Description

AGO – Long Thesis $48

Market cap $3.5b

We wrote up AGO a decade ago (4/11/2011) and now is great time to revisit.  We see +100% upside in 24 months.  

AGO is surprisingly underfollowed for a $3.5b company with an impressive 10-year track record of growing book value, buying back tons of stock and consistently raising the dividend. They are on the cusp of existing Puerto Rico, which will be a catalyst for re-rating and possibly accelerating an already aggressive buyback program. Furthermore, they have been incubating an asset management business and that has achieved considerable scale and will turn from a drag into a profit contributor in ‘22.  The $1 trillion infrastructure bill that passed this year will create increased demand for municipal bond issuance, further solidifying the longer-term positive fundamental outlook.  Also, if you are worried about Fed tightening cycle, AGO actually benefits from higher interest rates.  So in the coming quarters we will also see an inflection in earnings due to three tailwinds: rates no longer falling and possibly heading up, the investment management ramp-up flipping from an earnings drag to an earnings contributor, and a continuance of the recent trend of bond issuance outpacing runoff. Lastly, the valuation at 0.5x book value has room for significant upward re-rating and limited downside risk.      

Key Drivers 

Basically, AGO insures bond against default. They use their higher credit rating (AA+ up from AA as of Oct ‘21) to get lower rates for their customers than they could get on their own.  The volume of debt issued, the spread obtained and default rates on specific bonds are key fundamental drivers.  It is important to recognize that AGO gets cash up-front and holds reserves to cover potential long tail losses. Also, AGO is the leader in this industry with few competitors. 

In addition, AGO has gotten into the asset management business which is a more predictable fee driven model.  Assets under management were $17b as of 3Q21. This business should grow over time to becoming a meaningful profit contributor.  It should attain 20-30% margin profile with low capital intensity once fully ramped. 

Impressive Fundamental Track Record

Since 2010, AGO has grown their book value per share at 15% CAGR.  This is the best measure of historical value creation.  

Shareholder Friendly Management

AGO has consistently bought back stock.  The fully diluted share count has declined from 188.9m in 2010 to 73.5m as of 3Q21. This is an 8% average decline per year for over 10 years.  Also, apparent in the second chart below is the fact that buybacks have been larger more recently. 

Along with buybacks, AGO also has consistently raised the dividend. The dividend level has been raised every year since 2012 with a current yield of 1.8%.  

Management Alignment

If the buybacks and dividends are proof enough of shareholder alignment, the CEO Dominic Frederico owns 1.64m shares or ~$800m worth of stock.  The CFO Bailenson as well as the Chairman of the Board Borges own about $15m each. 

Catalysts

1)     Exit from Puerto Rico - The Puerto Rican insured debt has been an overhang on the stock for the past few years.  94% of the Company’s Puerto Rico bonds outstanding are covered by negotiated agreements (3Q21).  In mid 2022, this exposure should be cleared from AGO’s books.  Not only will this remove an overhang, but this will free up additional capital to the tune of $2b. This will help maintain AGO’s currently aggressive buyback program and could even lead to an acceleration of that. Mgmt has not quantified this impact yet, but will do so sometime in 2022. 

2)     Infrastructure bill passage – This will lead to more private/public partnerships and more new debt issuances.  States will need AGO to help issue this debt at a lower cost.  AGO currently has 8-9% market share and mgmt. believes they can get to 20-25% over time. 

3)     Higher in interest rates – Entering a Federal Reserve tightening cycle will likely lead to more volatility in interest rates.  This is a positive for AGO because as volatility or rates rise, spreads widen and AGO splits the spread savings with their customers.

4) The asset manamement business moving from an earnings drag to an earnings contributer.

Valuation & Price Target

The stock is currently trading at 0.5x ’22 book value per share.  This is on the lower end of the historical range.   Yes, there was a unique opportunity to buy this at a record low 0.3x book value in March of 2020, but the risks were substantially higher.  I would argue you are getting a better risk/reward today.  The company is better positioned than any time in its history and therefore I believe a return to ~0.9x book is warranted.  Also, the book valued I use is GAAP at $88.42/share as of 3Q21.  One could argue that the adjusted book value of $122.5/share in 3Q21 is more appropriate because it takes into consideration NPV of future revenues.  I suspect as AGO exits Puerto Rico, grows the investment management business and ROE rises, valuation will be anchored more to adjusted book value.  

My 2-year base case target price is $96 or +100% using 0.9x GAAP book value of $108/shr in ‘23.   

My 2-year bull case target price is $135 which uses 0.9x adjusted book value of $150/shr in ‘23.

Misc:  Underfollowed as only 3 Wall Street analysts cover the stock. 

Risks

A major bond default is the primary risk, but AGO is fairly diversified and under-levered, so it would be a setback but manageable.

Any delay in exiting Puerto Rico would be a negative, but should be viewed as more of a timing issue.   

Catalyst

1)     Exit from Puerto Rico - The Puerto Rican insured debt has been an overhang on the stock for the past few years.  94% of the Company’s Puerto Rico bonds outstanding are covered by negotiated agreements (3Q21).  In mid 2022, this exposure should be cleared from AGO’s books.  Not only will this remove an overhang, but this will free up additional capital to the tune of $2b. This will help maintain AGO’s currently aggressive buyback program and could even lead to an acceleration of that. Mgmt has not quantified this impact yet, but will do so sometime in 2022. 

2)     Infrastructure bill passage – This will lead to more private/public partnerships and more new debt issuances.  States will need AGO to help issue this debt at a lower cost.  AGO currently has 8-9% market share and mgmt. believes they can get to 20-25% over time. 

3)     Higher in interest rates – Entering a Federal Reserve tightening cycle will likely lead to more volatility in interest rates.  This is a positive for AGO because as volatility or rates rise, spreads widen and AGO splits the spread savings with their customers.

4) The asset management business flipping from an earnings drag to an earnings contributor.