Investment Evaluation: Ambac (ABK)

Ambac (ABK) Investment Evaluation

Initially Written: October 27, 2007
Last Updated: - Oct 27, 2007

I’m just a newbie investor with a contrarian tilt so feel free to e-mail or post comments to correct any mistakes or to improve things. Do not blindly base any decisions on anything I say; I don’t know what the hell I’m doing ;) . Also, since I write over a period of time, some facts and numbers may change from when I first looked them up (this is definitely the case with any market-price info e.g. P/E ratio).

Summary

Ambac (ABK) is the second largest debt insurance company, after MBIA Inc (MBI). Its business is to insure interest and principal payments on various debt for governments, infrastructure projects, mortgages, and so forth. Generally it doesn't insure the value of the debt, and only insures the payments. This is important because, given the credit problems in the mortgage and the ABS market, ABK will be spared the losses on the value of the debt.

Due to credit issues and various other problems, the stock has sold off sharply and is down almost 40% for the year. This sell-off made me investigate the stock and I have come to like it a lot. I'm planning to watch it closely and likely take a position in it in the future (although no guarantees on any future move).

I have to note that I'm not good an analyzing financials (accounting is too complex and can be manipulated) and all my opinion is based on some cursory analysis.


Industry Comparison

Sources: Bloomberg.com, finance.yahoo.com, bigcharts.com, Morningstar reports, S&P reports, grahaminvestor.com, company reports

There are 5 operators in the debt insurance industry, with MBIA and Ambac being the two largest by far. I decided to include Radian (RDN) because Martin Whitman has taken a position in it. He also took a position in MBIA back in July. All the stocks are down quite a bit since then and assuming Martin Whitman hasn't changed his mind, it gives me greater confidence in these companies. Radian is highly speculative in my eyes but it has massive potential. Ambac places very nicely against MBIA.

The table below, courtesy Morningstar.com, provides a 10 year view of valuation:

(source: morningstar.com)

ABK's current P/E is a 10 year low; so is its price-to-book-value. From a historical valuation point of view, ABK screams a buy. The reason the stock, along with others in the sector, has been beaten-up is because the market is worried about future losses from housing-related debt (CDOs, subprime debt, consumer ABS). I'll discuss this further down but one has to decide whether the risk is exaggerated or for real.

Earnings have been growing at 15% for the last 5 years, and 12% for the last 10. One of the most important metric for any business is book value growth. A lot people look at earnings growth but book value growth is arguably even more important (book value also has the luxury of being more difficult to manipulate than earnings). ABK has a 5 year book value growth rate of around 15%, and has been growing it around 13% for the last 10 years.

Ambac is AAA-rated so its debt to equity is very low and financial strength isn't a question. The only downside is that they have to keep a lot of capital on the books and can't leverage themselves as much as other companies. Returns can be somenwhat depressed because of that.

In terms of intangibles, ABK has been in the business for decades and has a strong reputation that is hard to replicate. It, along with MBIA, sit alone at the top of this industry--although large insurance companies can ramp up their operations in this area. Given all the uncertainty and turmoil in the credit arena, Ambac is well positioned.

Valuation

I'm not sure how one should be valuing insurance companies. I typically do a rough calculation with DCF but that is mostly useless for these type of companies.

Simply looking at valuation metrics over time, we can see that ABK is at the low point. As mentioned above, P/E and P/BV is at a low point. I think ABK can keep growing near its past rates. There may be some competition and difficulty entering foreign markets so a pessimistic growth rate may be around 12%. Even then, that's pretty attractive for a AAA-rated company. I personally have no problem picking up a company at a P/E of 6 and P/BV of 0.75 with ROE of around 13%.

One is basicaly looking at a total return of around 14% per year (13% ROE + 1% dividend yield). Since the stock is beaten down, there is even greater return potential if there is P/E expansion. You might end up with around 15% total return per year over a 10 year period. My opinion is that it is worth buying ABK below book value (it is around 25% below book value right now).

CDO and Subprime MBS Risk

The real question is whether any of the assets are impaired and whether large losses will have to be written down given the credit issues unfolding in the background. ABK has the largest exposure to the CDO market and that is why the market does not like this company. Let's look at ABK's CDO and subprime RMBS exposure.

(source: Ambac CDO document)

As can be seen from the graphic above, most of ABK's holdings are higher quality CDOs. The rating agencies are downgrading the higher quality CDOs and MBS but one other thing in Ambac's favour is that most of its exposure is from pre-2005 vintages:

Vintage dispersion:
2005 and earlier: 45%
2006: 46%
2007: 9%
Fixed rate borrower %: 48%
Average FICO score: 644

(source: Ambac CDO document)

A lot of the mortgage asset problems are with securities that were created in the last 2 years. As is generally the case, most of the shady agreements and questionable deals, likely driven by greed, are done during the late stages of a bull market (just like how a lot of the technology IPOs in 1999 and 2000 were terrible compared to the ones in 1995 and 1996). In housing, the peak was in 2005 and a lot of the problems are with the post-2005 securities.

Furthermore, a lot of the borrowers are at fixed rates and this is a good thing. There is a looming threat of resets on adjustable rate mortgages and ABK isn't as vulnerable to rate changes.

Another concern is with ABK's subprime exposure. Ambac's subprime MBS exposure has been declining over the years, from around 40% of total MBS to around 20% in 2006.

(source: Ambac sub-prime MBS exposure document)

There will certainly be some increased risk due to increased subprime default rates. But I am confident that ABK can weather through the storm. If you can tolerate the risk, this doesn't seem like a big deal. It looks like the market is treating ABK as if it were another fly-by-the-night operator, or as if it were as risky as mortgage lenders or CDO funds.

There was also some question about Ambac's $743 million writedown this week but this mark-to-market loss isn't a real loss. The following comment from Fitch Ratings (document posted on Ambac's website) reiterates their stance that mark-to-market losses aren't real losses:

Fitch remains consistent in its view that mark-tomarket losses from CDS within a financial guarantor’s insured portfolio do not have direct ratings implications for the industry, given that the underlying CDS transactions still remain very highly rated (often well-above minimum ‘AAA’ thresholds), and are not expected to realize actual claim losses in the future. In fact, from an underwriting perspective, the widening of credit spreads actually improves the financial guarantors’ pricing prospects on future business they may insure going forward. That said, the widening credit spreads generating the negative mark-to-market losses has been caused in part by significant problems being experienced in the U.S. subprime mortgage markets. Currently, many of those problem assets support CDS transactions insured by a number of financial guarantors, especially ABS-CDOs that maintain a heavy concentration of recent vintage subprime mortgage collateral.

Deterioration of the underlying collateral is expected to reduce credit enhancement levels in many of the ABS-CDOs insured by the financial guaranty industry over the intermediate term. This deterioration may not directly impact the underlying
ratings on many of these ABS-CDOs, since many of these transactions have significant credit subordination over and above minimum ‘AAA’ thresholds, although those
guarantors heavily exposed to this sector will be monitoring their portfolios closely over the near- to intermediate-term.

(source: Financial Guarantors — A Review of Recent Mark-to-Market Losses, Fitch Ratings Special Report, October 11, 2007)

So this clearly looks like a case where the market is discounting any company that mentions 'CDO' or 'subprime'. I suspect a lot of daytraders, who really don't understand the details behind any of these companies, are likely shorting some of these companies heavily. I'm not saying that there is zero chance of adverse developments for ABK; all I'm saying is that as of this time, the stock price decline looks overdone by a large magnitude.

After looking through these documents and thinking of the risk exposure, I feel that ABK is pretty safe. Its earnings may be weak due to mark-to-market losses in the future but those are misleading numbers. Unlike mortgage lenders and some of the smaller debt insurers, there is zero risk of this company going bankrupt or running into severe financial stress.


Bull Case

Long History and Solid Balance Sheet

ABK is one of the top companies in the debt insurance business. It is financially solid and should be able to weather any storm. It is a higher quality company than the market perceives. As I speculated above, short-term traders are probaby hammering this stock without knowing anything about the company. This doesn't mean the stock price won't decline further but the fundmentals look solid.

Near All-time Low Valuations

The stock is down almost 40% in the last year. Book value per share is in the $50's and adjusted book value (read company presentation for full definition) is in the $80's. Remember, this was a company that every single analyst thought was worth $100 a few months ago. Analysts aren't necessarily right all the time but losing half its value without any material fraud or scandal is crazy IMO. Financials typically trade at low P/Es but ABK's is extremely low right now. Earnings will weaken in the future but even then ABK looks cheap.

Not As Sensitive to the Economy

Like most insurance companies ABK is not too sensitive to the economy. A slowing economy may impact some government infrastructure products and the like, but it is unlikely to have a big impact on the industry. Since I'm bearish on the economy, this is a good industry to be in. If the present high-flyers (cyclicals, commodities, emerging markets, etc) come crashing down, there is a potential for P/E expansion here.

Good ROE

It's not spectacular compared to other industries but ABK has an industry-leading ROE of around 14%. Even if ROE declines to around 12% over the next 10 years, this is a great number. I typically use ROE to measure the attractivenss of a business. This company is one of the best businesses I have seen that has been sold off in my short investing career. I see a lot of cyclicals and growth stocks with high ROE being sold off at times but they have wildly fluctuating ROE, whereas ABK's ROE has been consistently around 14% for 10 years.

Will Benefit from Widening Spreads

Even though the credit problems are a short-term issue for this company, it actually helps this industry. Debt insurers do well when credit spreads are widening. Spreads have been very low for several years now but it looks like they are widening now. ABK should prosper in that environment.


Bear Case

Not a Classic Contrarian Case

Although the stock is down around 40%, analysts are still bullish on this stock. I generally don't like it when most analysts have buy rating on a stock. One might want to wait a few weeks or months to see if analysts lower their ratings before considering this. I personally think it is worth buying below book value (right now) but watch for sell-offs during any rating downgrade.

Further Write-downs

There is a possibility that further write-downs may occur. Although exposure to questionable debt seems low, it is hard to say for sure. After all, ABK is the largest CDO insurer and most of the problems are with the CDO securities. If the economy goes into a recession and far greater number of people default on their RMBS, ABK will likely take a hit. If losses are taken then ABK will need to raise capital to maintain AAA rating.

Low Growth

Although returns are solid, the growth rate looks to be decelerating slightly. Future potential growth is uncertain. There is great potential in developing overseas markets but that is blue sky potential more than anything.

No Catalyst

There may be no catalyst to propel the stock upwards. The stock can stagnate for years and there may not be a P/E expansion. In such a case, one will simply match (or slightly outperform) the market with a return of around 12%. You won't get rich off that.


Worst Case Scenario

Ambac may take massive losses due to the credit problems. Although the mark-to-market losses aren't real, I wonder if there are possibilities for real losses due to other unknown issues. Any weakening of credit or reputation may result in loss of future customers.
Ambac may also lose some market share to new entrants and new product developments. Instruments like credit default swaps may eat into Ambac's traditional insurance (Ambac also uses CDS but I'm thinking that CDS may be supplied by new entrants).

Is this a Low Risk, Highly Uncertain Investment?

Mohnish Pabri likes businesses that he considers 'low risk, highly uncertain'. I have picked up this thinking and look at investments in that light.

I think this fits the low risk, highly uncertain investment philosophy. I think the risk is low because the stock is at least 25% below book value for a AAA-rated solid company. The chance of this company going bankrupt or facing severe financial distress is pretty low. So the risk is low.

But ABK is highly uncertain--that's why the market has sold it off. The market seems to be scared of any company that utters words like 'CDO', 'MBS', 'ABS', or 'subprime'. This creates great uncertainty.


Investment Thesis

I remember Warren Buffett saying something like 'if you can find a company with an ROE of 20% and trading at a discount, you should snap it up'. His investment in Coca-Cola was an example of a beaten-down company with high ROE. Looking at these numbers, it seems like ABK fits that criteria to a small degree. It isn't 20%+ ROE like Coca-Cola but then again it has low debt and hard to dislodge business (anyone can enter the industry but hard to get a AAA-rated reputation). I get this feeling that this is a steal. One isn't going to get rich off this (upside is not huge) but it looks like a solid company that can grow forever.

Once the market prices in all the credit problems and seperates the good from the bad, I suspect companies like Ambac will recover. There is a risk that this stock may sell off over the coming months if analysts cut their ratings and/or due to tax-loss selling in November and December.

I think it’s worth buying the stock below book value, which is around $50. Right now the stock is trading at $44 and I think it is worth considering for long term investors. Depending on how much money I have and other opportunities that materialize, I will consider taking a position within a few months. I already own a reinsurance company (MRH) so I also have to decide whether I want another insurance company, albeit in a different type of insurance. If I take a position, it will likely be for the super-long-term (i.e. 5 to 10 years). One of the risks is that ABK may not go anywhere for years but long term investors should be fine.