What’s so attractive about Argo?

Recent investment into Argo Group by activist investor Voce Capital Management has thrown the Bermudian carrier into the M&A spotlight.

On 25 January, Voce acquired 5.6 percent of Argo shares and became the fourth-largest investor at the Bermuda-based insurance carrier.

Voce is known for its recent activism at Natus Medical Inc, which was directed at shaking up the company’s board and C-Suite. However, the hedge fund manager’s intentions at Argo remain unknown.

Notably, the position at Argo represents an estimated 60 to 70 percent fraction of Voce’s total assets under management, and over 80 percent of its non-cash positions.

The Voce investment comes after a period of increasing investor activism in the insurance space.

Some recent notable stories include Carl Icahn and John Paulson pushing for structural changes at AIG, Icahn successfully pushing for a higher bid for AmTrust, and TimesSquare Capital Management pressuring RenRe to become an M&A target.

Historically, shareholder activism in the insurance industry has been seen as challenging due to the highly regulated nature of the industry, but recent trends suggest activist investors are attempting to influence insurers’ policy, especially around M&A.

Although finding out Voce’s action plan as an activist investor at Argo is a virtually impossible task, below is a brief overview on what may have attracted the investor to the 70-year-old Bermuda-based (re)insurer.

Active M&A market

Considering a recent surge of M&A activity in the (re)insurance space, with a particularly high frequency in Bermuda, the main speculation is that Voce is seeking to turn Argo into an acquisition target. There are factors in place that both support and challenge this assumption.

On the one hand, Argo is a digestible size. In terms of market capitalisation, it is about as sizable as Navigators and Aspen – the targets of agreed deals last year. It is 60 percent the size of Validus Holdings and 20 percent the size of XL Group, whose takeovers closed last year.

The level of premium these acquirers paid for the targets speaks to optimism. The premium paid over the closing share price pre-announcement ranged from 9 percent to 46 percent.

The actual premium may in fact be even higher, as markets often tend to price in a certain probability of an acquisition weeks and months ahead of an actual announcement, subject to how each particular transaction developed.

On the other hand, the Argo’s current valuation stands out in relation to the recently targeted Bermudian carriers.

These companies had one important thing in common – they were all priced at book value prior to the acquisition. Argo is currently valued at 1.3x price-to-book, which is 20 percent to 30 percent more expensive than its publicly traded Bermuda peers prior to their acquisitions.

Navigators, which was priced at around 1.5x on price-to-book basis, is a poorer comparison as it is based in the US where valuations are relatively richer.

Importantly, M&A deals are a complex transaction from a legal perspective, particularly when initiated by a minority investor.

No matter how mightily an activist at Argo desires a takeover, there are several obstacles baked into the insurer’s corporate governance that make it harder for a minority investor to wield influence.

Those include restrictions on share ownership and voting powers, a staggered board with only a third facing re-election each year, and limited enforceability of judgements against the company or its personnel made by courts, regulators or laws outside of Bermuda.

Moreover, the fact Argo’s subsidiaries are present in at least seven jurisdictions implies that a potential change of control may be challenged by the applicable regulatory body in any of those jurisdictions.

With this in mind, we put forward some other options that make Argo an appealing holding for an activist investor.

More value hidden within expenses

From an activist investor perspective, further value could be extracted from more rigorous expense management at Argo.

Argo has been operating at an expense ratio that is highest in comparison to both Bermudian peers and US specialty peers excluding RLI Corp.

Expense ratio improvement was a hot topic on Argo’s earnings conference calls throughout the last year. In fact, the ratio improved by two points last year to 38 percent from 40 percent in 2017. However, the value is still highest among both Bermuda and US specialty peer groups.

On the Q4 2018 earnings conference call, CEO Mark Watson noted that Argo still sees most of the margin improvement coming from the expense ratio reduction going forward.

Buy and hold

In recent years, Argo has rewarded its passive investors with a remarkable performance.

Between 2015 and now, Argo’s shares have been the second-best performer among both Bermuda and US specialty carriers, trailing WR Berkley just by a small margin. Within this time period, the stock’s 42-percent cumulative return outpaced that of the average Bermudian by 23 points, US specialty by 15 points and the S&P 500 index by 8 points.

There are four factors that may further benefit Argo’s buy-and-hold investors going forward.

First, regardless of the stock performance, Argo is currently trading in line with its Bermudian peer group average and significantly lower in relation to the US Specialty carriers.

Argo’s price-to-book of 1.3x exactly matches the average for the Bermudians, but is lower than 1.7x of the average for US specialty insurer excluding the highly valued RLI Corp.

As a negative side note, the carrier is trailing all of the Bermudian peers on estimated operating return on equity (RoE), at around 8 percent versus the range of 10 percent to 12 percent prevailing among Bermudians.

Management is targeting RoE that is 7 percentage points above the risk-free rate, which makes the RoE target about 10 percent. Argo highlighted that the target level is expected to be achieved over the next 18 to 24 months.

Second, Argo is distinctly less weighted towards reinsurance business and more focused on specialty lines relative to its Bermuda peers. That positions Argo fairly closer to risk, and less exposed to recent elevated losses in property and transportation lines that have recently offered a poor risk-reward balance.

This weighting towards specialty lines may have helped Argo become the least catastrophe-exposed Bermudian (re)insurer in 2017 and the second-least cat-exposed last year, with cat loss ratios of 8.7 percent and 3.3 percent respectively.

Third, Argo has been an active and consistent returner of capital through stock repurchases, regular and special dividends.

In 2018, the company bought back 1.6 percent of shares outstanding, the second-highest among the nine peers. The dividend yield for the year was 1.6 percent, the fourth-highest yield among peers.

Finally, Argo appears to be committed to investing into technological advancement, but this is arguably something almost every insurance carrier professes to be pursuing.

Argo has reportedly been adapting digital tools to optimise underwriting practice for several years now.

CEO Watson stated on the Q4 2018 earnings call that digital tools increased efficiency and scale, as well as risk selection. They are improving the processing time of broker submissions, the measurability of operating results and the levels of loss ratios in the businesses, he said.

In summary, Argo has a number of positive attributes and characteristics – including its size, risk profile and upside potential – which would make it an attractive target for an activist investor. These are amplified by M&A momentum that has gathered around Bermudian (re)insurers in recent years.

However, downsides which could deter a transaction are potential corporate governance challenges around restrictions on share ownership and board structure. Argo’s performance in recent years also gives its investors incentive to hold onto the stock.

On the one hand, Voce’s intentions are unknown and hard to decipher. On the other, the commitment the manager demonstrated by allocating over a half of its assets into the Bermudian carrier hints at determination to further activist actions. There is arguably a case for Argo as an M&A target, but few hard conclusions can be drawn at this stage.

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