With the extreme growth in the Credit Default Swap market, a good risk
underwriting team, a counter-party credit rating of AAA and a stock price close
to book value, Primus Guaranty is well-positioned to earn insurance writing
returns.
The Business Driver
From its beginning in 1973, the trading of options has become extremely
popular as a method for implementing leverage and hedging, especially with
institutional managers that oversee significant assets.
One of the fastest growing areas of the global financial system is the Credit
Default Swap, or CDS, market. This market grew from $180 billion in 1997 to a
current estimate of $17 trillion in notional amount. One of the growing players
in the CDS market is Hamilton, Bermuda-based Primus Guaranty (PRS), which
specializes in helping financial firms limit their credit risk.
A credit default swap is simply an insurance contract that protects the buyer
from losses resulting from a default or credit event relating to the underlying
credit instrument. In a typical transaction, Primus sells a CDS to a client who
wants to reduce their exposure to defaults in exchange for a fixed premium for
the term of the CDS. In the event of a default, Primus must reimburse their
client. Like any insurer, Primus profits from the transaction by pocketing the
premium when the insured event fails to materialize during the term of the CDS.
Primus began operations in 2002 and has quickly taken advantage of this growing
market. The company reduces its risk by selling the majority of its credit
default swaps on investment grade credit instruments. In the second quarter of
2006, only 2.3% of new swaps sold by the company were rated sub-investment grade
down to “BB.”
Success in the credit risk business is highly dependent on the experience and
ability of the management team. Primus has fielded an experienced team headed by
CEO Thomas W. Jasper, who was a key executive of Salomon Smith Barney for 17
years. Mr. Jasper created Salomon’s interest rate swap business in 1982. Under
his leadership, Primus has experienced strong growth.
A good indication of the quality of Primus is its “AAA” credit rating by
Standard & Poor’s Ratings Services. While their business is all about risk, the
company appears to have it under strict control. Primus has had no credit events
with any of its credit swaps sold.
The Fundamentals & Valuation
When evaluating potential growth stocks, we often screen for companies that show
strong growth in an industry that is accelerating. Primus fits these criteria.
In their June 30 filing, the company reported that annual revenue surged 97%.
The last two quarters showed year-over-year growth of 707% (Q2) and 1,333% (Q1).
Annual earnings surged 735%.
The stock combines good fundamentals and superior valuation versus its peer
group. Earnings growth over the next five years is estimated at 30% annually
compared to 17% for the industry and 8% for the S&P 500. The stock trades at an
estimated 7.8 times its 2007 EPS compared to P/E ratios of 20.3 for the industry
and 15.7 for the S&P 500. The forward P/E is near the low end of its five-year
P/E range of 6.8 to 18.4, suggesting good upside potential in the stock.
The Technicals
Primus appears to be shaping an unorthodox double bottom base. The company
has a history of spiking runs, as earnings can certainly be lumpy. The stock
bottomed in March around $10.80 before spiking to $14 in May. It found a new low
in June at $9.71 but has since recovered to the $12 region.
Only 11% of the stock is owned by funds, but one of those funds is a well known
hedge fund that focuses on financial services. It is run by Tom Brown, one of
the few analysts who stood his ground against the pressure to change ratings for
investment bankers during the stock market bubble.
Summary
Primus Guaranty’s swap business is growing strongly within a booming
industry. Institutional ownership remains relatively low at 36.8% so it has yet
to catch Wall Street’s eye. We are impressed with the growth of Primus in only a
few short years and believe the stock deserves a closer look.
