American International Group (AIG) 4Q14: A Mixed but Refreshing Report

As we have seen in the past AIG’s earnings report [Source] this quarter was a mixture of good and bad news. It can be characterized as a quarter of “housekeeping” where the company takes hits in an effort to move forward with a clean slate.

Reflecting on the new CEO Peter Hancock’s first two quarters at the helm, perhaps this is better described as a Spring cleaning with a couple of large issues being refreshingly addressed. Before jumping into the details, let’s step back and look at where we are first.

Progress to Date:

Our initial investment in AIG was during April, 2012 and after almost three years into our original 3-5 year investment horizon we have a total return of 71% or an average of about 24% per year. To a large extent the period was dominated by AIG repaying the government bailout, restructuring and selling non-core assets, and share repurchases. So far so good. I’ll take those results all day long. We now turn to improving operating performance for future returns.

After the initial recapitalization of the company in early 2011 AIG set “Aspirational Goals” including a return to a 10% return on equity (ROE) by 2015. They didn’t get there, AIG’s ROE has been running between 7-8% during 2014 and the share price remains discounted to its book value because ROE performance is below expectations of investors and below AIG’s peers. At the current share price of about $54 and the 4Q14 book value of $77.69/ share, the company is selling at a 30% discount.

Insurer’s share price is usually a multiple of book value and that multiple is a function of return on equity. Insurer’s producing a 10% ROE sell at a multiple of about 1X book value, and insurer’s with a 7% ROE sell at a multiple of about .7X. AIG’s 2014 ROE is 20-30% below expectations so the shares sell 20-30% lower to make up for the performance deficit. Why pay full value for an underperforming company?

AIG CollagePath Forward:

This brings us to a critical question: If 7-8% ROE is AIG’s performance capability then it is now fully valued and our original expectations of a 10% ROE and 1X multiple were too optimistic. Or, is it reasonable to expect AIG to perform at a 10% ROE level, on par with peers, with a 1X multiple?

Peter Hancock and the management team seem to be working on operating improvements; reduce expenses, managing gross profitability and risk. But AIG is a big ship, and it takes time to turn a big ship back on course and we realized that a 3-5 year investment horizon may be needed in our investment thesis to realize AIG’s full potential. So if AIG continues to increase book value about 10% per year as it has done the past four years, repurchase shares at attractive discounts to book value, and achieves even a 9% ROE in three years; the book value will approach $100/share and the multiple will improve to about 0.9X for a $90/share stock price and a potential 70% further gain over today’s price. The additional potential returns are in excess of 20% per year.

Encouraging Words in the Conference Call:

In opening the 4Q14 conference call Peter Hancock recognized the quarter included both accomplishments and challenges. He then discussed two large concerns that have challenged AIG; unfavorable prior year developments and return on equity.

Specific to ROE, in part he said; “Our priority is to deliver sustainable ROE improvements as we look to 2015 and beyond. For the full year 2014, ROE excluding AOCI and excluding DTA was 8.4%. Over the course of the year access alternative returns and lower than expected catastrophe losses added about one percentage point to this full year ROE. Excluding that 1% gives us a good starting point to discuss ROE expansion going forward.

Over the next three years we’re focused on achieving annual ROE improvement through our commitment to managing gross profitability and risk. We seek to deliver a consistent level of expense savings through our technology, process redesign, shared service centers and simplification of our organizational structure.

…we believe that we can achieve 50 basis points or higher of annual improvement in ROE ex-AOCI and DTA through 2017 from the normalized base lines of 7.4% for 2014. Our ability to be higher will be driven in part by the timing of emerging benefits from our investments and the growth and savings resulting from these investments as well as catastrophe losses and investment returns that are in line with our expectations. Our long term ROE objective remains 10%. “

Admittedly, impatience is my investment weakness, however, AIG seems focused on the key performance and capital allocation issues. Progress continues to be made as we will see below and these improvements will eventually show as improvements in ROE, albeit at a slower pace than we had hoped. The biggest concern on achieving the remainder of our anticipated returns continues to be ROE improvements and the reserve deficiencies from prior years where AIG underestimated the cost of claims under prior management.

Year Ending 2014 and 4Q14 Highlights:

AIG reported net income of $655 million or $0.46/share for the 4Q14 compared to $2.0 billion for the 1Q13 for a 27% decline. After tax operating income was $1.8 billion for 1Q14 compared to $2.0 billion or $1.34/share for 4Q13. Full year 2014 net income was $7.5 billion or $5.20/share compared to $9.1 billion or $6.13/share for 2013. Reported net income included an after tax loss on extinguishment of debt of $824 million or $0.58/share during the 4Q14.

After tax operating income was $1.4 billion or $0.97/share for the 4Q14 compared to $1.7 billion or $1.13/share in 4Q13. For the full year 2014 after tax operating income was $6.6 billion or $4.58/share compared to $6.7 billion or $4.49/share for 2013. Operating results in 4Q14 reflected a pre-tax reduction in workers’ compensation discount of $568 million, adverse pre-tax prior year reserve adjustments of $297 million, and a pre-tax charge in Life insurance of $104 million to reflect valid claims not yet filed as a result of a multi-state audit.

AIG’s President and CEO, Peter Hancock summed the quarter up this way: “Our fourth quarter results showed progress on expense control, ongoing investments in our businesses, and our commitment to balance sheet management. AIG’s diversified and balanced business mix allowed for stable total insurance profits. Our strong balance sheet and continued profitability contributed to positive capital management in the fourth quarter, in the form of common stock and debt repurchases. We continued to optimize our funding profile by replacing high-cost legacy debt with new issuances at lower interest rates. Book value per share excluding AOCI and DTA increased 12 percent compared to year-end 2013. Our continued focus on managing our balance sheet to reflect our improved risk profile, combined with continued insurance company dividends, has contributed to the Board’s approval of an additional $2.5 billion share buyback authorization.

Financial Highlights:

In the 4Q14, AIG completed its reorganization and modified its presentation of results to reflect the new operating structure. The new operating structure includes two reportable segments, Commercial Insurance and Consumer Insurance, and a Corporate and Other category. The Corporate and Other category consists of businesses and items not allocated to AIG’s reportable segments.

4Q14 Highlights

AIG Fourth Quarter Conference Call Presentation [Source]

  • Book value per share grew 13 percent from year-end 2013 to $77.69
  • 4Q14 net income included an after-tax loss on extinguishment of debt of $824 million, or $0.58/share
  • 4Q14 after-tax operating income of $1.4 billion or $0.97/share
  • 4Q14 after-tax operating income reflected reductions in workers’ compensation discount and total adverse prior year reserve development of $562 million after-tax, or $0.40/share
  • Approximately $1.5 billion in share repurchases during the 4Q14, and $4.9 billion for full year 2014
  • AIG’s Board of Directors authorized the repurchase of additional shares of AIG Common Stock with an aggregate purchase price of up to $2.5 billion and declared a quarterly dividend of $0.125/share
  • AIG Parent received distributions from its insurance companies totaling $13.2 billion, consisting of $9.4 billion of dividend and loan repayments in 2014, $1 billion of net tax payments in 2014, plus $2.8 billion of dividend and loan repayments in January 2015

 

Capital & Liquidity:

  • AIG shareholders’ equity totaled $106.9 billion at December 31, 2014.
  • In the 4Q14, AIG issued an additional $750 million of its 4.500% Notes due 2044 ($1.5 billion aggregate principal amount of which were originally issued in July 2014).
  • In the full year 2014, AIG issued approximately $3.3 billion of senior unsecured debt. In January 2015, AIG issued $2.0 billion of senior unsecured debt ($1.2 billion aggregate principal amount of 3.875% Notes due 2035 and $800 million aggregate principal amount of 4.375% Notes due 2055).
  • In the 4Q14, AIG repurchased approximately $2.8 billion high coupon AIG notes for an aggregate purchase price of $3.7 billion.
  • In the full year 2014, AIG repurchased $5.0 billion high coupon notes for an aggregate purchase price of $6.5 billion. These 2014 purchases do not include the Direct Investment book (DIB), and will result in interest savings of approximately $249 million per year and capture a total economic value of $550 million.
  • In the 4Q14, AIG repurchased $2.5 billion notional amount of DIB debt for an aggregate purchase price of $3.0 billion, using cash allocated to the
  • In the full year 2014, total repurchased or redeemed DIB debt was approximately $7.5 billion notional for an aggregate purchase price of $8.4 billion.
  • In the 4Q14, AIG repurchased 27.9 million shares of AIG Common Stock.
  • AIG Parent liquidity sources decreased to $14.3 billion at year-end 2014 from $17.6 billion at year-end 2013.

Financial Objectives Announced:

You may recall last quarter Peter Hancock in a response to a question around legacy reserves indicated that shareholders could expect open and honest communications with management. This is important:” …we view our own practices as very much committed to a true north of giving our best estimates of reserves with the information that we have. We don’t try and squirrel away reserves for a rainy day. 

So what you see is what you get. It may lead to a little bit more quarterly EPS volatility than everybody would like from the outside, but we think that the long-term sustainability of our strategy is what is most important. And that comes from facing the truth on a timely basis, good news and bad news. 

And I think that is a philosophical belief that I would like to underpin the way we manage our business through out. We want to create sustainable long-term growth, and that requires us to face the truth on a timely basis, good news or bad.”

This open and honest approach with shareholders is reflected in the companies new “Financial Objectives” for the next three years presented during the conference call. It brings one of our two biggest concerns in realizing the full potential value of our AIG investment; the below peer performance return on equity, to the front and center.

4Q14 Financial Goals

[Source] 4Q14 Conference Call Presentation

Reserve Deficiency:

The second major concern we have and discussed in our last post on AIG [Source] is the potential for more legacy reserve deficiencies. These deficiencies arise from prior years where AIG underestimated the cost of claims that continues to impact performance. Here again the management team is bringing this issue front and center with the following table.

4Q14 Prior Year Developments

As we have done in the past, we will track these goals and other metrics to measure quantitatively how the investment thesis is playing out.

Summary:

AIG’s new CEO and the management team are focused on the key priorities of operations improvement and capital management. Operations needs continues to need more work but in the meantime share repurchases are made at accretive levels that should further leverage the operation improvements as they are realized.

It is encouraging to see open and honest communications on what is in our view two large operating issues that need addressed. This will help us assess progress quantitatively and build confidence there is not more to surface. It is also encouraging to know the key to unlocking and growing the intrinsic value of AIG on a sustainable basis is now front and center. That will help assure it gets the attention it deserves. Our investment thesis remains on track.

Disclosures: Long AIG common stock

Resources:

  • AIG 4Q14 Press Release [Source]
  • AIG 4Q14 Financial Supplement [Source]
  • AIG 1Q13-3Q14 Financial Supplement Revised [Source]
  • AIG 4Q14 Conference Call Presentation [Source]
  • AIG 4Q14 Conference Call Recording [Source]

You are encouraged to do your own independent research (due diligence) on any idea discussed here because it could be wrong. This is not an invitation to buy or sell any particular security and at best it is an educated guess as to what a security or the markets may do. This is not intended as investment advice, it is just an opinion. Consult a reputable professional to get personal advice that meets your specialized needs of which that the author has no knowledge. This communication does not provide complete information regarding its subject matter, and no investor should take any investment action based on this information.

 

 

 

 

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