Gator Financial May 2016 Letter – Ambac: Undervalued Special SituationVW Staff
Gator Financial letter to partners for the month ended May 31, 2016.
Dear Gator Financial Partner:
We are pleased to provide you with Gator Financial Partners, LLC’s (the “Fund”) year-to-date 2016 investor letter. This letter briefly reviews the Fund’s investment performance for the first four months of 2016, discusses our views of the market, describes the investment thesis for two portfolio positions, and discusses the Fund’s current net exposure and positioning by sub-sector.
Gator Financial – Review of YTD 2016 Performance
As you know, the stock market went straight down for the first 6 weeks in the 1st Quarter of 2016. We came into the year expecting a rally as we thought our portfolio was full of underpriced stocks that were subject to tax-loss selling in December. We were quickly proven wrong as the stock market declined almost in a straight line until the afternoon of February 11th, when both stocks and crude oil made new lows, but then recovered partial losses after a Dow Jones Newswire story hinted about OPEC output cuts. Some market participants raised questions about the validity of the Dow Jones report, but the stock market seemed like it was looking for an excuse to rally. After the closing bell on February 11th, Jamie Dimon, the Chairman of JP Morgan Chase, filed a report with the SEC stating that he purchased $26 million of JP Morgan stock in his personal account. This helped spark a rally in financial stocks, the broader stock market, and the credit market that lasted through quarter-end and into April.
Through April 2016, the Gator Financial portfolio has returned a positive 1.81%. We’ve benefited from a rebound in a few underperformers from 2015 and a couple of new ideas. Syncora Holdings, Ambac Financial Group, and The Carlyle Group have helped increase returns in 2016. Each of these stocks hurt performance in 2015, so we view the rebound this year as recapturing some of the losses from last year. We think all three stocks have the potential to deliver multiples of their current price. In our note to you in January, we shared our investment thesis on Ambac. We updated and refined that write-up and published it on Seeking Alpha – Ambac: Undervalued Special Situation. Lastly, we benefitted from the timely purchases of two new positions: we purchased Cowen Group, a broker-dealer with a large alternative investment business, and OFG Bancorp, the 3rd largest bank in Puerto Rico. Both companies are performing well, but had sold-off drastically since last June. Both were trading at a steep discount to tangible book value and have since recovered some of their previous losses.
On the negative side of the portfolio, many of our bank holdings were down more than 10%: Citigroup, Morgan Stanley, Bank of America, JP Morgan warrants, SunTrust warrants, and Zions warrants. We continue to hold these positions as we believe each of these companies are improving their returns on capital, are returning excess capital to shareholders, and are very inexpensive compared to both their own histories and other opportunities in the stock market.
Gator Financial – General Comments about Value in the Market
We believe the stock market is a “market for stocks,” and have consistently focused on bottom-up stock analysis. We see many media articles about the overvaluation of the stock market would like to share a few observations about the current stock market.
Small Cap and Value stocks have underperformed Large Cap and Growth stocks. We think there are two main drivers of this: 1) a risk-off market environment has forced investors to reduce exposure to smaller companies and to focus on higher-quality large companies and 2) the accelerating shift from actively managed investment strategies to passive index strategies has driven investors to the largest stocks. We think this market environment is similar to the market during 1999 and early 2000 when a narrow group of large-cap growth stocks drove the market higher. Similar to today, the small cap and value stocks badly lagged the S&P 500. In 2000, when the Internet bubble popped, the situation reversed and Small Cap Value stocks outperformed the market.
We also believe on a historical and relative basis, stocks in the Financials sector are cheap. For example, Banks are trading at valuations similar to past financial crises, while balance sheets and capital levels are greatly improved. We believe there could be multiple reasons for Financials stocks to rise in price. They will benefit from additional interest rate increases, improved stock and bond issuance, improved M&A activity or returning additional capital to their shareholders.
Gator Financial – Investment Thesis Review
In this section, we share our high level thoughts on two holdings: Colony Capital and Voya Financial. We believe we could earn compelling returns in both of these holdings.
Colony Capital, Inc. (Colony) is a REIT focused on commercial real estate. In 2009, the company came public as Colony Financial and was a permanent capital vehicle managed by Colony Capital. The
company invested in distressed real estate debt and equity. Over time, this opportunistic strategy led Colony to invest in a portfolio of industrial properties and another portfolio of single-family homes. Colony also originates first and mezzanine mortgages for commercial properties. The company is regarded as a sophisticated commercial real estate investor.
We became interested in Colony’s stock in 2015 after the company acquired its external investment manager. The external investment manager advised a series of private equity real estate funds in addition to Colony Financial. Colony Financial was renamed Colony Capital and the combined company has improved economics because the investment manager is an asset-light business that earns a high return on equity and does not require capital to grow. The company can reinvest the earnings generated by this business back into the core real estate portfolio or increase dividends paid to shareholders.
The investment management business has the potential to grow. With the balance sheet of the REIT, the investment management business can seed new funds which will accelerate growth. We have seen evidence of this with the new launch of a global credit fund. Colony’s investment management business at $9.9 billion in assets is large enough that it is at scale and small enough that it can grow at an attractive rate.
We believe there are a few catalysts on the horizon for Colony to drive its stock higher. First, we believe Colony will sell or spin-off to shareholders its stake in Colony Starwood Homes in late 2016 or early 2017. Next, we think Colony will recycle capital from other low yielding investments into higher return opportunities. Another possibility is the company announcing a significant stock repurchase. Lastly, we believe each earnings report is an opportunity for the company to show improved fund raising in its investment management business and/or improved results in its real estate portfolio.
A new potential catalyst for Colony shares appeared in early May. Colony confirmed that it was in talks to acquire NorthStar Asset Management (NSAM). NSAM is the external manager for NorthStar Realty (NRF). NSAM also raises capital and manages several other non-public investment vehicles. We’ll have to wait to see if Colony and NSAM are able to agree to a deal, but we think the potential combination is an interesting transformational opportunity for Colony.
Colony’s stock has underperformed over the last 10 months. We believe this is due to several reasons: yield-oriented Mortgage REITs have underperformed, there has been volatility in the CMBS markets, and Colony’s largest investor may have had redemptions from their fund and may have had to sell down their stake in Colony. At its recent price of $18, Colony’s stock trades near tangible book value, so we are getting their real estate private equity business for free along with a free option on a potential deal with NSAM.
We’ve owned Voya Financial since its IPO in 2013 and believe it represents an extraordinary opportunity at current prices around $31. Voya Financial is the old U.S. subsidiary of ING, the Dutch insurance company. ING needed a bailout from the Dutch government during the financial crisis. One of the conditions of the bailout was ING had to divest its US operations. So, after renaming the subsidiary Voya, ING sold a stake through an IPO in 2013 and sold off the rest of its stake through a series of secondary offerings in 2013-2015. ING no longer owns shares in Voya.
Voya has been undergoing a transformation for the last several years and management has already made significant progress. Rod Martin joined Voya in 2012 from AIG. At AIG, he ran the life insurance operation and helped to exit several lines of business to improve returns. His mission at Voya has been similar, and he has made significant progress. He has refocused Voya on higher return businesses. He has raised return thresholds in capital intensive businesses. He has also showed a commitment to returning capital to shareholders instead of expanding low return insurance businesses such as term life. Management has focused on improving returns by reducing capital intensity and cutting costs. At the company’s IPO, management set the goal of improving the company’s return on equity (ROE) from 8.3% in 2012 to 12% to 13% by 2016. One of the main tools Voya’s management has used to improve returns is to change the company’s focus from top-line growth and market share ranking towards measuring risk-adjusted returns, growth in distributable earnings, and sales with above target returns.
Management was able to hit their 2016 ROE goal two years early by posting a 12.1% ROE in 2014. At the company’s 2015 Analyst Meeting, management raised the bar by setting a 2018 ROE target of 13.5% to 14.5%. To hit the 2018 ROE target, management has begun focusing on reducing costs by reducing the complexity of Voya’s operations. We believe this improvement in ROE is important for driving the company’s stock price and valuation higher.
Voya’s valuation is very cheap. If you look at the graph below, you can see Voya currently trades at just under 0.6x book value. For the majority of the time since its IPO, Voya’s stock has traded 80% to 90% of book value. Voya would have to increase 40% just to get back to this valuation range. Voya has steadily increased its book value since coming public through retained earnings and repurchasing stock at a discount to book value. The large step up in book value at the end of 2014 was due to reversing the valuation allowance for its deferred tax asset. In the graph, we see that Voya’s stock price peaked last summer but its book value per share continues to grow.
As mentioned, Voya management has had a strong commitment to returning capital to shareholders. In less than 3 years since its IPO, Voya‘s management has repurchased 20% of the company’s shares. For example in 2015, the company spent almost $1.5 billion to repurchase 12% of shares. We expect the company to repurchase a similar dollar amount in 2016. With the stock at its current discount to book value, we expect the repurchases this year to help drive book value higher.
We believe as Voya reports increasing returns on capital, continues to run-off of the closed block of variable annuity policies, and continues to repurchase shares that Voya’s stock price will approach its $58 book value.
Gator Financial – Portfolio Analysis
Below are the Fund’s largest common equity long and short positions. All data is as of March 31, 2016.
From this list, we exclude ETFs and fixed income instruments such as preferred stock.
Below is a table showing the Fund’s positioning within the Financials sector as of March 31st:
The Fund’s gross exposure is 154% and its net exposure is 53%. From this table, we exclude fixed income instruments such as preferred stock. Preferred stock positions account for an additional 4% of the portfolio.
We made a change to our organization at the start of the year. Our CFO, Erik Anderson, has done an excellent job over the last three years. He has institutionalized our middle and back office. He put in place systems for trade reporting and portfolio accounting, he upgraded our Fund Administrator, and massively improved our budgeting and planning for the management company. This has afforded Erik the opportunity to partner with Gerry Coughlin at Oakpoint Advisors to start a CFO outsourcing business for hedge funds. They’ve named the new business Oakpoint Services, and Gator is their first client. Erik can still be reached at his Gator email address [email protected] and his phone number is (212) 588-6408. Their new office is a few floors above Gator’s existing office in the Wells Fargo Tower. From our perspective, we very much like the change because it is seamless as far as the service we receive, and Erik will have greater professional opportunities. If you know any hedge funds that need an outsourced CFO, please pass along Erik’s contact info.
We are beginning to see performance turn better. We have many stocks in our portfolio with significant upside. Hopefully, we will see the gains of March and April continue through the rest of the year. Thank you for entrusting us with a portion of your wealth. On a personal level, I continue to have significantly more than 50% of my liquid net worth invested in the Fund.
As always, we are available by phone whenever you want to discuss the Fund, our other products, or investing in general.
Derek S. Pilecki
Managing Member of Gator Capital Management, LLC, which is the
Managing Member of Gator Financial Partners, LLC
This report was prepared by Gator Management, LLC. ALPS Fund Services, Inc., our administrator, is
responsible for the distribution of this information and not its content.
See full PDF below.
Gator Financial – Ambac: Undervalued Special Situation
We believe the equity of Ambac is severely mispriced due to several factors such as 1) being a post re-org equity, 2) having crossover ownership from distressed credit funds who are forced sellers due to redemptions in their funds, 3) being a run-off business, 4) having difficult to interpret financial statements; and, 5) having valuation dependent on the outcome of litigation. We also believe there are catalysts in 2016 that will help unlock value.
Background of Ambac
Ambac Financial Group, Inc. (AMBC) is a holding company headquartered in New York, NY. Ambac’s main subsidiary, Ambac Assurance Corporation (AAC), was a provider of finance guarantee insurance and related services in the municipal finance and structured finance markets. AAC is domiciled in the State of Wisconsin and is regulated by the Office of the Commissioner of Insurance for the State of Wisconsin (OCI).
AAC historically provided financial guarantee insurance (or municipal bond insurance) for municipal and structured finance obligations. AAC has not provided any guarantees (i.e., written any new business) since 2008, so the company is in “run-off”. Its principal business now consists of mitigating losses through the pursuit of recoveries in respect to paid claims, litigation to recover losses or mitigate future losses, commutations of policies, purchases of Ambac-insured obligations and repurchases of surplus notes issued by Ambac Assurance or the Segregated Account and maximizing the return on its investment portfolio.
Ambac was formed in 1971 to insure municipal bonds. The business was stable and profitable for 35 years, but as the municipal bond insurance market became saturated in the late-1990s, Ambac ventured into adjacent areas of financial guarantee insurance. The two main areas of diversification were providing insurance wraps to RMBS transactions and wrapping AAA-rated tranches of CDOs. This diversification proved to be a horrible idea and by 2007 Q3, Ambac was reporting heavy losses.
In March 2010, AAC established a Segregated Account, under the control of the OCI as Rehabilitator, to facilitate an orderly run-off and/or settlement of certain liabilities, including policies relating to credit default swaps, residential mortgage-backed securities (RMBS), student loans, and other policy obligations with substantial projected impairments or transactions with contractual triggers based upon AAC’s financial condition or the commencement of rehabilitation. The Segregated Account was capitalized with a $2.0 billion secured note from AAC and an excess of loss reinsurance agreement with AAC’s general account subject to AAC maintaining a minimum surplus of at least $100 million.
Essentially, the Segregated Account is structured such that AAC is responsible for ensuring that the Segregated Account services its policies subject to AAC maintaining a $100 million surplus.
However, pressures on the insured portfolio continued to mount, restricting dividends from AAC to AMBC, leading AMBC to declare bankruptcy in November 2010. AMBC emerged in May 2013, cancelling all existing common shares and issuing 45.0 million of new common shares to senior debt holders, as well as 5.0 million warrants with a $16.67 strike price and an April 2023 expiration to subordinated debt holders.
Ambac Investment Thesis
We believe there is an exceptional opportunity to take a position in Ambac equity. Here is our investment thesis:
1. Valuation is compelling – We believe Ambac is worth ~$44 per share or ~3x from the current stock price.
Since Ambac is in run-off, we believe we should value the company with adjusted book value and then layer in some assumptions about potential changes. Ambac presents its own measure of adjusted book value at $24.78 as of 2015 Q4. Below, we suggest several adjustments to the company’s calculation.
As a starting point here is the company’s calculation of adjusted book value:
Here are adjustments that we make to the company’s calculation of adjusted book value:
Then, we adjust for Ambac’s outstanding warrants:
We then make other adjustments based on our view of various assets and liabilities (we explain each of adjustments and our rationale below):
In this valuation, we give no credit to the significant NOLs Ambac owns. Instead, we address NOLs in #7 below. We also do not include an upside to litigation recoveries, but discuss the possibility in #6 below.
(a) Improvement in RMBS credit – With steadily rising home prices, Ambac’s estimates of future losses on Residential Mortgage Backed securities is consistently declining. Here’s the recent history of expected RMBS loss payments versus RMBS outstanding:
As you can see, the Estimated Future RMBS Claims have steadily dropped over the past three years. We believe there will be continued improvement and estimate that Future RMBS Claims will only be 67% of the current estimate.
(b) Ambac-wrapped RMBS held on-balance sheet – Ambac holds repurchased Ambac-wrapped RMBS on its balance sheet at market value. We think this is too conservative because the discount to par reflects potential credit losses, but since Ambac has already reserved for these credit losses, it is double counting losses by holding the RMBS at a discount and keeping its loss reserve.
(c) Additional Excess Spread Recoveries – Ambac has been receiving a high amount of excess spread from securitization where the company has already paid losses. Over the last 9 quarters, Ambac has received $900 million of excess spread but has only lowered its estimate of future excess spread by $60 million. We estimate that Ambac will continue to receive more excess spread recoveries than management’s current estimate.
(d) Additional Reserves for Puerto Rico – We believe Ambac has set aside $250 million in reserves to deal with potential losses in Puerto Rico. We think this approximates what the ultimate losses will be. We believe Ambac could reinsure all of its Puerto Rico exposure and eliminate this risk today for $600 million. We assume that Ambac adds $350 million to reserves for Puerto Rico.
2. Three potential near-term catalysts – We believe there are three near-term catalysts that could drive Ambac higher:
a. A settlement with Bank of America regarding R&W claims – See #6 below.
b. A successful election of the company’s nominated directors at the shareholders meeting – A large shareholder and creditor, Canyon Capital, has nominated several directors for election at the Annual Meeting in May. Canyon has been publicly critical of management for not accelerating payments on the debt obligations that Canyon owns. Ambac’s Board has also proposed two new directors with two existing directors stepping down. We believe shareholders will support the two Company nominated directors. Resolution of this proxy contest may be a catalyst for the shares.
c. AAC Exiting Rehabilitation settlement with holders of Surplus Notes and Deferred Payment Obligations to restructure their holdings to enable AAC to exit Rehabilitation
3. Continued value creation from continuing to repurchase own liabilities at a discount – Management has been repurchasing Ambac’s own securities in the secondary market. Purchases have been concentrated on Ambac-wrapped RMBS. These transactions are value creating for the company. For example, Ambac deferred policy obligations at 85 cents on the dollar and accrue interest at 5.1%. Ambac has already repurchased $1.4 billion or 34% of these notes. Ambac also owns $1.8 billion of its own-wrapped RMBS.
4. Rapidly reducing financial guarantee exposures – Ambac’s financial guarantee obligations are rapidly declining at 8% to 10% per quarter. We expect this accelerated pace to continue through the end of 2017 as Ambac last issued policies in late 2007 and municipal bond are usually callable after 10 years. Because of this rapid run-off of existing exposures, Ambac is deleveraging very quickly. Ambac’s leverage as measured by outstanding guarantees compared to claims paying resources declined from 26.4x to 18.9x during 2015. With the cash from a recent J.P Morgan settlement, we forecast this leverage ratio will decline to 15.7x as of March 31st.
5. Special situation with no natural support from buy-side – Investors recoil from analyzing Ambac for a variety of reasons, but we believe this has created the extraordinary opportunity.
a. Post re-org equity – Ambac Financial emerged from bankruptcy on May 1, 2013. As you know, post re-org equities use fresh start accounting for the financial statements which has its quirks.
b. Crossover ownership from Distressed Credit funds – When Ambac emerged from bankruptcy, the former senior debt holders received shares of the company, so owners at the emergence were primarily distressed credit funds. Throughout 2015 and so far in 2016, the distressed debt fund community has been under pressure due to redemptions from their investors from losses on early energy investments and Puerto Rico. To the extent these funds also owned AMBC common, it has been an overhang on the stock.
c. Run-off business – Investors shy away from companies with no ongoing business. Ambac is not writing new financial guarantee business, so it is a liquidating pile of financial assets and liabilities. The catch is there are $5.8 billion of financial assets plus another $2.5 billion in potential payments from litigation plus a large pile of NOLs.
d. Difficult to understand financial statements – Ambac’s financial statements have many parts that are difficult to understand.
e. Business model – Financial guarantee businesses are difficult to understand when they are healthy going concerns. There is no clarity about the type of business Ambac will become once it winds-down its financial guarantee insurance subsidiary.
f. Upside valuation dependent on litigation resolution – Many investors avoid businesses where the value is dependent on litigation because legal cases can take unexpected turns.
g. Only boutique Sell-side brokers cover the stock – Only four analysts publish research on Ambac. They work at the boutique firms Odeon, BTIG, R.W. Pressprich, and MKM Partners, so their work does not get wide distribution. Only Odeon has a positive recommendation on the stock.
6. Additional upside from R&W Litigation Recoveries – We believe there is $16 per share of additional potential upside to our base case if Ambac can recover $0.8 billion more than they’ve reserved for lawsuits due to R&W litigation. Ambac has reserved $1.8 billion in subrogation recoverable for these lawsuits, so we think Ambac will recover $2.7 billion. There are two counterparties in Ambac’s litigation: Bank of America and Nomura. Here are some details of the cases with each counterparty:
Bank of America – We believe Ambac could settle with BofA for $2.5 billion compared to our estimate of $1.65 billion of subrogation reserves. Ambac is suing BofA as successor to Countrywide and First Franklin for mortgages that did not meet the agreed upon underwriting standards for RMBS that these firms had Ambac guarantee. The main Ambac/B of A lawsuit is in the same court that the MBIA/BofA case was settled in MBIA’s favor. The judge has said the same issues are appearing in the Ambac case as appeared in the MBIA case. We expect the next notable event will be a trial date set for 2H 2016 . We note that the start of a trial is often a catalyst for a settlement.
Nomura – We believe Ambac could settle with Nomura for $200 million compared to our estimate of $150 million of subrogation reserves. We believe the Nomura loans that they had Ambac wrap were some of the worst loans securitized during the financial crisis.
7. Additional value in NOLs – Ambac has $1.0 billion valuation allowance against a deferred tax asset arising from net operating loss carryforwards. If management were able to generate some additional income by entering a new business, there is potential to reverse these carryforwards. We ascribe a zero value to these NOLs but note $1.0 billion is equal to $20 per share or more than the current stock price.
8. Consistent insider buying – We note that the CEO has consistently made open market purchases of the stock. He purchased approximately $2.5 million of stock over the course of the past 9 months. He made purchases in July, November and December 2015 and in January and March of 2016. There have also been purchases by the Chairman and other Board members.
We believe the risks to Ambac common present themselves out quite quickly when first analyzing the stock. We believe the discounted price of the stock more than compensates us for taking these risks. Below I address the two largest risks to Ambac.
1. Puerto Rico – While Puerto Rico has presented headline risk over the past 9 months, we believe Ambac will have low losses on the island. We believe the current legislation in Congress will progress and a Control Board will be imposed on Puerto Rico. The Federal Control Board will cut unnecessary spending, will work to complete the audit of Puerto Rico’s finances, will work to repay Puerto Rico’s current debt, and will work to reopen Puerto Rico’s access to the capital markets.
We believe the debt situation in Puerto Rico is manageable, but the current governor has taken the island down an unfortunate path of trying to restructure its debts. Even if the current debt is restructured, the core problem of higher spending than tax revenues won’t change. The debts will just have to be restructured again in a few years unless government spending is rationalized.
We believe Ambac will have low losses in Puerto Rico, but the headline risk will continue to weigh on the stock. We believe Ambac could end the uncertainty and reinsure its Puerto Rico risk with one of its peers. If Ambac were to pursue this option, we believe it would cost $7 per share and we have this scenario built into our $44 price target. If Ambac’s Puerto Rico losses are greater than $600 million, then there would be downside to our price target. If Ambac retains the risk, we believe the losses could be lower.
2. Disappointing settlement in R&W cases – If Ambac settled with Bank of America, for less than $1.7 billion, there would be downside to our $44 price target. We believe this is unlikely because the setting of subrogation recoveries has to be based on evidence that the company’s auditors approve. An example may be an offer of settlement for the counterparty. We also know that Ambac has been adding to the subrogation recovery at the margin for at least the last four quarters.
Although the risks seem severe, we believe the stock price adequately compensates us for these risks. The worst case scenario would be if AAC, the insurance subsidiary wasn’t able to dividend any money to AFG, the parent or holding company. In a downside scenario where either litigation recoveries do not meet the company’s estimate of $1.8 billion or Puerto Rico losses exceed $600 million, we believe AFG, still has value of $10.
Base & Upside Scenario Analysis
We have a base case scenario where we think Ambac is worth $44. There are three potential upside scenarios that we do not include in our base case.
We believe Ambac is severely undervalued due to the complexity and lack of sponsorship on the buyside. However, we see multiple catalysts that could help revalue the shares. As time passes and Ambac’s guarantees decline, the company deleverages itself and the story become cleaner.
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