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You may want to first read my preview of Argo Group’s (ARGO:LN) interim results here.

My estimate for end-Jun Assets under Management (AUM) was $333.8 mio. Actual AUM was reported at $308.0 m – down (5.6)% from end-Dec, but up 1.9% y-o-y. The H1 return estimates I noted for The Argo Fund (TAF), the Argo Distressed Credit Fund (ADCF) & the Argo Local Markets Fund (ALMF) were all spot-on. [And my Argo Real Estate Opportunities Fund (AREO:LN) estimate was derived directly from their published results]. What tripped me up was the Argo Special Situations Fund (SSF) – its (20.6)% H1 NAV decline was rather unexpected… That’s a loss of nearly $23 m, which accounts for the vast majority of my AUM over-statement (net redemptions presumably explain the rest).

Even with more info to hand, I’m not sure I would have anticipated this kind of result anyway. Here’s management’s explanation: The main contributors to this position were the decline in share price of AREOF; a write down in the value of an investment in the Greek telecommunications company, On Telecoms; a higher valuation ascribed to the investment in TPPI.’ Now, let’s consider each of those components:

– The PT Trans-Pacific Petrochemical Industries (TPPI) gain is no great surprise – TPPI was also the main performance contributor for TAF & ADCF this year.

– While AREO’s price decline (from EUR 0.0522 to EUR 0.02) may seem fairly irrelevant at this point, the company’s share count is high & Argo (Group & funds) own a 73.9% stake. [NB: Argo Group itself only owns a 1.8% AREO stake]. That still translates into a meaningful write-down. If I assume SSF’s the only Argo fund invested in AREO – and I’m not at all sure that’s a correct assumption – by my calculation, its loss could total up to $18.8 m.

– As regards On Telecoms, the Greek telecommunications company, it was my understanding that SSF’s predecessor funds (ACPF & AHL) had already recorded a complete write-down on their investment in the company.

Considering the points above, I’m puzzled how SSF lost almost $23 m..?

I’m otherwise encouraged by the improved level of disclosure. Eyeballing the management commentary, it looks to be about 20-25% longer than last year’s – v welcome & here’s to more of the same! However, I note a definite emphasis on the more problematic funds (SSF & AREO) – that’s understandable, but an increased focus on TAF would be far more relevant (considering Argo’s $19.1 m investment in the fund). I’m also disappointed to see no AUM breakout (as promised) by gross subscriptions, performance & gross redemptions. Since Argo’s AUM is relatively static & returns are provided, arguably this analysis is unnecessary. But that’s missing the point, and a bit like management arguing good Investor Relations is also an unnecessary exercise. Investors in listed asset management companies automatically expect such disclosure these days…

Moving on, my anticipated non-AREO AUM increase obviously didn’t materialize. Average AUM was actually much unchanged y-o-y, as evidenced by $3.9 m of management fees & other income reported in both 2013 & 2012. [Despite the decline, non-AREO AUM (assuming no change from end-Jun) is only down 3.3% vs. the H1 average – which should imply only a small $0.1 m H2 revenue hit]. Of course, you’ll note AREO revenue is still included for 2013 – let’s revisit Note 12. in the last annual report:

‘In the directors’ view these amounts are fully recoverable although they have concluded that it would not be appropriate to continue to recognise income from these investment management services, going forward, as the timing of such receipts may be outside the control of the Company and AREOF.’

Er, my mistake. I simply took that to mean no AREO revenue would be recorded unless payment was actually received. Trust the accountants to utilize a more convoluted approach! In this case, for a number of reasons, their treatment’s clearly preferable – $1.3 m of AREO revenue (which is contractually due) is recorded, but this amount’s immediately written off as a bad debt provision in the P&L. Let’s ignore the TPPI incentive fee for a second – I calculate Argo’s underlying loss was still less than $(0.1) m. If we presume some (incremental) level of incentive fees received at yr-end (as with 2012), this should confirm my previous assertion that Argo Group will continue to be profitable – even if zero AREO fees are received.

But things look a lot brighter than that. An (unrealized) $1.0 m investment gain, plus the unexpected $0.8 m TPPI incentive fee, mean Argo’s actually delivered a $1.6 m H1 net profit. This corresponds to $0.6 m of free cash flow (FCF) – and that’s been supplemented since by an actual $1.2 m (EUR 0.9 m) payment from AREO in July. [Which appears to provide good support for my prior assumption that AREO paid a total of EUR 1.2 mio in 2012].

It’s bloody incredible to see something like $1.8 mio of annual FCF generated by a business that’s effectively valued at less than zero..!?

Hopefully we’ll see the same positive impact in Argo’s FY P&L – but this will depend on whether the AREO payment’s treated as genuine (current period) revenue, or as a settlement of outstanding receivables.

Sticking with AREO, there’s a troubling issue to highlight: Argo’s H1 reduction in receivables was redeployed into a $1.3 m loan to Bel Rom Trei, an AREO group company. While management stresses the recoverability of the loan, it’s presumably not secured & the AREO group’s obviously in (some) distress. I’m sure other shareholders will express their displeasure at such a potentially risky loan, but let me offer my own perspective: While a single loan obviously presents a binary risk, on average it’s really no more risky than an investment in TAF. But that just brings up two issues I’ve raised before:

– First, this loan’s the latest milestone in a steadily increasing level of investment in AREO over the past couple of years – in terms of equity & loan investments, and the deferral/write-off of fees. But management hasn’t provided sufficient info (or insight) for shareholders to perform any kind of cost-benefit/risk-reward analysis of their own regarding this investment.

– Of course, the real issue here is the actual investment of Argo’s surplus cash itself. In recent years, investors are increasingly likely to penalize companies which refuse to return surplus cash to shareholders – Argo Group’s current valuation looks like a prime example. When shareholders invest in a listed asset manager, they simply want: a) exposure to the asset management business, and b) surplus cash to be distributed, thereby enhancing returns & granting each shareholder the freedom to manage this cash directly, as they see fit. Right now, only Andreas & Kyriakos Rialas (as CIO & CEO, with a 36% stake in Argo) enjoy that kind of freedom…

[One final point: I actually have to admit I’m bamboozled by the reported AREO receivable. Logically (exc. FX), this should remain unchanged (i.e. fresh 2013 revenue receivable is offset by a similar bad debt provision). However, the actual receivable’s increased from EUR 2 m to EUR 2.8 m ($2.6 m to $3.7 m). Which actually exceeds the $3.0 m of trade & other receivables recorded on the balance sheet..?!]

Let’s get to some good news. FCF was $450 K better than my estimate, which puts cash & cash equivalents at $4.3 m, while investments came in much as expected at $19.4 m. I’m also going to count the subsequent $1.2 m AREO payment. I therefore calculate:

$5.5 m Cash (inc. AREO Payment) + $19.4 m Investments = $24.9 m / 67.4 m Shares / 1.5574 GBP/$ = GBP 23.7p Cash & Inv. per share

$24.9 m Cash & Investments + $308.0 m AUM * 3.75% = $36.5 m / 67.4 m Shares / 1.5574 GBP/$ = GBP 34.7p Intrinsic Value per share

[NB: See prior posts re 3.75% of AUM valuation of Argo’s asset management business. At this point, I need to highlight an important proviso – AREO’s shares have just been suspended. A financing termination notice is cited – but on the face of it, this appears v similar to numerous other announcements this year. For the moment, I’m going to assume this is another storm in a teacup – but obviously it bears close monitoring. The timing of the suspension’s somewhat ironic in light of management’s recent (& fresh) perspective on AREO’s listing: AREOF remains a major listed owner and operator of retail parks in the country thus making it more marketable to international investors over the long term.’

I suspect this statement was specifically intended to address the question (‘why is AREO listed at all?’), but I was intrigued yesterday to discover Globalworth Real Estate Investments (GWI:LN). It listed on AIM in July, raising a EUR 53.6 m blind pool (with an identified pipeline) to invest in (distressed) commercial property in Romania – by comparison, AREO’s latest market cap is EUR 12.2 m. GWI now trades on a rather ridiculous 38% premium to its recent EUR 5 offer price. That kind of investor response & demand is certainly somewhat unexpected, but may ultimately signal some encouraging potential/alternatives for AREO…]

At Argo’s current GBP 16.75p share price (& $17.6 m mkt cap), this implies:

Price / Cash & Investments = 0.71

Price / Intrinsic Value = 0.48

Upside Potential = 107%

As I mentioned, Argo’s technicals looked promising ahead of the interims. Which proved correct, the continued price rally now brings us within spitting distance of the 17.5p March high again. At this point, the basic fundamentals remain v supportive – Argo’s profitable, offers a 7.8% dividend, has zero debt, and cash & investments substantially exceed its mkt cap (and support 18 yrs worth of the current dividend!). And despite the H1 decline, AUM appears to remain stable: a) remember, the decline was due to performance, rather than a new trend in redemptions, and b) AUM remains within the $300-330 m range Argo’s oscillated within for the past 18 months.

We may now be seeing fresh momentum in the share price, but I think just two fundamental criteria are ultimately relevant. If we hope to see the present value gap eliminated, and Argo’s intrinsic value increased, we need to see: i) a significant level of (new) fund-raising, ii) a return of surplus capital to shareholders (via a value-enhancing share tender/buyback), or iii) (ideally) both! The less success Argo management has with fund raising (ALMF’s their first new fund in years & we’ve seen no further subscriptions since its launch), the more important a return of capital becomes…

Finally, I’ll leave you with my usual – and rest assured this is no idle request, shareholder response & support to date has been far more encouraging than you might expect. So please join in:

If you have a direct/indirect shareholding in Argo Group (large or small), and would also like to see a substantial return of capital to shareholders, please email me at wexboymail@yahoo.com

I’ll also make a fresh request. I note a 1 mio Argo share sale earlier this week at 14.25p, a rather painful 10% mark-down vs. the mid-price at the time:

If you happen to be selling a decent Argo holding – say, 500 K+ shares – please contact me. No guarantees, but I may have a potential buyer (or two) for you to get in touch with directly.

Thanks folks!