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Argo Group Ltd. (ARGO:LN)

  • Mkt Price:  GBP 14.5p
  • Mkt Cap:  GBP 9.78 mio
  • % of AUM:  4.0%  (of $379.7 mio)
  • P/C:  0.6
  • P/S:  1.3
  • P/E:  5.8  (pre-Amortisation)
  • Div Yield:  8.3%      

Continued from here…     However, Argo is a relatively small fund management business, so I still worry that a loss of funds or personnel could have a disproportionate financial impact. It’s also not clear when performance fees will be a significant contributor again for Argo. This will depend on future market performance, and how its funds stand in relation to their high-water marks. On the other hand: Argo obviously has a well respected investment record and reputation. I’m actually impressed that their AUM has only declined 6% in the past year, and 20% in the past 2 years, despite the difficult market. And, of course, the litigation issue…don’t underestimate this! I’ve dealt with this type of problem personally, and it’s nearly impossible to raise funds from (institutional) investors when there is such a due diligence stumbling block. Now this is out of the way, I think Argo finally has to chance to do some significant fundraising.

Second, I believe that current financial performance, good or bad, is almost irrelevant when one fund management business takes over another. The harsh reality is that the cost structure of an acquired fund business can be quickly/radically transformed (by sharing resources and, yes, firing people). If the acquirer is significantly larger there’s also usually a huge positive impact from increased sales and marketing muscle. Therefore, the industry takeout metrics do make sense and can be pretty easily justified in most instances by an acquirer.

These pros and cons present a bit of a conundrum, but I think overall there’s a pretty simple solution: Until I see some new significant fundraising to confirm fresh momentum for Argo, I’ll be applying a 50% haircut to my valuation. This 3.75% of AUM is equivalent to $14.2 mio. Pretty reasonable for a business with LTM Revenues of $11.6 mio (of which 15% is due to performance fees) and a 15.0% Operating Margin (pre-Amortisation).

What I haven’t mentioned so far is the amazing level of Cash on the Balance Sheet. This far exceeds Argo’s current Mkt Cap! At end-June, we have $10.250 mio Cash plus $15.722 mio Investments (in the Argo Fund, which has a 9.14% CAGR since 2000). Against this, we have GBP 0.348 mio spent on share repurchases since June. Therefore, we’re looking at Total Cash of $25.430 mio – equivalent to GBP 16.3 mio and an ARGO 0.6 P/C Ratio. This is pretty ludicrous! I think it illustrates how far ‘problem’ stocks can fall off the radar for most investors, and how slow some of these stocks are to recover even when the (legacy) issue is eliminated. This is what a true special situations/value investor dreams of finding.

Before we move on to estimate a final Fair Value, let’s look at where we stand on current stock metrics and another positive point or two: I’ve listed the current key metrics for ARGO at the beginning of the post. Pretty cheap and safe! Note that I’ve eliminated Amortisation in my Earnings calculation. This is simply a non-cash accounting entry to write down Goodwill created during the spinoff of Argo from ACMH. This gives me a LTM Basic EPS of $0.0392 or GBP 2.52p. I’ve ignored Diluted EPS, as Outstanding Options are non-dilutive. I’d also highlight the Dividend Yield. Despite an attractive 8.3% Yield, the Dividend is covered 2.1 times by Earnings, and over 20 times by Cash on hand!

But even these metrics don’t portray how cheap the business really is: We need to re-calculate on an Ex-Cash basis to show this properly. Remember that one should also exclude any Net Earnings derived from Cash/Investments when calculating an Ex-Cash EPS. I come up with the following (yes, all ratios are negative!):

  • Ex-Cash Mkt Cap:  GBP (6.536) mio
  • Ex-Cash % of AUM:  (2.7%)
  • Ex-Cash P/S:  (0.88)
  • Ex-Cash P/E:  (6.7)

OK, I think we’ve hammered home the Margin of Safety story enough now..! Let’s add a couple of other positives: Management clearly eat their own cooking, with the Rialas brothers holding 36% and other directors holding another 2%. This kind of ownership is perfect – not too hot, not too cold…! I’m sure many readers, like myself, have suffered at the hands of management or a shareholder with, say, a 60%+ stake in a business (listed on AIM, of course..?!). I can’t fault the brothers to date, they appear pretty conscious of the stock under-valuation. They’ve bought in (and cancelled) 8.5% of Outstanding Shares year to date. And with the last purchase occurring this week (Nov 30th, 250 K shares @ GBP 14.375p), there may well be more to come this year. Longer term, if the stock price doesn’t correct higher, one has to think they’ll be motivated to scare up a bid for the company. Of course, that could be a management bid, but with their current ownership stake and the Cash on the B/S they should be motivated to pay a generous premium.

Directors and employees should also be hugely incentivized by a 5.9 mio option grant early this year. Yeah, a little generous! But I’m impressed with the GBP 24p strike price, more than double the share price at the time. So if we ultimately see some dilution coming through, I don’t think we’re going to be feeling too bad! Far better than the usual guzzlers at the trough behavior where management (in the UK, not just the US) actually roll down the strike prices on their options. Some small credit to US management, they usually accept a reduced number of options in exchange and even seek shareholder approval on occasion. UK management usually doesn’t even bother with these niceties…

I was pretty bemused by the pigs over at Theo Fennell (TFL:LN). They recently rolled the strike price down on 1.8 mio options (equiv. to about 8% of Outstanding Shares) from about GBP 39p to 22p. In exchange for what?! The abysmal management of a badly capitalized business? I actually contemplated a TFL purchase at one point, to my shame… Mostly, I confess, because I’m still kicking myself for not pulling the trigger on some planned Mulberry (MUL:LN) purchases. Then I noticed their 11% Gross Margin. Jesus, what’s wrong with these people?! I could possibly forgive a fast growing company for a minimal/even negative Operating Margin, but there’s no way you can claim to be a luxury business unless you have a 50%+ Gross Margin!

Right, let’s put together my Fair Value estimate for ARGO:

$25.430 mio Cash/Investments + (3.75% * $379.7 mio AUM) = $39.669 mio / 1.5586 = GBP 25.452 mio / 67.428 mio shares = GBP 37.7p Fair Value per share

This offers me 160% Upside Potential for a safe and cheap business, which also offers long term (low volatility) emerging markets exposure. As I’ve mentioned, I now have a 5.0% ARGO stake in my portfolio, at an average GBP 13.2p entry price. It’s my third largest holding, and I include it in my Event Driven portfolio category. I would add to my stake further, but I’m conscious of the small Mkt Cap of the company. Let me just wrap up with some target metrics:

  • Tgt % of AUM:  10.4%
  • Tgt P/S:  3.4
  • Tgt P/E:  15.0
  • Ex-Cash Tgt % of AUM:  3.75%
  • Ex-Cash Tgt P/S:  1.2
  • Ex-Cash Tgt P/E:  9.3
  • Tgt Price:  GBP 37.7p
  • Upside Potential:  160%

Best of luck, dear reader, if you already have, or might now be contemplating an ARGO holding. All comments/questions/suggestions are of course very welcome!