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Inside In Full: Argo: Don't eat the marshmallow

Activist investor Ron Bobman's Capital Returns Management published a letter yesterday advocating for a whole-company sale of Argo at an optimistic $80/share...

Inside P&C Research

The Inside P&C Research Team believes that although an eventual sale is likely, further management action would yield better results than a rushed sale.

Yesterday, when the news of Capital Returns activist campaign targeting Argo was announced, it reminded us of the Stanford Marshmallow Experiment.

If the subject, usually a toddler, can avoid eating one marshmallow and delay gratification for a short time, they can get a better snack (often more marshmallows) later. Academics found that those that demonstrated the ability to defer gratification went on to show better life outcomes based on higher self-esteem and a greater ability to deal with stress.

In our takeout piece, we highlighted Argo as a name likely to feature in future rounds of consolidation. However, we don't feel that the time is now. Argo is already in the initial innings of trying to pick up the pieces after Mark Watson's departure and is slowly rebuilding the franchise. Taking a hard left would only result in the franchise careering and going off the rails.

Stepping back, we are generally supportive of activism in insurance. Despite the popular perception, activism has led to some successes in our sector, alongside some of the better known failures.

Overall, any activism – when grounded in unbiased analysis – can serve as a wake-up call for management teams. Argo management is, of course, not new to activist pressure – and, indeed, it is in the midst of pursuing a series of changes effectively precipitated by Voce Capital's 2019 campaign.

Ron Bobman's Capital Returns has had some notable successes in the past, involving FBL Financial Group, FedNat Holding, and Watford, with recommended bids to acquire the companies increased and requested board members added.

In his letter to management, Bobman pushes for a sale of the whole business, or at least a more complete dismantling of the international operations with the Bermuda business sold as well as Lloyd's Syndicate 1200.

Let's go back back to the marshmallow test. Choosing a sale at this time would be akin to picking the immediate reward over waiting for a bigger deferred reward if Argo continues to achieve some of the outlined objectives discussed in its recent investor days.

Turning around an insurance company is a tough job. Ask Brian Duperreault, Tom Motamed, or Chris Swift. It takes several years before the fruits of the labor can be tasted. Rushing through the process probably means you will not get to the desired outcome.

It, therefore, makes sense for Argo to continue working on its strategy, showing results and securing a re-rating as a US specialty insurer, allowing it to negotiate from a position of strength – rather than allowing itself to be dragged to the deal table now.

In our investor day recap, we had welcomed the continued pruning of underperforming businesses and moves to fix the expense base as long-delayed remedies. However, a forecasted RoE of 8%-10% by next year appeared aggressive to us.

But despite that skepticism, a focused, gradual approach to the turnaround could still yield a better result vs a distracting quasi-fire sale.

Below is our take on various pertinent issues and how they might play out.

Firstly, this is not Argo's first dance, and it's trying not to step on its partners' toes.

In February 2019, Voce Capital published a letter criticizing then-CEO Mark Watson's use of company funds, including sponsorships of sailing and race car teams and perks such as private jets and personal homes in New York and Bermuda.

The activist did not win board seats via a proxy fight, but the chain reaction it unleashed resulted in Watson's departure and the installation of insider Kevin Rehnberg as CEO, with Voce subsequently coming inside.

And since that point, much of what management has done has borne more than a passing resemblance to the steps that Voce called for during its campaign.

Argo's exhaustive efforts to drive improved performance in the business are set out below.

Although Capital Returns’ frustration is understandable with the stock underperforming, we think it's too early to give out final grades to the management team.

  

 

Secondly, Argo is still parsing through underperforming businesses.

Argo's remediation steps are focused on reducing low-performing businesses and growing profitable businesses.

Bobman points to Argo's US specialty lines business as the most successful part of the company and highlights its ability to draw significant attention from buyers. We agree with this assertion and believe that once the international business is sold off, the company will be re-rated accordingly.

Argo's Syndicate 1200 underperformed Lloyds significantly, by an average of 11pts each year since 2017, and has been worse than the market average for 10 of the last 11 years.

Recently, as reported by sister publication Insurance Insider, the company has set the wheels in motion on a potential sale of this business.

This aligns with Rehnberg's comments in late 2020, which noted that if results proved challenging, this business would be placed on the selling block. Rehnberg seems willing to make the tough decisions and walk the walk vs letting underperforming businesses remain a millstone around Argo’s neck.

Below we see that Argo's US business consistently outperforms the international business with a lower underlying combined ratio. The same is true in terms of client retention, with the US consistently better than the international business.

  

 

Apart from its Lloyd's businesses, Argo's Bermuda business is not a differentiator either. Argo had acquired PXRe for cheap in 2007. However, with prior CEO Watson never truly comfortable with this piece, the benefits of the acquisition have been mostly frittered away.

The disposal of the Bermuda entities would be a logical next step in the simplification of the organizational structure, and would support the re-rating of the business as a true US specialty franchise.

Thirdly, operational inefficiencies are still weighing on multiples.

The expense ratio, which was one of Voce's major concerns, has improved slightly so far. Management pointed to an ambitious 36% by the end of 2022. So far, the improvement appears to be lagging the industry, with Argo's expense ratio improving 0.3pts in the first half of 2021 and its peer group improving 0.8pts.

  

 

Even if the full financial targets are not met by 2022, the trading multiple would likely still re-rate as the company's core E&S book comes into focus and uncertainty around future reserve charges subsides.

  

 

Fourthly, a fire sale would not achieve the optimal multiples.

Argo has been a potential takeout candidate for years given its trading multiples, reflecting the uncertainty of how Voce activism will play out, the AM Best downgrade, volatility in earnings, fear of further reserve charges, and results dragged down by the international business.

The company has targeted a 10% RoE by 2022. We've previously discussed the likelihood of Argo reaching this lofty goal. Sometimes comparing trading multiples to the peer group can lead to higher expectations.

In any event, regressing Argo on future expectations leads to a stock multiple of 1.5x future year-end book, which leads in theory to an $80/share price by year-end 2022. This analysis does not factor in any remediation actions, dispositions, or reserve adjustments, so on the surface it might overstate the takeout value.

  

 

Finally, potential buyers may be strategic.

In the letter to management, Capital Returns noted several potential buyers. Argo has mostly traded at a discount to book since 2003.

Consequently, this name has featured quite often as a likely takeout target. It's also expected that there have been many transitory suitors, but no one serious enough to put a ring on this.

This could be attributed to company issues as well as unrealistic takeout expectations from the prior management. As a result, although consolidation is often talked about quite freely in the insurance space, actual deals are difficult to pull through.

Quite often, when buying a longer-tailed player, the asymmetric information comes back to bite. This means there might not necessarily be a line around the block to acquire Argo, since it's not a financial takeout.

In addition, most commercial lines franchises right now are focused on backing their underwriters to grow into the hardening market. More acquirer interest would be likely as the market starts to soften.

Below we segment the potential buyers in three buckets (high, medium, and low likelihood) of interest in Argo over the next several years. Our comments are quick takes on what these companies might think if it came to evaluating Argo as a target.

  

 

In conclusion, we believe that Argo is getting ready for the dance. It still has some way to go, including re-underwriting, expense rationalization, and dispositions to attract potential suitors. We expect that day to come over the next few years. We do not believe that day is now.

 

Inside P&C provides unparalleled market intelligence on the entire US P&C market – from small commercial and personal lines right through to reinsurance and Bermuda. Redeem your complimentary 14-day trial for more premium content from Inside P&C.

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