American International Group Inc. (AIG) has been and continues to be one of our very favorite investment opportunities. Rarely does a day go by that we aren't buying the stock or selling puts for clients' or for our own accounts. We've laid the investment thesis out on several occasions and things have really gone as planned for the most part. Moving forward, the key to the future performance of AIG's common stock will be its ability to improve its underwriting margins in both P&C and Life Insurance, and how management allocates surplus capital.
It has been an extremely busy December for AIG. On December 9th, the company announced that it was selling up to 90% of its aircraft leasing subsidiary, International Lease Finance Corporation (ILFC) to a group of Chinese investors putting the value of the business at $5.28 billion. The deal is structured so that the investor group is acquiring 80.1% of ILFC for $4.23 billion and then has an option to acquire 9.9%. AIG will retain 10% of the business moving forward and the deal is not expected to be approved until sometime next year. ILFC was no longer a practical business for AIG to retain because as AIG has divested other key businesses such Alico and the majority of AIA, the balance sheet has shrunk. Therefore, the tremendous assets and liabilities that are characteristics of aircraft lease financing businesses became too much of a burden on the overall company. Putting a value of $5.28 billion on the business will force a write-down from ILFC's 9-30-12 book value of $7.9 billion. Obviously it is disappointing that the company must take this write down, but if you look at where other aircraft leasing business are being valued it would have been crazy to think the company wouldn't be forced to do so.
On Dec. 14, the U.S. Treasury sold its final 234.2MM shares of AIG for approximately $7.6 billion. Not only does the profitable disposition by the government put an end to the most tumultuous 5-year period in AIG's history, but it also removes a supply/demand barrier for the common stock. Because all market participants were aware that the government had to divest its stake due to political ideals, there was tremendous trepidation by many to invest in AIG until the heavy selling and government oversight was over. Most of the government's stock sales were done at a discount to the closing price the day before, so I believe the stock traded at an extreme discount based on these short-term technical issues, in addition to the fact that financial stocks as a whole have been given overly pessimistic valuations for some time now. Much of AIG's institutional ownership stake consists of long-term value investors such as Bruce Berkowtiz, Daniel Loeb and many others. While I would never personally buy a stock simply because other smart people own it, I'd certainly prefer to be in partnership with these types as opposed to the Federal Government, which was selling huge amounts of stock whenever it got the chance to do so.
On Dec. 16, AIG announced its intention to sell the remainder of its 13.7% stake in Hong Kong based AIA Group. The company should receive $6.3-$6.5 billion from the sale, which should leave ample opportunity for stock buybacks. AIA Group is a gem of an asset but unfortunately once AIG divested the majority of its shares to pay back the Federal Government, it really became necessary to rid itself of the rest of its stake. Part of the rationale behind this is that new regulations and capital requirements are highly punitive towards minority stakes, therefore the realization of cash from the sale of the assets should materially improve AIG's capital positions when it is reviewed during the CCAR process next year.
While none of these developments are particularly surprising, AIG should now be able to focus management's time and attention exclusively on improving the operating metrics of the remaining businesses. The two core businesses are AIG Property & Casualty (formerly Chartis) and AIG Life and Retirement (formerly SunAmerica). Both businesses have impressive scale and distribution but have posted less than desirable underwriting results in the past. Efforts have already begun to improve results. The companies have book values of $49.6 billion and $38.9 billion respectively, as of September 30th. It will take time and painful cost-cutting measures but I believe a 10% ROE for both businesses is within reason. This would peg normalized earnings from these two businesses at roughly $8-9 billion annually. Even with the lackluster underwriting results of the past, these businesses have generated substantial earnings which I've discussed on previous articles, so just a little more consistency and fewer revisions related to the legacy long-term policies should make this goal highly attainable.
I believe analysts were disappointed during the third-quarter earnings call because AIG's management was not very positive about additional stock buybacks, after purchasing about $13 billion in stock thus far this year. One of the key problems with heavier oversight on banks and large financial companies such as AIG is that the level of bureaucracy is even greater than in the past. The Federal Reserve has not always been very transparent in what it is looking for in assessing capital plans, as both Citigroup (C) and MetLife (MET) found out during the CCAR process last year. AIG also carries about $74 billion in long-term debt, which is fairly high cost given the low interest rate environment, so I do believe the company will work to reduce that and improve interest coverage ratios, which are important to the overall credit ratings of the firm. Despite these issues, I do believe that the recent dispositions have provided AIG with the opportunity to execute another small buyback at least to reduce the write down incurred on the ILFC acquisition.
There is no denying the accretive math on stock buybacks with AIG trading at these distressed levels despite improving fundamentals. Each 50 cents spent is buying $1 worth of assets, so there is no activity more beneficial to shareholders or the company than buying back stock near current prices. At the end of the 3rd quarter the company had roughly 1.643 billion diluted shares outstanding. If the company used $6 billion from the sale of its stake in AIG to buy back stock at around $35 a share, the share count would be reduced to roughly 1.473 billion. Shareholder equity would increase far beyond any write down from ILFC or losses from Hurricane Sandy, which were pegged at roughly $1.3 billion. The declining share count will boost earnings per share numbers and increase pro-rata ownership for long-term shareholders.
AIG is not as strong or diverse of a business as it was during the glory years of Hank Greenberg. On the plus side though, the company is a much leaner operation and the risks of the Financial Products division have been whittled down aggressively. Chief Executive Robert Benmosche now has the ability to remain laser focused on improving underwriting profitability and reducing the cost structure of the firm. AIG is the largest pure play insurance company in the world in terms of shareholder equity, and has the resources to acquire the best managers for its operating businesses. Progress has been made already and the company has been upgrading its IT infrastructure. I like the idea of focusing exclusively on the AIG brand for marketing purposes and the fact that U.S. taxpayers made a nice profit on the deal has reduced the negative overall sentiment of the company markedly.
AIG has done a great job given extremely difficult circumstances but the work is not done. Management needs to target underwriting profitability more than ever due to the low interest rate environment, which dictates that income from the investment portfolio is often too low to overcome a substantial underwriting deficit, negating the value of the massive float. After recent developments the company should be able to focus all of its attention to formulating a capital plan for the CCAR process and improving operations. The Federal Reserve did announce that if they were to reject a capital plan in 2013, it will give the company an opportunity to resubmit based on the Federal Reserve's figures. Due to this development, which should reduce the risk of a flat out rejection, I believe Benmosche should be aggressive in his plan to buy back stock. The company has mentioned a dividend but that is not tax efficient or advisable when the stock trades at 50% of book value. Moving forward, I believe AIG's long-term potential is enormous and I'm excited to see one of America's great second acts continue on its path toward redemption.