Invest Skeptically

Overview–
Primus Guaranty Ltd. (PRS) sells CDS (credit default swap) protection on single name corporates, CDO tranches, and ABS. As selling protection is the same as going long credit risk, the business’ success relies on management’s ability to select names that pay a good spread for their level of risk and to trade credit exposures as conditions change.

Despite the recent turbulence in the credit markets they have maintained their AAA rating (in Primus Financial Products LLC) and grown the portfolio. The notional size (amount of credit protection they’ve sold) of their portfolio at September 30, 2007 was $20.4 billion.

Economics–
One way of measuring the value of the business is to estimate the value of their backlog. Essentially the business model is a net interest margin (NIM) or net spread business. To illustrate, the $20.4 billion portfolio pays a CDS premium (like an insurance premium) of 46 bps annually. This portfolio is financed using debt and preferred shares that cost 14.5 bps to service. This makes the NIM 31.5 bps or $64.3 million annually. The value of the portfolio is the present value (PV) of this stream of cashflows: $226 million, or about $5 per share. As a comparison, the stock closed on Thursday at $6.53.

These figures were calculated using a discount rate of 5.35%, the yield on GE Capital bonds (let’s say this is the minimum cost of capital to Primus), and a tenor (or term) equal to 4 years.

The portfolio’s value represents the amount that a similar credit derivatives product company with the same skills, technology, and back office support (to avoid incurring additional operating costs) would pay to buy the portfolio. In other words, this is an absolute maximum value for the business at a given point in time. If operating costs were included in this analysis, the net spread would go from 31.5 bps to 8.2 bps, or 74% lower.

Growth is a risk–
The above analysis indicates that the stock is at least 23% overvalued. But this analysis looks at the portfolio at a point in time. What if it changes? Management can grow the notional size, extend the tenor, and increase the spread (spread ~ riskiness). Over the last four quarters, the portfolio has been growing at an average rate of 7% per quarter, or 31% annually. Can this continue? I think not:

• The portfolio is already quite large at $20.4 billion
• Continued fears in the credit markets may make it difficult to raise new capital at favourable rates
• The ratio of shareholders equity to portfolio notional has been declining over the last four quarters and now stands at 1.5%. This may make it difficult to grow without raising new equity capital which will be costly and dilutive to existing shareholders. Equity capital is undoubtedly required to maintain their AAA rating.
• While CDS spreads have risen dramatically in the last six months, the ability to trade into new, higher spread, contracts will be limited as the rise in spreads has resulted in negative mark-to-markets on existing positions.
• Defaults will change the capital requirements of the business and hinder growth. The historically low default rates enjoyed in recent years can not continue forever… can it?

I’m including a link to a summary of my PRS backlog analysis. The four scenarios at the top try to incorporate a suddenly larger portfolio size and longer tenor on day 1. The average stock price of the four scenarios is $6.42. Again, this backlog figure is the theoretical value of buying the portfolio and collecting the net spread without incurring any operating costs to manage it.