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Inside in Full: Argo’s strategic review: April showers bring deal flowers

It’s okay. Really, it’s okay to admit when the time has come to move on and start thinking about other options...


Too often, management teams get permanently stuck in the "we can fix this" mode.

Unfortunately, this mindset can often lead to worse outcomes when pivoting the book, or playing whack-a-mole with old and new issues.

The eventual result is then worse when the options have run out, and a belated acknowledgment of problems leads to a choice between less-than-optimal lifeboats.

In our February note on Argo, we came out and called for the board to explore a sale of the business. (See “Argo: It’s time to think about a sale of this franchise”)

The recent reserving charges and the widening gap between ROE expectations and actual returns hurt the management's credibility as stewards of this franchise.

This management team has put in much arduous work addressing the prior challenges. Still, it was increasingly evident that a drip-drip approach was taking too long to lift the valuation cloud over the name.

Yesterday, Argo's board announced that it had initiated an exploration of strategic alternatives and would consider a potential sale, merger, or other strategic transaction.

Having covered Argo for more than a decade, we are familiar with the evolution in its management and business mix and the challenges over time. The press release was silent on any update on CEO Kevin Rehnberg's medical leave update, so chairman and acting CEO Tom Bradley is likely running point on this process.

Argo is doing the right thing considering the state of the current markets, the firm’s stock multiple, and the progress on its turnaround plan. However, commercial and specialty insurance pricing is beginning to come off its highs, and the interest rate rises this year could be a double-edged sword.

Argo's share price continues to underperform, having done a full round trip back to where it was pre-pandemic. It is still down 27% for the year even after yesterday's move up, compared with the S&P 500 at down 10%, and the S&P Insurance index which is flat for the year.

If stock is a proxy of how your firm is valued, it hasn't worked in a while, so an alternative approach is correct.

Most of this is due to the noise compared to the lofty expectation set at various public forums, including its investor day last year.

For 2021, the reported operating ROE was 2.2%, while investor day expectations were +6.5%-8.5%. For 2022, management had set even more aggressive expectations of a close to double-digit ROE, which they reiterated on the February earnings call. However, with the consistent misses, Argo's investors had begun to view any guidance with considerable skepticism.

Announcing a strategic review serves two positive purposes.

First, it puts the company out there, allowing suitors near and far to know about this. Second, it mostly puts an end to the persistent questions surrounding the future of this franchise. Management can go back to executing its plan.

Separately, yesterday, our news team had revealed a potential sale of Axis Capital's reinsurance business. So, it remains to be seen whether these vastly different books of business compete against each other for partners.

Below, we look at potential suitors, an updated take-out analysis and historical ROEs.

Firstly, now is the time to explore a sale before rate momentum fizzles out.

Although there have been rumblings about the sale of parts of Argo, a complete sale is always the preferred outcome.

We saw a similar scenario with Alleghany where despite discussion surrounding its parts being sold off the end result was a sale of the whole.

Insurance and reinsurance pricing has been strong and has outlasted initial expectations. Now is the time to explore alternatives given the risk pricing deceleration accelerates and the economy starts bottoming out.

Yesterday's GDP numbers showed a decrease, down 1.4% in Q1 2022, which renewed recession fears. Any potential buyers might hunker down if the economy does enter an uncertain environment.

The table below shows a list of potential buyers. The (re)insurance space has seen meaningful consolidation more out of necessity than strategic from the seller's vantage point.

In our piece “Where have all the reinsurers gone?" we discussed the sales of Aspen, Allied World, XL Capital, and Flagstone Re, which were in the investor penalty box. Beyond this, we also saw take-outs of Endurance, Montpelier Re, Platinum Underwriters, and Alterra, which were more strategic.

It might also be that the buyer emerges from left field and could even be a private-equity led buyout.

PE has benefited from a low inflation environment, and abundant capital and deal activity tends to slow down when rates rise. So, we would not be surprised to see buyers emerge wishing to deploy or face a cloudier interest rate environment.

List of potential buyers, with conviction levels

Secondly, our updated analysis shows a range of $40-$60/share in a potential take-out.

Since any take-out for Argo will have to account for a potential reserve adjustment, we updated our analysis.

Note that Argo has redone some of the reserving buckets shown in the 2021 10-K compared to the last annual report. Argo reports on May 2 and it remains to be seen if there are any additional adjustments, or a meaningful impact from catastrophe losses.

Using the reserving buckets from the 10-K, a 5% adjustment to the classes which have seen noise gives us an additional haircut of ~$100mn for reserve deficiency. The below is a high-level analysis, and we would caveat that a serious buyer would have access to much more detailed reserving data.

The analysis below takes the Street tangible book value estimate of $43.24/share for year-end 2022 and applies various multiples and reserving haircuts to give a range of outcomes. Note that our analysis applies reserving haircuts to the lines showing noise.

An actual analysis using deeper by-line data could also reveal pockets of redundancies in other lines, which could offset this haircut.

With that in mind, our analysis gives a price in the mid-$40s to $60s at the top end. This range compares to a pre-announcement 30-day volume-weighted average price of $41.38/share.

A reasonable number might be in the middle. Using a midpoint of $51/share would equate to a premium of 21% from last night's close, and 24% from the undisturbed price.

Whatever deal is reached runs the risk of disturbance from activists pushing for a sweetener, with Ron Bobman’s criticism of the board clearly not at an end. Voce outwardly has remained silent, but if it didn’t like the take-out price, it could go public to pressure the board to hold out for more.

Thirdly, a standalone franchise had lofty ROE targets to begin with.

The chart below shows the operating ROE of Argo vs. the broader (re)insurance peer group. Although the company was targeting an operating ROE of 9%-11% for 2022, its recent results suggest it will fall well short. The last time the company reported a double-digit ROE was close to 15 years ago.

We acknowledge the work and effort it has taken to rightsize the ship following all the noise and re-underwriting, including expense initiatives. But the persistent catastrophe loss noise and reserve volatility made it difficult to accept that a double-digit ROE was right around the corner.

This target was reiterated on the Q4 earnings conference call on February 28 2022. A take-out of the company will allow a buyer to take a surgical approach to course correction compared to the present, where every action is viewed with a microscope and second-guessed.

In summary, yesterday's news validates our thesis that a sale of this franchise is the best course of action. An outside set of eyes with a renewed focus on underwriting, reserving, capital deployment and growth opportunities would be better equipped to deal with Argo's challenges.


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