Ambac Financial Group Inc (AMBC) 2004 Q3 法說會逐字稿

Good morning, ladies and gentlemen. Welcome to the Ambac Financial Group incorporated, third quarter earnings conference call. [Operator Instructions]

A brief question and answer session will follow the formal presentation.

[Operator Instructions]

As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Mr. Thomas Gandolfo, Chief Financial Officer of Ambac Financial Group Inc.

Thank you. And now welcome to Ambac's third quarter conference call.

My name's Tom Gandolfo. With me today is Rob Eiseman [ph], our corporate controller and Pete Poillon, our Head of Investor Relations.

Our earnings press release and quarterly supplement on our website and will be mailed out to those who have requested it. The call is also being broadcast on the web and will be accessible through December 31st.

Fourth quarter 2004 earnings will be released on January 26th, 2005 at 8:00 a.m., with a conference call at 11.

During this conference, we may make statements that would be regarded as forward-looking statements. Those statements are based on management's current expectations. I refer to you our press release for factors that could change actual results.

Let me jump into the highlights for the third quarter. Net income came in at 183.5 million, or $1.65 per diluted share. That's up 14% on a per diluted share basis from the third quarter of 2003.

While Ambac reports net income in accordance with GAAP, the research analysts make certain adjustments to reported net income to calculate their reported estimates. Therefore, we continue to provide information on those items that the analysts adjust out of GAAP net income to arrive at their current estimates to eliminate any confusion. Those items are first net after tax gains and losses from sales and investments securities, and marked market gains and losses on credit derivative contracts and derivative hedge contracts, which in the third quarter of '04 were net gains of $4.4 million, or 3 cents per diluted share, and this compares to net gains of 1.2 million, or 1 cent per diluted share in the third quarter of '03. Some analysts also back out the after tax effect of accelerated premiums earned on obligations that have been refunded and other accelerated premiums. Total after tax accelerated premiums amounted to $12 million, or 11 cents per diluted share in the third quarter of '04. That compares to 11.8 million, or 11 cents in the prior year quarter.

Moving on to adjusted gross premiums written, or AGP, AGP came in at 273.7 million, that is down 3% from the 282.5 million we reported in the third quarter of '03 and I'll take you through the highlights there.

First, public finance, public finance AGP came in at 105.9 million. That was down 33% from the third quarter of the prior year. While MUNI issuance as reported by third party sources was down quarter on quarter from 89 billion in the third quarter of '03 to 78 billion in the third quarter '04, insured penetration remains strong at 58.4%. Ambac continues to focus its attention on those segments where we bring the most value. Typically, the more highly structured segments of the public finance market.

Ambac's market share in the quarter was approximately 22%. That's slightly better than our 20% share in the third quarter of the prior year and about flat to the first two quarters of 2004. AGP and public finance was down from the prior year primarily due to lower market volume and one very large structured municipal transaction that was closed in the third quarter '03, making the comps more difficult.

Moving on to domestic structured finance, structured finance AGP came in at 123.5 million, that is up 28% from the prior year. Transactions closed in the segment were again broad, but activity in the mortgage back and home equity sector was strong. The MBS and other consumer asset backed securities market remained very competitive. However, as we mentioned last quarter, we have recently seen some more opportunities to win business in these markets. The higher MBS writings in the third quarter were partially offset by fewer domestic-owned utility transactions in the quarter, as that market continues to see tighter credit spreads.

Moving on to international, international AGP in the third quarter came in at 44.3 million. That's up 58% from the prior year. The quarter's results were highlighted by strong writings in international utilities. As discussed in the past few quarters, we are not writing much new CDO business due to narrow credit spreads in that asset class. Additionally, international has seen a slowdown in closings of the very large deals that typically have a dramatic impact on the top line. We believe that the international markets still provide a great opportunity for growth, as the capital markets there continue to expand geographically by product.

UK, PFI remains strong and the government remains supportive. Encouragingly, PFI is expanding to other countries in Europe with potential opportunities in Italy, Spain, Portugal and France.

Moving on to premiums earned, net premiums and other credit enhancement fees earned excluding refundings, increased to 174.3 million, that is up 16% from the third quarter of 2003. Public finance, our most mature product, continues to display strong growth coming in at 18%. Structured finance domestic grew 11%, while international grew 20. As discussed last quarter, while the growth in structured finance and international is still good, it is moderated compared to last year, as the respective books of business have grown and the comparisons have become more difficult. Also, the growth rate is being negatively impacted by a reduction in the growth of our MBS and home equity segment, driven by prepayments in our existing book and increased competition for new business. Additionally, the CDO book has experienced significantly slower growth, resulting from tight credit spreads in that market. The less stable shorter-term exposures are running off and being replaced with more stable, long-term business at attractive returns. The result will bring short-term fluctuations in earned premium growth, but the result instability to the long-term growth is a positive.

Deferred earnings, which represents future earnings that are either in hand or contractually due us grew to $5 billion. Those deferred earnings will be recognized in earned premium in the future over the life of the exposures.

Losses and loss adjustment expense provisioning increased to 17.7 million, that is up 1.8 million from the third quarter of the prior year and up slightly from the 17.5 million in the second quarter of '04.

Net insurance loss reserves of September 30 were 228 million, that is an $8 million decrease from June 30, 2004. To further break that down, our ACR increased 11.9 million, to 162.8 million and our case reserve decreased by 20 million to 65.2 million. The decrease in case reserves was due to claims payments made during the quarter for credits that had previously been reserved. This quarter's payment included a $16 million final payment for a healthcare credit that originally defaulted in the '90s and has been fully reserved for years.

In addition to the insurance reserves, we have a $21.5 million reserve established through market to market accounting in our credit derivative book.

Moving on to our financial services segment, financial services net revenues excluding realized gains and losses were 17.2 million, that compares to 18.6 million in the comparable prior period. The decrease was primarily driven by a large swap that was transacted in the third quarter of '03, combined with a $4.8 million positive market to market adjustment in that quarter as well. I am happy to report that our investment agreement business results have stabilized nicely since last year with notable improvement in net interest rate margins.

Return on equity -- at which -- excluding net investment gains and unrealized gains in the investment portfolio came in at 16.2% for the quarter. We're very pleased with our return on equity results, and particularly in light of the historically low interest rate environment that we're in and its impact on our investment yields.

In summary, this was a solid quarter, with acceptable top line production. Although competition has intensified, we remain committed to maintaining our industry leadership in return on equity by underwriting solid credits at acceptable pricing. With that, Megan, I'd like to open it up for questions, please.

Thank you, sir. Ladies and gentlemen, at this time, we will be conducting a question and answer session.

[Operator Instructions]

Please hold while we poll for questions.

Our first question will be coming from Geoffrey Dunn of KBW.

Good morning, guys.

Hey, Jeff.

First question, you said that the pipeline, or the large deal closings have slowed, but didn't, I think maybe that's a choice of words. Are the deals not coming in, or are they just being extended in the pipeline longer on the international front?

And then second, there's been a lot of noise in the last couple days about potential Spitzer [ph] issues with specifically mini bond insurance. I think a lot of worries being perpetuated. Can you walk us through what the facts are of contingency commissions, brokers, kickback issues, anything in financial guarantee and how that specifically works?

Sure.

Let me start with the international question. And maybe that was a poor choice of words. It's hard to get visibility, you know, the pipeline is active. We are seeing deals, we are looking at deals, but as far as the mega deals, deals that you maybe become accustomed to, that you saw last year, you know, the $50-60 million premium deals, you know, they're not in the near future. We are highly confident that they are out there and how do we get this confidence? If we look at what's going on in the international markets, you know, we're seeing very good support from the government in the UK on their PFI initiative. We're seeing obvious evidence that that is expanding into the countries I mentioned in the prepared remarks, Italy, Spain, Portugal, France. The problems with these deals, Jeff, and I hate to sound like a broken record, they take a long time. You know, we-- it could take two years to close one of these deals. So I just don't want to give the impression that you should be looking for something like this in the next quarter. We fully expect to do these transactions, but it's very lumpy and very difficult to predict.

In the meantime, we are seeing good transactions in that kind of medium level. I mean this quarter alone, you know, we did a utility. We had about $16 million of premium just on that one deal alone. We did an attractive transportation deal. You know, we did a second utility. We did a couple-- actually a few utilities. So, you know, we're seeing decent business, but those mega deals are going to come on a very lumpy basis.

So just, when we look out on or projections, it's always probably a guess at best on a quarter to quarter, these kind of levels, would you say, are a better area to be thinking of and then, you know, let the big deals hit when they do? Or do you think this is abnormally low quarter based on whatever kind of general trend you might be seeing in the deals?

You know, it's hard to say whether the 44 million would be a general trend. I would-- I think we're going to still see some decent deals in that $10-15. We kind look at the mega deals as the plus-25 million, if you will. I think we're going to see good activity in the 5, 10, $15 million deals so, maybe this is a good indication. And, I think, you probably want to look at the mega deals as gravy when they hit and they will hit. It's just it's going to be choppy.

Okay.

Moving on -- I think your second question was on--

Basically all the stuff that's been hitting insurance lately and specifically I think some people have tried to make some noise about the mini bonds industry in the last two days. If you could just provide sort of your fundamental view on all the issues that have been brought up.

Sure.

Lot of press with the Eliot Spitzer Marsh & McLennan matter and I have heard the rumors. I think some of the hedge funds are spreading rumors that perhaps our industry is going to be impacted next, and I can tell you, you know, our business is significantly different from the traditional insurance market and we are not impacted by the allegations in the Marsh/Max Spitzer matter.

How our business different? Most importantly, we do not-- obviously we're not a broker, but most importantly, we don't pay broker commissions to anybody and we don't pay any fees of any kind to anybody in order to source our business. Our business comes through underwriters, investment banks and financial advisors who are working for their municipal clients. I'm talking about municipal now and it's a very competitive bid process. As I think all of you have known for years, in the municipal world, pretty much the low bidder wins the deal, and, you know, that's just the way it is, so we don't have any opportunities in this business to get involved in any of the things that's going on in that broker industry. In the non-municipal sector, structured finance and international, same thing.

No commissions of any sort paid by Ambac to anybody or any other fees to source business. So can't be more clear, you know. I strongly believe we have no impact from these allegations.

And there is no direct financial tie between you and investment banker in any of the transactions you deal with?

Absolutely not. And you know, and let me add that not only do I feel this way, there are no investigations that I'm aware of in the industry, certainly not at Ambac by any legal or compliance or regulator of any kind. You know, the only folks, who, you know, are in here frequently is our, is the rating agencies, which is our unofficial regulator and, you know, they do a very thorough scrubbing and we're glad they do, but no issues.

Okay. Thanks, Tom.

Thanks, Jeff.

Our next question will be coming from Mike Grasher [ph]of Piper Jaffray.

Good morning, Tom. Congratulations on a nice quarter.

Thank you.

I just wanted to follow up. If you could go back and just talk about, I guess, give a little more color around pipeline and how do we define pipeline and maybe, you know, what does the current mid-level of deals look like from an international structurally financed picture?

Yeah, I mean, the definition of pipeline, I want to be careful and be clear. Pipeline doesn't necessarily mean we have been mandated the deal. Okay when we talk about pipeline, we talk about what do we see on the horizon, what do we see being discussed in the market, what's being brought to us in terms of an ability to bid on, and this, really goes for all the sectors. International being the hardest to project because, you know, the capital markets are developing there and you have different types of competitors there. You know, in the international market, you are also competing with the banks as well. So I don't know if I can be too helpful in terms of putting a number on it for you, but what I can tell you is we are seeing activity, you know, investment banks bring us the business. You know, we're looking at, you know, I can't name the deals. I can tell you where we're looking at some very attractive deals right now, but I hate to pin it down to pipeline in terms of timing and mandate. I wish I could be more definitive for you on that.

Okay. Fair enough.

Then just in terms of share buy back program, I just happened to notice the, and this maybe nitpicking, but the share count went up very modestly in the quarter. Just curious, I think that you sort of the program would be to buy back any additional share grants through employees, but if the stock were to remain relatively cheap here over, you know, 6/9 months, might you take a look at advancing the program?

Yeah, we would. I think it, you know, our theory, our strategy on buy backs would be to buy back primarily to mitigate the effective dilution from the share ownership programs that we have.

Right.

But, you know, if we saw our share get to the stock get to the point that we thought it was unreasonably cheap, we would step in and step that up a bit, not dramatically, but we would step it up a bit. One of the reasons why you saw more diluted shares this quarter, the way the calculation works for diluted shares, the higher your stock price, the more dramatic impact that has on diluted shares outstanding.

Right.

So there was a little bit of that going on this quarter too.

Okay. Thanks very much.

Thank you.

Thank you. Our next question will be coming from Rob Ryan of Merrill Lynch.

Good morning.

Good morning.

Could you describe any qualitative, or quantitative for that matter, changes in the watch list, total number of credits, any trends that you're seeing in terms of sectors coming on, off, particular concentrations, that kind of thing?

Sure.

In terms of the watch list, I guess let me focus on the more, the more dramatic, the below investment grade which we disclose to you in the supplement every quarter. Probably the-- it's relatively flat quarter on quarter. It went up about $250 million. Healthcare actually came down about 150 million. Mortgages, I think mortgages went up about 300 million, but net-net and the total below investment grade, up about 250 million. I think it was about 110 basis points of net par, Rob. On terms of the credits though that, I guess, are of the highest concern, which would be where we're paying claims, it's pretty much the same as I described last quarter, with two exceptions. One of the healthcare credits, there was two healthcare credits, one we fully paid out so we don't anticipate anymore claims on that, that was the 16 million. We still have the handful of mortgage deal we're paying claims on, we paid 7 million in claims in those this quarter. I think we're going to continue to pay claims on those mortgages, probably for, you know, two more years, and then I think the other credit I've talked about in the past that's changed is the CDO, where I thought we were going to pay about another 10 million on that, said it might be possible, that credit's actually improved rather significantly. There was one particular name we were worried about in there that restructure and their debt's actually trading above par right now. So we may get out of that without paying a claim. That deal matures in 2005, in May of 2005. But nothing dramatic, Rob, other than what we've already told you.

Okay. Great. Thanks.

And briefly, could you just go over some of the general healthcare underwriting guidelines, what gives you comfort about the deals that you have done in that sector where we know there can be fairly high severity of losses?

Sure.

You hit the nail right on the head. Healthcare, we view as probably our highest risk sector, for the exact reason Rob just said. When there is a default in healthcare it, tends to be of higher severity than it would be in any of our other sectors that we planned. For that reason, you know, we only deal with the cream of the crop. We look for hospitals that are vital to the communities that they serve. You know, we get a lot of comfort out of essentiality when we underwrite a healthcare credit. Things we look at is competition, are there other hospitals in the area, how vital, how critical is it the community, can the city let that hospital fail, is there another one that can step in for them. Those are the type of factors we look at when we underwrite hospitals. We want to see a strong investment portfolio. We want to see strong management. We want to see high market share. We want them to have high market share within the community that they serve, so to sum it up, we really look for the cream of the crop when we underwrite healthcare.

Thanks a lot.

Thank you.

Our next question will be coming from Mark Lane of William Blair and Company.

Good morning.

Good morning.

The first question is regarding 2005 and the guidance that you provided in the press release, what sort of new business environment are you presuming over the next 6 -- 12 months? Pretty stable spread environment, improving, moderately higher rates?

Sure.

What we have seen in this quarter and we think it will probably be with us for a while, is moderately narrowing credit spreads. Not dramatic, but we've seen credit spreads narrow. For example, in the municipal world, we've seen credit spreads narrow as municipalities have slightly improved. However, on a relative basis, credit spreads are still very attractive from where we were, you know, let's say back in 1998, with one exception and that's California. We have seen fairly significant improvement, or narrowing in credit spreads there because as you're probably aware they were upgraded during the quarter to A-rated. So I think, as far as environment, Mark, we're going to see credit spreads not at the level they were at two years ago, but still attractive, still able to meet our hurdle rate of returns and we think we're going to see more competition. You know, one of the reasons we lowered, we went to the 12-14% core earnings growth next year is because of the slower growth in CDO's and mortgages. In mortgages, we've seen tough competition. This was a great quarter for mortgages. We had an exceptional structured finance quarter this quarter. We don't know if that can continue.

Can you just clarify that though in terms of competition. You're talking about competition from the market.

Well, two places. In mortgages, it had been primarily from the market in the form of senior sub structure. However, we do see competition in, more intense competition from our traditional sources in the very low risk sector of the MUNI world, we're seeing a lot of competition again there and I think you'll see that bear out when you see the market share numbers for our competitors. You are going to see a couple of our competitors with very high market share chasing that low risk sector of the business, and that's had an impact on pricing. That's not where Ambac focuses its capital, fortunately. We do have one of the financial guarantors that beside fairly aggressive in mortgages, so you are seeing pockets of aggressive behavior in certain sectors. And, you know, my guess is that doesn't let up. What I can assure you is Ambac's not going to get caught in the trap of chasing prices down below it's hurdle rates of return and it's underwriting standards will not change. You can write very good business-- you can write bad business that looks good for a few years and then it looks very bad after that and you know, Ambac's not going get caught up in that.

What about structured finance though, narrowing credit spreads and public finance, more competition and structured finance, you have highlighted and the mortgage back market, but the last couple quarters-- well, let's go back just a quarter and a half. You know, you reiterated this quarter that you're seeing some better opportunities to write more business because presumably spreads in certain areas have widened, you know, modestly from very tight levels earlier in the year. So does that modestly, moderately narrowing credit spread apply to structured finance as well? I mean how tighter can CDO's get?

Well in CDO's, remember CDO's are classified in our international business primarily.

Okay.

And I don't think, you know, the risk of credit spread narrowing in the CDO world is a big risk. Certainly not for Ambac, because we've kind of backed off writing business there, so spreads are historically tight there, as you know, in corporate world right now. So my guess would be spreads are going to widen again there eventually as soon as we get a headline, you'll probably see spreads widen that business, so that will probably be a positive. I'm not sure it can get much worse in that sector. You know, but we've seen spreads narrow in structured finance, particularly in the mortgage area. But not to the point where it's impacting, or having a significant adverse impact on our returns. Because you have to remember, when I say they are narrowing, they are narrowing off of historically wide levels. We're still in better shape than where we were in the boom time of the mid and late '90s.

Okay. That's helpful.

On the share repurchase, it's always been opportunistic, so the question, is, I mean, if you're looking at slower growth and more competition and your exposure growth is going to be lower, your AGP is lower, the credit is improving, so, you know, you should get some credit, credit-credit within your portfolio through this year. So why wouldn't you take a more aggressive stance on share repurchase versus two quarters ago? I mean two quarters ago, the position was, well, we still see really good growth in front of us. Now you're saying something different, so why wouldn't you be a little bit more aggressive on share repurchases?

Sure.

No, it's a fair question. You know, I guess my opinion that, you know, 12-14% after tax core earning growth is still pretty good growth. I think a lot-- that would be the envy of a lot of public companies. Remember too we're not lowering our return on equity target. Okay. We're still committed to a 15% ROE target. So we are still seeing opportunities. I mean we did $274 million of AGP this quarter. We're still seeing opportunities to put capital to work at an attractive ROE's for our shareholders. I agree totally and we're all shareholders here, the day comes where we don't see those opportunities, we certainly would consider stepping up the share buy back program.

But if you're generating higher returns, you're arguably generating capital internally and therefore, you know, that is exceeding your exposure growth. That's my only point.

Yeah, but we're still optimistic, Mark, that we're-- even though, you know, we brought the target down to 12-14, we're still optimistic on the market and when I say spreads have narrowed, yes, they have narrowed, but that doesn't mean, you know, the opportunities aren't going to be there to still write attractive business.

Okay. Last question is on competition, are you-- this quarter you wrote a deal with Ameri [ph] Credit.

Yes.

That's an issue where you've never done business with before -- because of credit concerns. Do you feel that you're being forced to look at different areas that, maybe at one point, you didn't need to because of, because competition is broadening?

No. that's a great question and the answer is absolutely not. Ameri Credit is a credit we've looked at for years, and, you're right. We didn't write business there back when they were having their liquidity issues. This is typical Ambac style. What we do is we look at, not just, not to pick on any names, but industries, whether it be the airline industry or credit cards or auto securitizations, we like to come in late after the problems have been surfaced and resolved. And we feel in this particular case, this is a good time to come in, because we feel the problems have been resolved and it's a good time for Ambac to enter. Another example of that, Mark, is the EETC, you know, aircraft leases. We didn't do that business in the '90s because credit was too good and you couldn't get good structures. We came in and started doing that business, you know, after 9/11 because you could get good structures. So that's kind of our strategy.

Okay. Thank you.

Thank you.

[Operator Instructions]

Sir it, appears there are no further questions at this time. Do you have any closing comments?

Yes, please.

Well, I wanted to thank everybody for joining in on the call today and just emphasize that Pete, myself and Rob are here all day and feel free to call us directly if you have any follow-up questions. Thank you very much.

Thank you, ladies and gentlemen, for your participation in today's teleconference. You may disconnect your lines at this time, and have a wonderful day.