By:
Joe Flynn, AIM Student at Marquette University
Disclosure:
The AIM Equity Fund currently holds this position. This article was written by
myself, and it expresses my own opinions. I am not receiving compensation for
it and I have no business relationship with any company whose stock is
mentioned in this article.
Summary
• Argo Group International Holdings, LTD (NASDAQ: AGII) underwrites
specialty insurance and reinsurance products in the property and casualty
market worldwide. The company reorganized its reporting structure during 1Q17
and now operates through two segments: U.S. Operations & International Operations.
• Industry competition in
the market and the inability to increase prices will likely weigh on profits
going forward. AGII will see earnings growth come under pressure in 2017 &
2018. However, Investments in technology and gains from cyber offerings would
complement the company’s existing services and help offset the effect.
• The broad recovery of
property & casualty insurance has halted, and low interest rates remain a
drag on bond yields. AGII’s invested premiums are very sensitive to
interest-rates, but have the ability to improve ROE if tightening continues.
• The industry’s current
capacity is a major concern making it crucial for AGII to return capital. Share
repurchases and dividends may protect the stock’s downside in the near term,
but capital appreciation looks to be uninspiring over the long term.
Key
points: AGII’s risk/reward profile has seen better days. The
challenging pricing environment will likely extend into this year and beyond. Costs
from the recent acquisition of Ariel Re will also weigh on share net. Losses
are expected to show deterioration resulting in weaker earnings through 2018. However, the recent strength in investment
income reassures AGII’s ability to meet its obligations in the near term. The
industry has experienced insignificant investment income since the financial
crisis from the low yields offered on bonds.
AGII started to shift exposure to higher returning
vehicles such as equities & corporate debt to combat low interest rates. Recently,
the fed began gradually increasing rates and AGII was the beneficiary of a
greater risk profile. AGII’s portfolio duration of 2.2 years and portfolio
leverage of 2.44x makes the portfolio very sensitive to interest rates.
According to estimates, having 2x portfolio leverage modeled ROE gains of 15-16 bps/year after a 50bp
increase in rates. Net investment income made up 60% of net income in the first
half of year. This could indicate that AGII relies too much on investments to
drive bottom line growth. The 30% increase of investment income this past year
looks to have peaked and challenges lie ahead. A rising rate environment would be the best
case scenario to for any chance of continued investment growth.
The fed hasn’t been very clear regarding rate hikes
and economic figures such as wage growth do not seem to indicate inflation.
Therefore, it looks like the industry’s capacity will determine the direction
of P&C stocks. The insurance industry is oversupplied after a prolonged
period of minor catastrophe risk. AGII will have difficulties raising rates due
to the unattractive supply levels, which will continue eating into profits. Share buybacks must be a key initiative for
insurers facing the limited coverage demand. AGII currently is buying back
shares and increased their dividend, but concerns about future cash flow
generation have been raised.
The company issued $325M in LT debt in 2017, and now
has a D/E ratio of 30% which is significantly higher than the industry’s median
of 20%. Many of AGII competitors have begun paying down debt to lessen default
risk. The added $55M principal and interest due in 5 years could inhibit the
company’s ability of carrying out their capital allocation plans. The leverage
also puts AGII in a tough position for a late cycle credit environment and risk
facing severe consequences if capital markets dry up.
What
has the stock done lately?
Fears of potential claims
and increased losses from Hurricane Harvey sent the stock down 6% to $56.50 on
September 7. The stock has rebounded to its current level of $60.70 and it
appears that companies have the funds to settle the claims of $20B. The
financial impact of Harvey was not as devastating as expected and did not free
up insurance demand.
Past
Year Performance: AGII has increased 10.21% in value over
the past year, and just recently was dragged down from the industry’s soft
pricing. The stock has had very little volatility and currently has a beta of
.80. The three largest shareholders are passive and control around 25% of
shares. The stock may have traded due to flows into passive and not on its
fundamentals during the period.
Source: FactSet
My
Takeaway
The stock was originally
pitched with a price target of $69.11. I am revising the price target down to $62.65
or 1x its book value. Assuming the company can continue returning capital to
shareholders, the discounted multiple and low beta should provide support for
its BV. The excess leverage and interest rate exposure poses several risks and
I believe it would be smart to exit the position sooner rather than later. The
large weight of insurance stocks in the International Fund have depressed its
relative returns, and it would be smart to sell one. One suggestion would be to
find a company that has a strong balance sheet to withstand the late cycle or a
company with a competitive advantage not tied to the success of its industry.
