American International Group (AIG) Update

Since the August 3 post on AIG a lot has been accomplished:

 

 

  1. The U.S. Treasury conducted two sales of AIG common stock reducing government ownership to 242 million shares or about 16%, down from 92% at its peak. AIG purchased $8 billion of these shares (252 million shares) bringing the year to date 2012 total to $13 billion (421 million shares) at an average price of $30.88/share.
  2. We anticipate another U.S. Treasury sale before the end of the year, likely closing out the government’s equity position in AIG. Previous sales of AIG common stock were
    over subscribed showing a continued demand by institutional investors for the stock.
  3. Book value as of 9/14/12 is estimated at $65.52/share based on AIG buybacks alone (assuming all else constant). At a current share price of about $35/share; the company trades at a 47% discount to book and remains an incredible bargain.
  4. As illustrated in the table below these actions compare favorably with our more optimistic investment assumptions. More shares were purchased sooner than expected and at a lower price than we estimated.

What can we expect going forward? The following factors should act as catalyst increasing the intrinsic value of the company and reducing the gap between share price and intrinsic value.

Near Term Capital Management:

With the Maiden Lane II & III asset sales complete and the final common stock sale by the U.S. Treasury likely before the end of the year, the restructuring is coming to a  close. Expect further asset sales as AIG unwinds its positions in ILFC the aircraft leasing business ($7-8 billion) when market conditions improve, and the remaining shares in AIA, its Asian life insurer group ($5.6 billion remaining).  The U.S. Treasury is locked up for 60 days before it can sell more common shares, while AIG is locked up on its remaining stake in AIA Group (Hong Kong) for 90 days.

Some were disappointed in the recent $2 billion partial sale of AIA because more sales would enable AIG to buy back more shares at about 53% of book value. Barron’s made a good point in a recent report: “the lower buyback was more a reflection of management taking a more conservative approach in front of obvious Federal oversight, likely holding a bigger capital cushion to ensure that the Fed’s view of AIG’s capital position is similar to management’s view and thus confirming the opportunity for continued capital management in 2013 and beyond (both from non-core asset sales and operating free cash flow).”

OK, that’s fair enough; management must balance capital needs and be cautious especially when they are yet to be fully defined.  AIG is likely to be classified by regulators as a “systemically important” financial institution. It would then become subject to oversight by the Federal Reserve. Perhaps AIG can get out of some aspects of the Volcker Rule by selling a small bank it owns (CEO Benmosche said AIG is planning to do that). But, even if AIG sells the bank, it could still be subject to limitations on proprietary trading.

Improving Fundamentals and Lower Risk:

Since the financial crises the company has significantly lowered risk and is steadily improving core businesses. AIG reduced its derivatives portfolio from investments of $1,800 billion in 2008 to $190 billion at the end of 2011. Fears that the U.S. Treasury will “dump” the stock are gone. Both the government and company management have demonstrated prudent behavior in this regards. With AIG now primarily owned by common shareholders the reduced government ownership and strong institutional buying should further support the share price going forward.

A recurring cyclical problem with insurance companies is they will sell policies too aggressively to gain market share by lowering policy prices that will not cover the potential for future insurance payouts and losses. This is typically measured by the “combined ratio” and when this happens, profitability declines. AIG has some history of over aggressiveness in this area but under the new management team the combined ratio is improving; a promising indicator of the management’s stewardship and discipline.

AIG is still a major property-casualty and life insurance company but will be a smaller and likely better focused on improving core business going forward.  Completion of the restructuring will focus management’s attention on operations. A better than expected 2Q earnings report will hopefully be followed by a good 3Q report. Improving return on equity from single digits to AIG’s aspirational goal of 10% will increase the price to book value multiple from the current depressed level of about 0.5X to a more typical 1.0X.
Before the financial crises AIG’s return on equity averaged about 14%.

Bruce Berkowitz of the Fairholme Fund made a huge bet on AIG and summed it up in his
AIG presentation this way:

Bruce Berkowitz’s estimated 20% returns can only be expected if you buy the stock at the current large discount before everyone else catches on.

Potential Dividend:

With the U.S. Treasury’s sales of its position in AIG occurring sooner than expected “the
company may be in a position to consider a dividend by next summer” CEO Bob Benmosche said on Tuesday, September 11, 2012. Although share buybacks at 47%
discounts are strongly preferred in my view a dividend could be another strong catalyst for the share price to catch up to the company’s intrinsic value.

A survey of 16 dividend paying insurance companies show the average dividend payout ratio is 35% (annual dividend per share divided by annual earnings per share). Apply
this average to AIG analyst consensus earnings estimate implies over the next two years ($3.50-4.00/share) the capacity to pay a dividend of $1.22-1.40 yielding 3.5-4.0% on today’s share price of about $35. The dividend if it is reinstated will probably be phased in over time. Still, not a bad yield in today’s low interest rate return environment.

Keep in mind the above analyst estimates are for the years 2012 & 2013. If management achieves its aspirational goals of a 10% return on equity (net income per share divided by book value per share) an even better picture emerges. At the above current estimate of book value ($65.52) a 10% return on equity will yield net income of $6.55/share. Applying the industry 35% payout ratio shows an annual dividend of 2.29/share for a yield of 6.5% on the current share price. A dividend may be a nice income stream in addition to the share price improvement we are expecting.

Summary:

Our investment thesis is playing out well; risk has been reduced significantly; we can now patiently wait for our returns to further materialize as others catch on. Expectations were so low for AIG that the absence of any significant bad news will allow for the outsized gains we hope for. It is just hard to see a lot of downside from here and incredibly the stock is still a bargain.

Disclosures:

I am long AIG common stock and AIG warrants.

The information contained herein is provided for informational purposes only, is not
comprehensive, does not contain important disclosures and risk factors associated with investments, and is subject to change without notice. The author is not responsible for the accuracy, completeness or lack thereof of information, nor has the author verified information from third parties which may be relied upon. The information does not take into account the particular investment objectives or financial circumstances of any specific person or organization which may view it. Nothing contained within may be considered an offer or a solicitation to purchase or sell any particular financial instrument. Any investment can be very risky and is not suitable for everyone. You should never enter into an investment unless you can afford to lose your entire investment. Always complete your own due diligence
. Before making any investment, investors are advised to review such investment thoroughly and carefully with their financial, legal and tax advisors to determine whether it is suitable for them.

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