Description

Buy Ambac Financial Group common stock, ticker AMBC. 

The range of outcomes for the value appears to have favorable skew, with only 20% downside and 150% upside.  This is a counter intuitive situation, because Ambac's main operating subsidiary is characterized by the reverse (that is the nature of bond insurance) and is the source of the opportunity in the common.  Judging all the probabilities is a challenge, but I consider the adverse scenario unlikely. 

Investors and accountants alike are uncertain about the value of AMBC.  During the prior 52 weeks, the stock has been as low as $13, and as high as $27.  During the past three years, adjusted book value per share has fluctuated between a low of $1 deficit and a high of $32.  Given the uncertainty, it makes sense to review the assets, beginning with the most certain, and proceeding to the less certain and contingent ones. 

I will skip a history of Ambac and a description of the business.  Those can be found readily, including in some highly rated posts to this community.  

• $12+ per share of net asset value at AFG
  • $8.50 per share of cash and investments
  • $3.50 per share of tolling payment receivables
  • $6.00 per share in potential value from $1.4 billion of NOLs allocated to AFG

AFG.1) $8.47 per share of cash and investments

Ambac Financial Group (AFG) is a holding company, and most assets and liabilities are accounts of the main operating subsidiary, Ambac Assurance Corporation (AAC).  AAC has large existing liabilities and massive contingent liabilities.  So the net worth of AAC is highly uncertain.  But AFG holds $381 million of investments ad $4.2 billion of net operating loss carryforwards with no debt.  A description of AFG's assets in on page 63 of the Form 10-Q filed November 8, 2017 and on page 24 of the "Third Quarter 2017 Investor Presentation."

• AFG holds $98 million of liquid assets consisting of asset backed and short-term securities. 
• AFG holds $204 million of AAC surplus notes (including accrued interest) and $6 million of AAC insured securities, also known as deferred amounts or DPOs. As part of the Rehabilitation Exit Support Agreement, AFG will exchange these for $128 million of secured notes and $105 million of surplus notes.  The former are secured by the first $1.4 billion of proceeds from litigation to enforce AAC's contractual representations and warranties, they have a cash coupon of 3-month LIBOR plus 5.0% (~6.5% today), and a five year maturity.  This should make them liquid.  The latter will continue to accrue interest at 5.1%, and AFG has agreed to delay selling, perhaps for as long as until June 8, 2020.  This makes them illiquid.  Converting the $105 million of remaining AAC surplus notes to cash will depend on the net worth of AAC.  But these obligations are senior to the equity.  
  
  
• AFG holds $74 million of interests in two tranches of a variable interest entity, the Corolla Trust, that are secured by $350 million par of AAC junior surplus notes.  The trust issued $300 million of senior secured notes to third parties and AFG retained a subordinated "residual equity interest" on the remaining $50 million of principal.  After several years of accrued interest, AFG's total residual equity interest claim is $65 million carried at a fair value of $34 million.  In July 2017, AFG repurchased senior secured notes of the Trust with a par amount of $45 million ($55 million total claim with $10 million of accrued interest) that is carried at a fair value of $40 million.

The trend in AFG's "cash and investments" has been stable, outside of $120 million increase since the end of 2015, mostly due to $100 million of tax tolling payments.  This is because AFG's operating expenses, around $10 million per year, are roughly covered by up to $5 million per year from AAC (after March 2017 this reimbursement is at the sole discretion of the rehabilitator with a $4 million cap) and investment income. 

AFG.2) $3.50 per share of future tolling payments for use of net operating loss carryforwards (NOLs)

Ambac accumulated a tax net operating loss (NOL) exceeding $6 billion, primarily from over $10 billion (billion with a B) in pretax losses in 2007 and 2008.  In 2013, the company emerged from Chapter 11 bankruptcy protection with a Reorganization Plan that stipulated how the NOLs would be shared intercompany between AFG and AAC.  A substantial portion of the NOLs were allocated to AAC ($2.8 billion remain), and as AAC utilizes the NOLs it makes tolling payments to AFG pursuant to a formula.  A description of how the tolling payents are calculated is on page 53 of Form 10-Q filed November 8, 2017 and on page 26 of the "Third Quarter 2017 Investor Presentation."

So far, AFG has received $100 million in cash tolling payments from AAC.  In May 2016, AFG received $71 million, and in May 2017, AFG received $29 million  AFG can collect $136 million in additional cash tolling payments, or $3.50 per share.  This is sort of an off balance sheet receivable because the DTA is fully offset by a valuation allowance and DTL.  

Tolling payments will pause, however, because AAC generated new NOLs (after September 30, 2011) of $254 million in 2017 that must be utilized exclusively by AAC before tolling payments related to the old NOLs (before September 30, 2011) are resumed.  By my calculation, AAC generated $209 million of taxable income in 2016, $834 million in 2015, and over $40 million in 2014.    

AFG.3) Up to $6 per share of deferred tax assets, undiscounted

Ambac has $4.2 billion of net operating loss carryforwards (NOLs).  AAC was allocated a majority, which now equal $2.8 billion, and the usage of these NOLs drives the tolling payments to AFG described previously. AFG was allocated a minority, which now equal $1.4 billion.  The NOLs begin to expire in 2029.  Because the holding company does not have a source of taxable income, the AFG NOLs have not been utilized and there is no DTA net of the valuation allowance and DTL.  

Ambac is pursuing business transactions that could utilize the NOLs. While the likelihood of succeeding is remote, similar economic incentives have attracted capital and savvy investors before.  Recall that KKR led a nearly $600 million capital raise for WMI Holdings for the purpose of acquiring a business to utilize Washington Mutual's $6 billion of NOLs.  Based on my research and discussion with bankers, the probability that AFG can realize much of the $6.50 per share in potential future value is remote.  But it is a contingent asset that represents upside, and therefore worth mentioning.  Obviously, just because I cannot figure out how Ambac might realize value does not mean they will not. 

Downside looks like $11.50, or 20% from recent prices around $14.50.  This could be lower if the $1.65 per share of interests in the Corolla Trust are further impaired (they are carried at 56% of par already).  This could be higher if the $6+ per share of deferred tax assets can be realized.  

While the financial reporting is complicated, the business is not.  The upside is limited to the net asset value, plus any contingent assets.  Initially, the upside scenario from AAC does not look compelling. 

• $200 per share of assets
  • $135 per share of investments
  • $41 per share of legal recoveries
  • $18 per share of residual interests
  • $6 per share of future cash installment premiums
• $200 per share of liabilities
  • $151 per share of claims
  • $34 per share of debt
  • $15 per share of preferred shares
• $0 per share of net assets

But the accounting is misleading, and material adjustments should be considered in construction of an upside scenario. This yields upside from AAC of $24 per share.

AAC.1) $135 per share of investments – no adjustments

In most cases, Ambac collects cash from the borrower at the outset of the financial guaranty contract.  These proceeds are invested in a portfolio of securities to cover AAC’s operating expenses and to meet claim liabilities.  Today, AAC’s investment portfolio has a carrying value of $6.1 billion and yields 6.1%.  The investments are carried at fair value, and most are Level 2 assets.  Details of every security can be found in AAC’s statutory filings, and the company supplies the information in a Microsoft Excel file on its website under Investor Relations.    

AAC.2) $41 per share of legal recoveries – with $15 per share of upside

Ambac estimates that it will recover $1.8 billion from underwriters, primarily Bank of America and Nomura, for claims payments that Ambac made on void policies.  The estimate is based on various scenarios and different probability weightings, and is recorded on the balance sheet as a contra-liability that reduces gross loss reserves.

Technically speaking, when AAC issued financial guaranty insurance policies covering the payments on residential mortgage backed securities (RMBS) underwritten by banks (i.e. Countrywide), the policies included agreements and policies that describe various representations and warranties made by the underwriter, as well as remedies available to the insurer (i.e. AAC) in the event of a breach of those representations and warranties.  Because many RMBS performed well below expectations, Ambac began to investigate the underwriting and discovered that over 60% of the loans were in breach of representations and warranties.

Bank of America settled with the other two major bond insurers already.  In 2011, Bank of America settled with Assured Guaranty for over $1.1 billion, and in 2013, Bank of America settled with MBIA for $1.6 billion.  A possible explanation for why Bank of America has not settled yet with Ambac is that BAC considered Ambac in a weak negotiating position given that Ambac utilized bankruptcy protection and AAC is still in rehabilitation (heightened regulatory supervision and making certain claims payments only partially in cash).  AAC is on the verge of exiting rehabilitation, however. 

For two reasons, this particular asset could be worth more than $1.8 billion.  First, the $1.8 billion probability weighted estimate is significantly less than the amount Ambac seeks to recover.  If Ambac is seeking $2.75 billion and settles for 80%, or $2.2 billion, then it will record a gain of $400 million or $8 per share.  Second, the $1.8 billion does not include recoveries for fraudulent inducement.  If Ambac recovers $300 million, then it will record a gain of $300 million, or $7 per share. 

With 45 million shares and significant net operating loss carryforwards, every $100 million of recoveries in excess of the $1.8 billion book value is worth $2.20 per share of value, or 15% of the current share price.  So there is significant upside potential for the common equity shareholders.

AAC.3) $146 per share of claims liabilities -- $5-6 per share upside

Ambac’s claim liabilities include (a) $3.0 billion of unpaid claims, (b) $0.8 billion of accrued interest on unpaid claims, and (c) $3.0 billion of estimated future claims. 

The first two are referred to as deferred amounts, which total $3.8 billion.  Ambac negotiated to satisfy these obligations are 93.5%, which will reduce the liability by $250 million, or $5-6 per share.  Ambac has repurchased $1.6 billion of this obligation.  The liability remains gross of the purchases at $3.8 billion, and the carrying value of Ambac-insured RMBS (of which deferred amounts is a component) is $2.2 billion with a yield of 10%. 

The $3.0 billion of estimated future claims could also be overstated.  The trend has certainly been for Ambac to revise this estimate lower.  Four years ago, Ambac’s reserve ratio was 20% and today it is only 16%.  Another 1% reduction would equal $60 million, or more than $1 per share.     

AAC.4) $47 per share of debt and preferred shares – upside of $3 per share

Debt includes $755 million of surplus notes and $332 million of accrued interest for a total of $1.1 billion.  The rehabilitation exit plan calls for these notes to receive new claims equal to 93.5%, resulting in upside of nearly $2 per share.

Debt includes $350 million of junior surplus notes and $94 million of accrued interest.  Ambac owns 30% of these notes, carried at a fair value of 56% of par plus accrued.  If the asset is worth the liability, that would cause upside of nearly $60 million, or more than $1 per share.

Ambac has $660 million of preferred shares that are carried as a noncontrolling interest at $264 million.  Further upside could come from repurchasing these at a discount to par.    

Upside to $36 per share from a combination of $12 per share for AFG and $24 per share for AAC. 

• $215 per share of assets
  • $135 per share of investments
  • $57 per share of legal recoveries
  • $18 per share of residual interests
  • $6 per share of future cash installment premiums
• $192 per share of liabilities
  • $146 per share of claims
  • $31 per share of debt
  • $15 per share of preferred shares
• $24 per share of net assets

The main risk to the value of AAC (and AMBC) is that Ambac has insured Puerto Rico public finance obligations equal to $9.5 billion of net principal and interest.  The financial obligations are clearly detailed in the company’s investor presentation on Puerto Rico exposures.  The company has $801 million of loss reserves.  

The key insight is that Ambac has purchased 40% of the largest exposure, $7.3 billion of Senior Sales Tax Revenue bonds (COFINA) and at current market prices the remaining 60% could be acquired for under $600 million (10% of the investment portfolio).  In addition, Ambac has purchased 24% of the second largest exposure, $1.0 billion of Infrastructure Financing Special Tax Revenue (PRIFA).

It appears to me that Ambac has a much higher reserve ratio and much smaller immediate cash obligations that MBIA, and MBIA recently completed a $250 million share repurchase.  

Note also the series of insider buying recently.  

Catalyst

Ambac continues to purchase Ambac insured COFINA debt and significantly reduces tail risk