Friday, September 22, 2017

A Current AIM International Fund Holding: Argo Group International Holdings, LTD (AGII) by: Joe Flynn "Hurricanes and Insurance Don't Mix Well"

Argo Group International Holdings, LTD (AGII, $60.70): “Argo is Time to Go”
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.


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.