A Premium Pick
By Catherine Seifert
Standard & Poor's Focus Stock of the Week is Ambac Financial Group (ABK ), which carries S&P's highest investment ranking of 5 STARS. This premier provider of municipal bond insurance and financial guarantees has leveraged that strength and market dominance and has successfully applied its AAA-rated guarantee to markets beyond traditional municipal finance.
As a result, Ambac is now a leading provider of financial guarantees to the structured, asset-backed and mortgage-backed securities sectors. The company has also expanded overseas, and is rapidly growing its presence in Europe, Australia, Japan, and in select markets in Latin America. During 2000, adjusted gross premiums written grew 11%, to $658.9 million, of which municipal finance accounted for 39%, structured finance for 35%, and international for 26%.
Adjusted gross written premiums should rise between 12% and 15% in 2001, as a result of the continued strength in the structured and asset backed markets, coupled with a modest increase in municipal bond issuance activity (thanks to the lower interest rate environment).
A BETTER MIX.
Ambac's success over the last few years at shifting its business mix to the more rapidly growing structured and international markets can be seen in the premium breakdown. In 1997, municipal finance accounted for 78% of earned premiums, while structured finance comprised 16% of the premium mix, and international business accounted for a scant 6%. By 2000, municipal finance had declined to 47% of earned premiums; structured finance increased to 37%, and international surged to 16%.
Standard & Poor's estimates that a further shift in the mix will occur in 2001 and 2002, whereby the premium mix may be fairly evenly divided among the three main segments. This shift has helped Ambac ramp up its top line growth without sacrificing underwriting standards.
Because of a number of characteristics inherent to the market for financial guarantees, the long-term outlook for this segment of the financial services industry is very favorable. In the general commercial lines insurance marketplace, nearly a thousand participants vie for market share in a mature, slow growing industry marked by intense premium price competition. (S&P estimates written premiums for the overall property-casualty industry will rise about 6% in 2001.) This contrasts sharply with the financial guarantee marketplace, where four large participants dominate a market that is growing at a double-digit clip and is characterized by pricing discipline.
Based on its share of the new issue municipal bond market, Ambac is the second largest municipal bond insurer (with a 22% market share); and MBIA Inc. is the largest muni bond insurer (with a 28% market share). The other two major participants in the financial guarantee business are FGIC Corp. (a unit of General Electric Company) and Financial Security Assurance Holdings Ltd (FSA).
Another favorable aspect of this business: its high barriers to entry. This is because of the AAA credit and financial strength ratings -the highest possible- that are necessary to obtain from all the major rating agencies (including Standard & Poor's)- in order to even be in this business. Although a number of smaller, less significant players have recently entered the field, S&P anticipates the overall market for financial guarantees will continue to be dominated by this handful of top tier firms. This market dominance will keep competition in check and pricing relatively firm (compared to the overall property-casualty insurance market).
Ambac's strategy in the municipal bond insurance market is to maintain its high quality, diverse portfolio of credits to ensure a steady and consistent stream of earnings. Ambac guarantees the payment when due of principal and interest on the bonds it insures. Ambac primarily insures newly issued bonds, and the issuer normally pays a single premium to Ambac when the policy becomes effective. The economic value of bond insurance to the issuer is the savings in interest costs that results from the difference in yield between an insured bond (backed with Ambac's AAA credit rating) and the same bond if it were uninsured.
At year-end 2000 49% of the insured portfolio had an internal credit rating of A, 30% was rated BBB, 14% was rated AA, 6% was rated AAA and less than 1% was rated below investment grade. As of year end 2000, the $18.9 billion insured portfolio was diversified: Lease and tax-backed bonds accounted for 41% of the portfolio; General obligation bonds for 17%; Utility revenue bonds for 7% and all other municipal obligations for the remaining 35%.
Because this business is really more of an arbitrage credit spread business than a "traditional" insurance business, claims are actually pretty rare. But they do occur. The latest involves California's two largest utilities. Ambac's combined exposure to Southern California Edison and Pacific Gas and Electric is less than $150 million in net par value, and is secured by first mortgages. Claims expected from these defaults are not expected to be material.
Ironically, situations like the California utility crisis actually help drive up demand for municipal bond insurance. Greater demand for bond insurance, coupled with a modest resurgence in municipal bond issuance and refunding activity-thanks to a drop in interest rates- should lead to 10% operating earnings growth form this segment in 2001.
By cultivating and leveraging its relationship with a handful of high quality issuers, Ambac is successfully capitalizing on the burgeoning market for asset-backed securities, structured finance products, and credit derivatives. Half of the company's $27.4 billion (net par value) structured finance portfolio was comprised of mortgage-backed securities and home equity loans. Asset-backed securities and conduits accounted for 39%, and an array of other structured finance products accounted for the remaining 11%.
The company's small ($19 billion of net par value at year end 2000), but rapidly growing international portfolio is comprised primarily of structured credit derivatives. Continued robust growth in the structured finance and international segments will likely propel overall operating earnings growth by about 14% in 2001.
Standard & Poor's estimates that operating earnings per share (which exclude realized investment gains or losses) will rise to $3.95 a share in 2001, from the $3.46 a share reported in 2000. Looking ahead to 2002, S&P anticipates operating earnings per share of $4.50. At current levels, the shares are trading at about 13.9 times S&P's 2001 estimate, or a p-e multiple that is about 65% that of the S&P 500 (21.5 times its 2001 estimate). Insurance stocks typically trade at a discount to the overall market, with a p-e range typically 55% to 80% of the overall market.
Given Ambac's franchise value, its superior overall growth prospects, its ability to achieve double digit operating earnings growth, and its 15.9% return on equity in 2000 (up from 15.0% in 1999) the shares merit an expansion in their current p-e multiple. Moreover, with a p-e to growth ratio of just under one, (compared with a PEG ratio of between 1.3 and 1.5 for S&P's entire universe of insurance stocks) S&P believes there is clearly room for upside expansion.
Standard & Poor's has a 6-12 month price target of $65, or approximately 16.5 times its conservative 2001 operating earnings estimate and approximately 77% of the multiple of the S&P 500, representing potential appreciation of approximately 18% from current levels..
Seifert is Director of Financial Research for Standard & Poor's