tokio Marine, and Intact.  A premium of 20% above Voce‘s cost basis of $55 would be a $66 per share sale price and represent 1.4x book value.  Timing, again, would likely be 18-24+ months including the process and regulatory approvals.

A sale to a financial buyer in a take-private transaction also creates shareholder value and would give new management the opportunity to make operational changes necessary without the demands of quarterly reporting.  Assuming comparable exit multiples to other trading multiples in the space (JRVR, RLI, PLMR, KNSL), there is room for a sponsor to pay anywhere from 1.2-1.4x book value, which would represent a $57 - $66 per share transaction, both above Voce’s cost basis.  Timing would be comparable to the strategic scenario.  The risks involved in a sponsor-led transaction is complexity (as it would likely involve multiple parties) and might require simultaneous monetization of non-core assets to finance the transaction.

This scenario offers similar upside without the complication of selling the International business on its own, however, may present challenges for a sponsor or financial buyer to put together a transaction given its potential complexity.

Upside scenario 3 —Status quo implementation of new management’s improvement plan

If scenarios 1 and 2 do not come to fruition, there is still upside available in the stock from new management’s plans to create value with assistance from Voce.  Refocusing on Argo’s core business, rationalizing its portfolio, cutting corporate level costs and continued investment in digital capabilities to reduce expenses in the long-term are all low-hanging fruit that will allow Argo to improve earnings with a tailwind from the current dynamics in the U.S. specialty P&C market.  Additionally, management could consider moving risk to investors in the form of alternative capital (i.e. sidecar or other structures) that would allow Argo to reduce its reinsurance costs and potentially earn fee income for distributing the risks.  While it would take much longer, acquiring a smaller U.S. specialty platform (PROS, TSU.TO, GBLI, HALL) would help to focus investors on the U.S. business and accelerate multiple re-rating.

The market has clearly not given Argo credit for the management / board changes and refocused strategic vision. Assuming a 5-year BVPS CAGR of 5% as a result of the planned “low-hanging fruit” changes beginning off 2021 Street estimates, and a multiple re-rating from 0.7 to 1.0x book value, the stock would trade at $61 per share.  This does not assume any uplift from any acquisition or alternative capital solution.  Voce would likely have to stay invested to at least this level or beyond if they are looking to recover their investment (albeit over a very long time horizon).  

Given the longer duration of this scenario, it is certainly not as attractive as 1 or 2 but offers some protection in the case where asset or whole company sales are not feasible.  Additionally, Rehnberg’s performance as CEO of the U.S. business since 2013 should not be ignored here, as he clearly is capable of executing a turnaround plan as shown by the results since 2015.

Downside scenario – No asset sales, improvement plan fails, and reserves continue to be an issue

Even if all these scenarios do not come true, and the new management team fails, there is still very good downside protection at 0.7x book value and $34 per share.  The share price has been beaten down significantly following the Voce campaign / management changes, poor 4Q19 and 1Q20 results, A.M. Best downgrade and COVID-19 impact both broadly in the market and specifically in Argo’s results.

The tail risk here is more downward pressure on the current stock price of $34 from additional larger reserve issues related to the International or run-off business.  A material, earnings-event reserve charge ($25-125 million) would likely trigger a smaller correction (say 5-10% to $30-32) since the market is likely currently viewing Argo skeptically and expecting similar outcomes to historical trends, given the negative valuation on the international business and history of charges in the run-off business.  A larger reserve charge impacting capitalizationwould likely take the stock down to somewhere between 0.7 and 0.5x book value ($24 or 31% downside at the floor) but seems like a very low probability event given management’s opportunity to “kitchen sink“ the reserves they inherited already.

Catalyst