Primus Guaranty

(NYSE: PRS)

An Analysis and Valuation of

Primus Guaranty
By James Cullen
June 11th, 2008

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 Foreword
Almost all metrics of Primus, when taken at face value, make it
seem as if this is a terrible company. With a market capitalization
of about $200 million, Primus has reported a loss of $1.5 billion
over the last four quarters. Accordingly, book value is deep in the
red, and the losses have only accelerated over past quarters.
Of course, a face value assessment of Primus’ numbers couldn’t
portray a more inaccurate picture.
The trouble, I believe, comes from a combination of factors relating
to Primus’ line of business, as well as GAAP accounting standards
that the company uses to report earnings. As a credit derivatives
products company (CDPC), Primus is specially structured to eco-
nomically write credit protection against a portfolio of debt; posi-
tions it intends to hold to maturity. Accounting rules related to de-
rivatives, however, require the company to mark these positions to
market quarterly - which can result in wide fluctuations in reported
results in volatile times, even those the marks have no impact on
Primus’ credit rating or liquidity.
When Primus is viewed net of these mark-to-market results on its
credit default swap portfolio, a different picture of the company
emerges. Economic book value, which will be explained in more de-
tail later, amounts to $9.60 per share at the end of the most recent
quarter - put another way, the stock trades for less than half of
book value. Economic EPS implies a single-digit multiple to earn-
ings for a company in an extremely fast-growing niche of the finan-
cial sector.
All together, I believe Primus’ small size, slightly esoteric business
model and line of operations, and unique accounting factors have
resulted in this stock selling at a substantial discount to net worth.
Nonetheless, Primus is a small company with a concentrated risk
profile, and trading is likely to be volatile. For these reasons, it is
appropriate for the conservative investor to mentally allocate this
stock to the more speculative portion of a portfolio.

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 What is a Credit Default Swap (CDS)?
A CDS is a credit derivative product allowing for hedging or specu-
lation on a third-party entity’s credit risk profile. In such a swap,
the buyer is purchasing credit protection (in the event of a default)
for a specified time period (typically five years) on a reference en-
tity in exchange for making periodic premium payments to the
credit seller. A credit default swap, then, is essentially insurance on
a debt instrument - accordingly, the credit protection seller (Primus
only sells CDS protection) hopes that premium income offsets any
potential credit losses and then some.

In the case of a default, the credit protection buyer delivers the ref-
erence entity (i.e. the bond) to the credit protection seller in ex-
change for par value. Thus, while CDS amounts are often quoted in
notional amounts equal to the principal value, realizable losses can
be offset somewhat by any recovery on the defaulted instrument.
Moody’s (via William Blair & Co.) notes that, in the last 25 years,
the lowest recovery rate in any one year on all defaulted corporate
debt was 24%. Further, Moody’s says that, since 1920, there have
never been more than 16 companies in a year that have defaulted
within twelve months of holding an investment grade credit rating.
Primus focuses its portfolio on investment grade corporate debt,
and as of yet has not experienced a default in the corporate debt
space.

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 Derivatives Accounting Issues
Because Primus deals in derivatives, GAAP accounting regulations
that investors may not be familiar with come into play. As I alluded
to in the foreword, by traditional accounting metrics Primus looks
like a terribly poor-performing company; losses are extremely high
relative to its size, and the company looks to have no equity. The
reason behind this is that credit spreads (the rate investors are
generally paying for this type of insurance) have widened dramati-
cally, increasing the replacement cost of Primus’ existing portfolio
of swaps, and thus making the existing swaps less valuable. Primus
is required to mark these positions to market quarterly, even
though the company fully intends to hold each swap written to ma-
turity. Over the entire life of a swap, the “marks” must net out to
zero absent a credit event. Primus is currently carrying more than
$1.2 billion in unrealized CDS losses on its balance sheet.
Why is this important? The unrealized losses are not cash losses
and thus do not affect Primus’ liquidity condition. As an AAA/Aaa
rated CDPC counterparty, Primus does not need to post collateral
on its swap trades. Put another way, the unrealized losses Primus
has been posting are not significant as long as the underlying refer-
ence entities in the swap portfolio do not have problems servicing
their debt.
In order to strip out the unrealized changes in value due to quar-
terly marks, Primus focuses on “Economic Results,” which is essen-
tially a cash-based accounting methodology. I will primarily be
speaking in terms of these Economic Results, and will differentiate
in the case I switch back to standard GAAP accounting.

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 Primus: Operations
Primus Guaranty is Credit Derivatives Products Company (CDPC)
and an AAA/Aaa rated counterparty structured to sell (short) credit
default swaps (CDSs). Primus also has an asset management busi-
ness that focuses on handling structured finance products, such as
Collateralized Loan Obligations (CLOs) and/or Collateralized Swap
Obligations (CSOs). In its asset management business, none of Pri-
mus’ capital is at risk.
The primary line of business for Primus is the selling of CDSs, for
which it receives regular premium payments. The CDS universe has
been a rapidly growing and increasingly important field of late for
hedging risk, with notional values outstanding roughly doubling in
each of the last three years.
Under agreements with ratings agencies Moody’s (ticker: MCO) and
Standard & Poor’s (part of McGraw-Hill, ticker: MHP), Primus can
leverage its capital base up to roughly 35x; that is, the notional
value of Primus’ outstanding CDS portfolio can be about 35x its
capital base. This is a leveraged business, and such leverage does
mean the company faces additional risks, although Primus is cur-
rently underleveraged relative to its ceiling at around 28x its capital
base as of last quarter. Management typically targets a leverage ra-
tio in the low 30xs, implying about 15% expecting growth in no-
tional value, although the ability of Primus to write new business
has been impacted by a temporary slowdown in the CDS market as
some financial institutions struggle to find capital capacity to initate
new contracts.
Primus typically holds the CDS contracts it has written to maturity.
To date, approximately 10% of notional values written have been
terminated prematurely due to credit conditions (<2%) or portfolio
rebalancing (<9%).

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 Credit Spreads: Widening
As was discussed in the section on derivatives accounting, widening
credit spreads (the market rate for CDSs) causes Primus’ existing
portfolio of swap contracts to decrease in value. These mark-to-
market losses, as long as they are a result of natural fluctuations in
the market, are not a cause for concern.
I will argue that when Primus is showing the greatest mark-to-
market losses under GAAP, external factors are actually most in Pri-
mus’ favor. But first, some background.
For a multi-year period coinciding with the economic expansion of
2004 to early 2007, credit spreads were tight. Times were good,
credit was (too) easy, and defaults were low. Of course, that would
begin to change as 2007 progressed, and financial companies
would begin to see widespread defaults on mortgage loans. Mort-
gage guarantors would come under enormous pressure, and credit
card debt would come under question as well.
The one area that has remained relatively stable in terms of real-
ized credit quality is corporate debt. While concerns have arisen
about a number of leveraged buyouts that took place, so far wide-
spread defaults have not materialized. Nonetheless, the implied in-
crease in default risk (per the CDX investment grade credit default
swap indices) has increased by at least 4x in the last twelve
months, slightly down from a peak of up to 8x following the Bear
Stearns (ticker: BSC) rescue.
In addition to requiring Primus to record large mark-to-market
GAAP losses, the widening of credit spreads has increased the rate
at which Primus can charge for writing CDSs. While most of Primus’
business so far has been written in times of narrow credit spreads,
future premium revenues should be higher as a percentage of no-
tional value.

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 Credit Spread Environment

Graph of credit default swap indices on investment grade debt,

2007 to present. (Bloomberg)

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 Credit Spreads: Tightening
As depicted on the last page, the spreads on investment-grade cor-
porate CDS contracts have started tightening after a local peak in
mid-March. While any guesses as to whether the true peak of the
CDX index has been reached is just that - a guess - it’s worth ex-
plaining how a tightening spread environment will impact Primus.
First, the negative GAAP marks will begin reversing, so Primus
could potentially post very large “profits” in coming quarters, espe-
cially if spreads tighten quickly. On Primus’ earnings conference call
at the end of May, CEO Tom Jasper said that the main proxy index
for Primus’ business had tightened 40% since the end of the quar-
ter in March. This alone would result in the reversal of a significant
portion of mark-to-market losses, which again, however, would not
materially impact Primus’ business.
The tightening of CDX indices likely indicates a restoration of some
of the liquidity that was absent from the system; the blowout in
spreads had to do with a combination of factors - namely, actual
fears of default, as well as liquidity-driven widening. While tighten-
ing will mean Primus receives fewer basis points for writing protec-
tion, the restoration of liquidity means that they can actually use
some of their excess capacity. While certainly a tradeoff, I believe
lower spreads are a substantial near-term positive given that they
represent a return to some degree of normalcy, and could serve as
a catalyst for the stock during future earnings announcements.
Of course, the background issue here is the proper pricing of risk in
the CDS market. While there are a number of variables in play and
asymmetric payoffs to account for, it seems reasonable to expect
the CDX indices to find more stable ground near some midpoint of
the lows reached in good economic cycles and the highs seen when
market participants saw the global financial system as being in
danger. Net/net, this view implies the market will undergo addi-
tional tightening off the levels we saw in Q1 2008 - something that
Primus said was occurring between Q1’s end and late May.

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 PRS: Financials
Primus ended Q1 of FY2008 with $871 million in cash and equiva-
lents, compared to $329 million in long-term debt in addition to
$98.5 million in preferred equity. Because of Primus’ capital struc-
ture, we will use an Enterprise Value” (EV) approach to calculate
many financial ratios. EV nets market capitalization of common
stock against both cash and the value of outstanding debt and pre-
ferred equity. By using EV, we can get a more holistic picture of
PRS’ financial state. Primus has an Enterprise Value of $150 million.

• PRS’ last trade as of June 11th was $3.90

• The 52 week trading range is $2.97 to $11.55
• Economic book value is $9.58/share, meaning the company
trades for about .41x book
• Trailing twelve month (ttm) Free Cash Flow was $135.5 million
• Capital Expenditures (ttm) were small, at about $2.5 million
• Economic Results (ttm; net income excluding unrealized changes
in the value of the swap portfolio and including all credit provi-
sions whether realized or not) was $21.6 million or 48 cents per
share. By this metric, Primus sells for 7x earnings in a year with
above-average credit provisions.

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 Risks
Investing in equities involves risk. Certain risks are systematic and cannot be
diversified away; this “market risk” includes global macroeconomic shocks in-
cluding but not limited to economic slowdowns, recessions and wars. Primus
also carries specific risks. This includes but is not limited to:
• Leverage. Primus has a highly leveraged capital base. While in-line with
current ratings agencies guidelines for an AAA/Aaa counterparty, leverage
inherently increases the magnitude and speed with which problems can de-
velop.
• Ratings risk. There is no guarantee the existing ratings agency models will
not change in a manner which would have an adverse effect on Primus’
business.
• Other operations risk. This includes but is not limited to model/valuation
risk. Additionally, an adverse macro environment that sees widespread cor-
porate credit defaults could have a substantial adverse impact on Primus.
• Holdings risk. The majority of Primus’ shares of common stock are held by
a small handful of individuals and funds. The decision of any one of these
individuals or institutions to sell all or part of their holdings in Primus could
result in a supply/demand imbalance that negatively affects the stock price.
• Political, regulatory, and legal risk. Primus operates in the dynamic and
fast-growing field of credit derivatives. As this field becomes increasingly
complex and important to global financial markets, there is a possibility for
increased regulation that may negatively impact Primus’ profitability.
• Competition. Primus competes for swap business against a number of com-
panies, some of which may be better capitalized and positioned than Pri-
mus. There is no guarantee Primus will be successful in its operations.
• Financial risk. Primus carries debt and has issued preferred stock. The need
to pay interest and/or principal on that debt and stock may negatively im-
pact the company’s liquidity position for holders of common stock.

A complete list of risks can be found by accessing Primus’ latest SEC filings.

Please read this section twice, and carefully consider your risk (volatility) toler-
ance before purchasing shares of PRS.

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 PRS: Valuation
Earlier, I noted that Primus is trading at a significant discount to
economic book value, or net book value excluding the unrealized
marks on Primus’ swap book. Additionally, Primus has a predictable
future earnings stream from recurring premiums of approximately
$400 million. After factoring in interest income that can be received
from the company’s capital position against future expenses and
net liabilities, it becomes clear that Primus has a capital cushion for
credit events in excess of $600 million, or 245 basis points of the
outstanding swap portfolio. Primus’ management has guided for
credit mitigation costs of 5 basis points per quarter, on average.
Obviously, there is a large disparity between what the market is
pricing in and the risks Primus sees as being inherent in its portfo-
lio. What does the market have wrong?
I see Primus’ diverse portfolio of reference entities as a strength,
and in accordance with ratings agency guidelines, it is well diversi-
fied among a large group of investment-grade companies in various
industries and geographic locations. Further, Primus’ exposure is
short lived (on average, 3.5 years) relative to a mono-line bond in-
surer or other guarantor, and the clearly defined risk profile should
be viewed as a positive.
Keeping in mind that a run-off scenario suggests an equity value
upward of $15/share as long as credit mitigation costs do not sub-
stantially exceed guidance, what is a reasonable estimate of value
for Primus business? Current economic book value plus half of out-
standing future swap premiums (halved to allow for credit losses)
yields a value of $14/share. Again, however, that estimate ignores
any value Primus can generate beyond the 3.6 year life of its exist-
ing swap book. Given that the typical insurer trades at a price-to-
book of 1.2x to 1.7x depending on the part of the underwriting cy-
cle, it seems reasonable to assign a midpoint multiple of 1.5x to
Primus’ economic book value. This falls within the $14-15 value es-
timate under other models; thus a final target of $14.50/share.

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 PRS: Final Word
A long-term fair value price of $14.50 against a stock price of
$4.00 is a huge discrepancy. Why is the market undervaluing Pri-
mus by such a great margin? On a first-glance level, Primus
touches most of the worrisome areas and buzzwords at the center
of current market uncertainty; it is a “financial guarantor” that sells
“credit derivatives” and has posted huge “mark-to-market losses”
while “highly leveraged.” A deeper examination of the company,
however, shows that many of the problems seen with other finan-
cial companies have only a tangential relation to Primus. The guar-
antors who have come under true siege in the last year are the for-
mer mono-line bond insurers who strayed into underwriting protec-
tion on structured finance products tied to consumer debt. Simi-
larly, questions about the validity of the ratings agencies’ models
stem from problems relating to residential mortgage securities; not
the traditional field of corporate debt. Further, mark-to-market
losses have no tangible impact on the company, as the marks net
out to zero at maturity of the swap unless a credit event occurs. Fi-
nally, while roughly 30x leverage requires delicate risk manage-
ment, Primus could ratchet up leverage and still remain well within
the defined boundaries for an AAA/Aaa rated counterparty.
PRS will be a volatile stock, thus the designation for it to be allo-
cated to the speculative part of a portfolio. Nonetheless, I believe
that this stock has a very real chance of showing triple-digit returns
two to three years out. Yes, there is inherent risk in a credit default
swap writer - much as there is risk in any insurer. Primus’ manage-
ment, headed by Risk Hall of Fame member and CEO Tom Jasper, is
recognized as among the most prudent and conservative in finance.
In the end, I believe they will on average underwrite good risks,
and that investing in Primus at a substantial discount to economic
book value will be one of the better speculative plays to rebound
after being beaten down as part of the shunning of financials.

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 Notes and Disclosures
• This report is by no means a recommendation to take action for
your personal portfolio. It is recommended that you consult your
own investment, legal, and/or tax advisor before acting on any
information contained within this report. Failure to seek profes-
sional, personally tailored advice before acting could lead you to
act in a manner contrary to your best interests; consequences
include but are not limited to loss of money.
• At the time of this report, the author owned (is long)
shares of PRS. However, the author reserves the right to
change his position at a later date without notice. I do not
own shares of any other company mentioned in this re-
port.
• Equity valuation involves the use of theoretical pricing models
and estimates of factors such as future earnings growth and eco-
nomic trends, none of which are guaranteed to be accurate.
• This report was prepared independently, and the author has no
relationship with PRS. All opinions, estimates, and/or other sub-
jective statements are the author’s own.
• To contact the author, email James Cullen at jcullen3@gmail.com

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