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Published: August 9, 2010
Sometimes an investment looks like a
no-brainer -- until you dig a little deeper.
On the face of it, Assured Guaranty (NYSE: AGO) looks
like one heckuva stock. The company offers insurance policies
for
bond buyers, focusing on the state and local
municipal bond business. It's a good business in normal
times and a great business right now, thanks to especially high
premiums to insure these increasingly risky bonds.
Assured's two main rivals, MBIA (NYSE: MBI) and Ambac
Financial (NYSE: ABK) are on the ropes, enabling the company
to steal
market share. Assured reported second-quarter profits last
week of $0.91 a share, roughly +30% ahead of consensus forecasts
and a company record since being spun-off from insurance giant
ACE (NYSE: ACE) in 2004. And even after a nice
double-digit gain on Friday, shares trade for just 80% of
book value or about six times likely 2010 profits and 4.5
times expected 2011 profits.
The "potential" in this case depends on the
economy's cooperation.
But what happens if the economy weakens further and state and
local governments start to default on their bonds? Or what will
happen to state finances once the Obama administration is no
longer offering support to keep teachers and policemen employed?
(The Senate recently voted to give the states another $26
billion, but it is unclear if states can count on such largesse
in 2011). In a worst-case scenario, a wave of bond defaults
would force Assured to pay up on all of those bond insurance
policies, wiping out any profits the firm hopes to earn.
Yet we may not be headed for such a dire scenario, and those
fears are starting to look overblown. Assured Guaranty has been
diversifying its revenue streams and is seeing more stable --
and profitable -- results from an acquired division that focuses
on France and Belgium, which don't face the specter of bond
defaults. And the company's reinsurance business, which helps
backstop other insurers as they take on risk, is a boring but
steady profit driver.
Indeed much of the upside in the most
recent quarter stemmed from the fact that the most challenging
parts of the business, muni bond insurance and mortgage
insurance, are not doing as badly as some had feared.
To be sure,
earnings are extremely volatile, as they involve a constant
marking up and marking down of the perceived health of various
insurance liabilities. Some investors prefer to focus on book
value. UBS sees Assured's book value rising to the $26 or $27
range during the next 12 months and sees shares rising up to
almost that figure.
Yet as noted earlier, the competitive environment has clearly
shifted in Assured Guaranty's favor, and profit spreads could
surge to peak levels. Some investors think a target
P/E ratio is a wise way to go. In this context, if the
company can avoid a wave of large bond defaults in the coming 12
months, then shares might move up to around 10 times potential
2011 profits, meaning the stock can double from current levels.
Action to Take --> The
strong business trends in evidence in the second quarter remain
in place, setting the stage for more estimate-topping results in
the coming quarter. Shares are likely to have a solid floor
under them, even after a recent run in price.
From there, perception is everything. If investors come to think
that state and local governments can muddle through this crisis
without defaulting on bonds, then shares should steadily climb
through the $20s in the near term. And if states and cities
actually do avoid a total financial meltdown, then this stock
could double. Conversely, is state and local finances weaken
even further from here, then shares will move into the doghouse.
-- David Sterman
Staff Writer
StreetAuthority
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