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Suddenly, Primus Is A Bargain (1/07/12)

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Enterprising Investor Member Level  Saturday, 02/18/12 11:06:37 PM
Re: Enterprising Investor post# 2
Post # of 48 
Suddenly, Primus Is A Bargain (1/07/12)

As a bonus holiday gift to readers, allow me to share with you one of the oddest special situations I can recall coming across in my 30 years of investing: an erstwhile financial services niche player, now in runoff, called Primus Guaranty, Ltd (PRSG.PK).

This won’t take long. Primus is in the business—or rather, it was in the business—of writing credit default swaps. The company was a tiny specialist in what was at one time a $62 trillion (notional) market. Its counterparties include all the big players, including JPMorgan (JPM), Citi (C), and Goldman Sachs (GS). Primus’s portfolio size at its peak: $22.5 billion. In the long-ago sunny days before the financial world went crazy, the company had a nice little business.

But then the financial world did go crazy, and everything changed. When the credit crunch hit and panic gripped the markets, Primus’s counterparties suddenly had no interest in doing business with small niche players anymore, and would only deal with massive, too-big-to-fail leviathans, instead. So Primus found itself frozen out of the market. In 2009, with things at a standstill and no prospect of that ever changing, the board threw up its hands and elected to put the company into runoff. That runoff will end in 2014 at the latest, when the last of Primus’s CDS matures.

In the meantime, though, the company will continue to receive premiums on its remaining CDS portfolio (now $8.2 billion notional) and will generate a significant amount of free cash. The company is using much of that cash to repurchase debt and common stock.

Given all this, figuring out what Primus will eventually be worth as it runs off is not complicated. Calculate the premiums the company will receive between now and the moment its last contracts expire, estimate losses in the interim, then add back the cash that’s already on the company’s balance sheet, and you have Primus’ intrinsic value. Our work puts the number at between $9.00 and $9.50 per share.

And yet against that $9.00 of estimated value, the stock is lately trading at around $4.80 per share—a 53% discount. But just two weeks ago, the discount was much narrower--closer to 30%. Since then, the stock’s price has dropped by 15% and the gap between Primus’s stock price and its true value has become yawning.

Which gets me to the part of the story that’s so odd. The first, last, and only reason I know of that can account for Primus’s recent, dramatic price decline couldn’t be more mundane: the stock collapsed on the day it delisted from NYSE (to save on expenses) and moved to the pink sheets. That’s it. There has been no change in the company’s portfolio or fundamental outlook. The company’s runoff continues. It was just the de-listing and re-listing that brought about this sudden and astounding bargain. That sounds crazy, but it’s true.

In any event, we have a stock that has, by my calculation, up to 80% of upside or more over the next one to two years. What’s more, the company is actively working to shrink that gap, by returning its growing cash hoard to shareholders. We believe Primus could start to pay a dividend to shareholders in the second half of this year. Eventualy, the company will likely sell its portfolio outright, once it’s down to a certain size, to a financial buyer. (I should add, in case you haven’t already guessed, that Primus is one of the larger holdings in the portfolios I manage.) The major risk that I see is that the eventual portfolio sale will be at a lowball price—but that sale is still a long way off and, given the stock’s current price, is not something I’m not too worried about.

Situations like this aren’t supposed to happen anymore in a fully wired, globalized stock market. But in this case, it has. As I say, I can’t recall every coming across a special situation as attractive and straightforward as Primus appears to be. The risk/reward in my view, is very attractive. Happy New Year.


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