The slogan "Financial Peace of Mind" might seem ironic to shareholders of Ambac Financial Group
Ambac's main line of business is providing financial guarantees to issuers of public finance and structured finance obligations in both U.S. and international markets. Ambac's promise to make scheduled interest and principal payments in the event of a borrower's default enables an insured issue to obtain a higher credit rating than it would otherwise receive. In short, Ambac sells insurance to governmental agencies and corporate entities so that they can issue debt securities at a lower interest rate.
On the surface, Ambac's third-quarter results suggest that business is great. Net income increased 22% to $213.5 million from the previous year's third quarter. Net income per diluted share was up 23% to $1.98 in the same period. At a recent share price of $85, Ambac stock is trading hands at a reasonable 11 times earnings. Investors have enjoyed a year-to-date total return of almost 11%.
But the growth in the bottom line was not a reflection of changes in the top line. Ambac's revenue increased only 5% in the third quarter. Net premiums earned -- the company's bread and butter -- actually declined. Instead, the improvement in net income was largely the result of a reversal of Hurricane Katrina-related losses that had been recognized in the previous year. Investors should not expect such reversals to remain an ongoing source for earnings growth.
Management has acknowledged that currently narrow credit spreads -- the difference between an issuer's interest costs and a benchmark rate -- make for a challenging pricing environment for underwriters of financial insurance premiums. That is doubtlessly true; such credit cycles are an inherent facet of this industry. When spreads inevitably widen again, the few firms with rock-solid balance sheets and seasoned underwriting experience will surely increase their sales of credit enhancement products. In addition to Ambac, that group of monoline insurance companies includes MBIA
The concern for Ambac shareholders is not whether demand for credit enhancement products will rebound, but the degree to which future market demand will be satisfied by products other than financial guarantees. Increasingly, debt issues are achieving a credit-enhanced status through the use of senior/subordinated deal structures or credit default swaps. And these alternative transactions do not require the participation of Ambac or one of its traditional insurance rivals.
Ambac's experience, expertise, and capital structure provide it with important competitive advantages. In addition, the company has been expanding its product offerings to include new types of derivative products that can serve as alternatives to financial guarantees. Nevertheless, while Ambac is levered to growing capital markets, its future role in those markets might not be as critical. In contrast, the increasing complexity of capital markets is enhancing the dominant role that ratings organizations like Moody's
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Fool contributor Michael Leibert welcomes your feedback. He does not have a position in the stocks of any of the companies mentioned above.