American International Group (AIG) 3Q13 Mixed Results

American International Group (AIG) reported 3Q13 earnings on October 31, 2013 [Source]:  AIG reported net income of $2.2 billion for the 3Q13 compared to $1.9 billion for the 3Q12 and after tax operating income was $1.4 billion for 3Q13 compared to $1.6 billion for 3Q12. Diluted earnings were $1.46/share for 3Q13 compared to $1.13/share for 3Q12; and after tax operating income was $0.96/share compared to $0.99/share in 3Q12 beating the $0.94/share consensus estimate of analysts surveyed by Thomson Reuters.

Robert Benmosche, President and Chief Executive Officer of AIG said, “AIG’s solid performance this quarter underscores the strong fundamentals of our businesses and builds upon the momentum that we generated in the first half of this year. Our insurance operations reported improved pre-tax operating profits this quarter from the third quarter of 2012, and we continue to remain optimistic about the future.”

In the Second Phase of the Turnaround:

We’ve discussed before how successful turnarounds typically have two levels of stock price appreciation. The first level occurs when investors realize excessive fear drove the share price below the underlying value of the company even with the bad news factored in. Value investors start buying and the stock price appreciates as investors realize the company will survive and the over-reaction created a bargain. In the second level mainstream investors recognize the company will not only survive but may thrive if management can make it a contender often with operations improvements needed. As these improvements occur traditional investors consider the company as an investment and drive the share price towards the intrinsic value as sustainable operations improvements are made.

AIG Bring on Tomorrow

Anticipated Improving Performance:

Anticipating the need for operational improvement at AIG after the recapitalization of the company, management developed enterprise wide, long term ”aspirational goals” during the 1Q11 for the key operation metrics of the company. In the 1Q11 10Q on page 92 [Source] the aspirational goals were introduced: “Following the completion of the Recapitalization, AIG is developing business plans for its operations in relation to certain long-term aspirational goals. Among the most significant of AIG’s enterprise-wide long-term aspirational goals are the following…to increase its ROE to 10 percent or more by the year ended December 31, 2015, from its 6.2 percent normalized ROE as of and for the year ended December 31, 2010…”

In our February post “Measuring AIG Going Forward” [Source] we discussed how Bob Benmosche, President and CEO, closed the 4Q12 conference call referring to AIG’s goal to become an investment-grade company; ”…and 2015 is our aspirational date, and we’re still marching pretty quickly towards that date and the things we need to achieve for it.” Encourage by the CEO’s recognition that AIG was entering the second phase of the turnaround, and operation improvements would be required, we decided to monitor the improvements as the primary catalyst for the remaining increase in share price that we anticipate.

AIG hit a rough patch during this quarter, reporting a mix of good and not so good news. This is just part of turnarounds; things don’t move linearly in a smooth ratable fashion. There will be bumps but as long as the company on average is headed in the right direction our 3-5 year investment time frame will pay off.

CEO Bob Benmosche deserves a lot of respect for his ability to navigate AIG through the first phase of the turnaround. His forthright manner, boldness, and strong leadership was instrumental in guiding the company through the controversial government bailout, lawsuits, public relations issues, proposed new regulations and employee morale. These qualities can be a two edged sword however and the most troubling aspect of the 3Q13 report in my view were comments on the aspirational goals during the conference call; in part [Source]: “On the aspirational goal comment that I made yesterday…in May of ’11 there was some serious concern in the marketplace, could AIG survive and continue to grow and thrive? And we put together some key points that we felt we needed to all work towards to give you the confidence that we can, in fact, return to a very strong company…we have been committed…and we are still committed to those aspirational goals…However, as we get closer to 2015, we feel that comments going forward are more like guidance rather than the direction we’re all working towards. And so we are going to stop making comments on that progress towards the aspirational goals… we are still, as I said, committed to them, but we’re not sure whether we’ll get them done by 2015…and beginning to comment on it, that’s where the theory of guidance comes into play…we’ll get there as quickly as we can.”

In the 4Q12 we went from; ”…and 2015 is our aspirational date, and we’re still marching pretty quickly towards that date and the things we need to achieve for it.” to this in 3Q13; “…And so we are going to stop making comments on that progress towards the aspirational goals…” During the conference call some analyst were upset because they felt they no longer would get guidance. As a value investor we don’t use company guidance, we use our estimate of intrinsic value. And therein lays the problem….

Insurance Company Values:

Insurance companies make money from writing profitable insurance policies (underwriting) as measured by the combined ratio; and from returns on the invested premiums (float) as measured by return on investments until the premiums are paid out as claims. Both sources of earnings are reflected in the return on equity the primary measure for shareholders (equity owners) of how much the company is earning for us.

Our intrinsic value calculation for AIG is based on: the book value of the company that will increases with profitable insurance underwriting and increasing returns on the invested float to increase the return on equity (ROE). As shown in the graph below the higher the ROE, the higher the multiple to book value, and the higher the stock price becomes. So a company with a weak 5% ROE will trade at a multiple of about .75 X book value and a company with a strong 10% ROE will increase book value faster and therefore trade at a more attractive multiple of about 1.0 X book value.

AIG Price to Book vs ROE GraphSource: Casualty Actuarial Society

AIG reported a 3Q13 book value of $67.10/share so with a 10% ROE (the aspirational goal) it would be valued and trade at about 1.0X book value or $67/share, however at the 3Q13 reported 6.2% ROE it would be valued at about 0.8X book value and trade about $53-54/share. That’s about a 25% difference, performance matters.

A Lot of Work Still Needed:

So why did the share price drop 6.5% on this earnings report? Is Mr. Market over reacting or is there reason for concern? As value investors we often find ourselves at odds with the market’s perspective but that doesn’t mean we should always be contrarians. This may be one of those times when Mr. Market has it right. Investors are likely concerned management is letting themselves off the hook for measuring performance against objective standards.

The first phase of the recovery, with all due credit to CEO Bob Benmosche and company was helped along by the huge government bailout and the recovery of the economy from the economic crisis. In that sense the improving economy, bailout and stock market accomplished the first phase of the turnaround to a large extent.

Now it is time for management to earn their keep by improving operations as measured by return on equity. Two years remain before the end of target year of 2015. There is little doubt management will continue working towards improvement but the best way to get results is measuring performance against objective standards (goals) not stop talking about the goals. Management explained they don’t want to talk about the goals because it is equivalent to giving guidance. A more likely reason is it appears less likely they will meet the goals and no longer want to talk about under performance. Two key metrics; return on investments and return on equity are deteriorating not improving:

AIG ROE AUM 3Q13

Improving Performance or Changing the Score Card?

Prevailing low interest rates and competitive pressures make it a tough environment for all insurance companies. Management’s job is to come up with offsetting initiatives to these unfavorable interest rates and competitive pressures. Their competitors face the same issues and some are doing a better job dealing with them. Has the company changed from improving performance to ignoring the score card? This is a fair question and only time will tell.

Mixed Results:

Peers generally reported stronger 3Q13 results but it appears the rate of improvements may slow. Progress is still being made but it could be better. Contrary to management’s suggestions, as owners of the company, we will continue measuring AIG against the performance goals, and talk about the good and the bad.

We expect improvement in return on equity, investment returns and the combined (loss) ratio especially in property and casualty over the next couple of quarters. AIG still trades at a significant discount to book value and this only improves with improved returns on equity.

Our key metric, book value per share, in 3Q13 was $67.10/share; a decrease of $1.77/share or 2.6% from the year ago 3Q12 period:

AIG Thesis Progress

The Highlights:

  • The 3Q13 after-tax operating income of $1.4 billion; after-tax operating income per share of $0.96
  • Growth in insurance operating income of 38 percent to $2.2 billion from the prior-year
  • AIG Property Casualty accident year underwriting results improved from the prior year quarter
  • AIG Life and Retirement benefitted from strong sales and overall positive net flows
  • Mortgage Guaranty continued to benefit from United Guaranty Corporation’s proprietary risk selection model and an improving housing market
  • Increase in book value per share, excluding accumulated other comprehensive income (AOCI), of 8 percent from year end 2012 to $62.68, and $67.10 on a reported basis for a one percent increase
  • AIG may not be able to sell its ILFC aircraft-leasing subsidiary in the fourth quarter raising the possibility an IPO of the unit may be required.
  • Declared a quarterly dividend of $0.10 per common share to be paid on December 19, 2013
  • The company invested $192 million to buy back 4 million of its common shares under a $1 billion share buyback authorization

NEW YORK, October 31, 2013 – American International Group, Inc. (NYSE: AIG) today reported net income attributable to AIG of $2.2 billion for the quarter ended September 30, 2013, compared to $1.9 billion for the third quarter of 2012. After-tax operating income attributable to AIG was $1.4 billion for the third quarter of 2013, compared to $1.6 billion for the prior-year third quarter. Net income attributable to AIG for the quarter exceeded after-tax operating income attributable to AIG largely due to valuation allowance releases associated with deferred tax assets from capital loss carry forwards, partially offset by a $260 million after-tax increase to litigation reserves related to legacy crisis matters.

Diluted earnings per share attributable to AIG were $1.46 for the third quarter of 2013, compared to $1.13 for the third quarter of 2012. After-tax operating income per share attributable to AIG was $0.96 for the third quarter of 2013, compared to $0.99 in the third quarter of 2012.

“AIG’s solid performance this quarter underscores the strong fundamentals of our businesses, and builds upon the momentum that we generated in the first half of this year,” said Robert H. Benmosche, President and Chief Executive Officer. “Our insurance operations reported improved pre-tax operating profits this quarter from the third quarter of 2012, and we continue to remain optimistic about the future.

“Every day, we reaffirm our commitment to our customers around the world by creating and offering innovative insurance protection and retirement products that meet their needs. As we work together and capitalize upon the diverse areas of expertise within AIG, we’re seeing the results of our continued investments in our business, our infrastructure, and our people.”

Third Quarter Key Themes:

AIG Key Themes 3Q13

AIG Conference Call Presentation [Source]

Financial Highlights:

AIG Financial Highlights 3Q13

(1)    Computed as Annualized After-tax operating income divided by Average AIG Shareholder’s equity, excluding AOCI.

After-tax Operating Income (Loss):

AIG Op Income 3Q13

Strong Capital Position:

The company has a strong capital position. Continued strong dividend flows from the insurance companies are helping to strengthen liquidity.

AIG 3Q13 Capital Position

Parent Liquidity:

AIG continues to expect $4-5 billion in annual dividends and distributions from the insurance subsidiaries.

AIG 3Q13 Parent Liquidity

Enterprise Goals:

Following the completion of the Recapitalization, AIG is developing business plans for its operations in relation to certain long-term aspirational goals. Among the most significant of AIG’s enterprise-wide long-term aspirational goals are the following:

As discussed above, varying degrees of improvement, but there is still work to be done. The good news is if they meet their original goals there is the potential for still more gains.

AIG 3Q13 ROE EPS Graph

Some improvement in the P&C combined ratio and an increase in the home mortgage insurance combined ratio:

AIG 3Q13 PC United Combined Ratio Graph

AUM showed an increase of $10.7 billion from the prior quarter and up $28.9 billion over previous year quarter. Investment yields continue to face strong headwinds industry wide in the low interest rate environment. AIG’s yields decreased to 5.41% from 5.83% the previous quarter and down from 5.86% the year ago period:

AIG 3Q13 AUM Life in Force Graph

Disclosures:

Long AIG common stock

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