Seeking Alpha
Long only, deep value, registered investment advisor, portfolio strategy
Profile| Send Message| ()  

Rarely does a unique franchise with durable competitive advantages become so incredibly cheap that just average results over the next 3-5 years could cause the stock to triple. A situation like this can only occur when there is a vast contrast between perception and reality. In 2008, American International Group (AIG) was America's financial nuclear bomb being dropped within our own borders. While I'd argue that the biggest issues were liquidity related and likely would have worked out reasonably over time in a more functional capital market environment, the government stepped in so that the rest of the economy wouldn't be jeopardized after the disastrous handling of Lehman Brothers. There is no question that the company had lost its way and without the American taxpayers' help, AIG would have gone bankrupt due to collateral calls placed on it due to downgrades on various securities. Sometimes stocks are like a bad relationship experience in that if you dwell on the past, you miss out on the present and future. The AIG of today is a completely different company without nearly the level of risk as it had in 2008, and due to a lack of faith and knowledge of its current financial condition from most market participants, there is an epic opportunity to profit for the disciplined, long-term investor.

AIG has unified its brands under the AIG name, and I really think that is more than just symbolic, because AIG is much easier to understand now that it was in its conglomerate past. The company has roughly 86 million customers including 96% of the Fortune 1000, so unifying its marketing and promotion towards one brand makes a ton of long-term sense. After the pending divestment of International Lease Finance Corporation, AIG has two linchpin businesses, which are the global Property & Casualty business, and the Retirement and Life Insurance operations. Both businesses are more than capable of generating about $1 billion apiece in profits per quarter as currently constructed, but of course, with insurance, consistency is not always part of the equation. In addition, the company has a very strong mortgage insurance operation that has the potential to improve profitability moving forward, but will not materially move the needle like the other businesses can.

Formerly, under the leadership of Hank Greenberg, AIG's strength was its global presence across the globe in both its P&C and Life Insurance operations. AIA and Alico were the two largest components of that international footprint that unfortunately had to be divested to fully repay the U.S. taxpayers. AIG's biggest weakness was that it had grown so vast and gotten so complicated that risk management was far too lax, leading to massive losses in the financial products business, and constant upward revisions of loss estimates in the insurance operations. After paying back the government in full, CEO Robert Benmosche has been focusing on improving risk management practices. AIG has invested into its datacenter and analytics to improve its underwriting principles, and the company has shifted its priorities from chasing premium growth at any cost to increasing its capabilities in more specialized lines of insurance that tend to offer higher profit margins. In addition, AIG has entered and will likely continue to enter foreign markets such as China and Brazil through joint ventures to regain a broader international life insurance business once again. The other major priority for the company is to both improve its profitability and reduce debt, to increase its interest coverage ratios in an effort to placate the ever-unreliable ratings agencies.

Through divestments, AIG has accumulated surplus funds, and after buying back a large amount of stock in 2012, the company is buying back higher-yielding debt securities to save on interest expenses. The company ended the 4th quarter with $16.1 billion in liquidity at the parent company, up from $11.1 billion at the end of the 3rd quarter, primarily due to the sale of AIA shares. In a perfect world, AIG would be able to be far more aggressive and continue to buy back stock with the price so far below intrinsic value. The reality is that AIG experienced a near-death moment where it had to access capital from taxpayers, and because of its size, is likely to be regulated by the Federal Reserve. Therefore at this juncture, the company does not have the ability to go too far on the offensive. I would at least like to see the company buy back about $2.5 billion in stock to offset the reduction in book value caused by the sale of ILFC, and I'm sure that when Benmosche gets more clarity about how exactly AIG is going to be regulated, he will give strong consideration to this. As evidenced below, the fact that AIG was able to post a small operating profit despite the massively damaging impact on one of its largest P&C markets in the Northeast United States, AIG's earnings power should really begin to shine through as 2013 progresses, helping coverage ratios. Part of AIG's long-term transformative goals is to obtain a return on equity of 10% by the end of 2015, and Benmosche has mentioned that the company is well on its way to doing so. Buying back stock at a large discount to tangible book value could meaningfully expedite the process by reducing the equity component in the calculation. Not only would stock buybacks increase book value per share if done below tangible book, but the increase in return on equity would likely lead to a much higher valuation on the actual business.

AIG concluded an extremely busy and transformative 2012 campaign with a messy 4th quarter that continues to mask the full embedded value of the franchise. The company reported a net loss of $4.0 billion, or $2.68 per share in the 4th quarter. For fiscal year 2012, the company generated $3.4 billion of net income, or $2.04 per diluted share. The net loss in the 4th quarter reflects a $4.4 billion net loss on the sale of International Lease Finance Corporation, which was sold at a large discount to book value. AIG gained $240MM from the sale of its final $6.5 billion in shares of its former Asian insurance company, AIA. AIG's after-tax operating income in the 4th quarter was $290MM, or $.20 per diluted share, while after-tax operating income for the full year was $6.6 billion, or $3.93 per diluted share.

4th quarter and full year 2012 financial results included pre-tax catastrophe losses from Superstorm Sandy of $2.0 billion, or $1.3 billion after tax. Sandy was the second largest single catastrophic event for AIG in the United States, so the fact that the company was still able to churn out a slight operating profit speaks volumes about progress being made throughout the business. The U.S. Treasury divested the remaining part of its stake in the quarter at a solid profit to taxpayers. In total, the Treasury's profit was $22.7 billion, which will be enhanced when it sells its warrants that enable it to buy approximately 2.7 million shares of AIG stock. Book value per share, excluding accumulated other comprehensive income (AOCI), ended the year up 15.5% for the year at $57.87. Book value was reduced by $2.97 due to the sale of International Lease Finance Corporation. Book value, including AOCI, stood at $66.38 as 2012 closed, which was up a staggering 24%.

Unsurprisingly, AIG's P&C business reported an after-tax operating loss of $945MM in the 4th quarter, but a profit of $1.82 billion for the year. If Sandy were excluded, the P&C business would have posted 4th quarter operating income of $1 billion, reflecting the unit's improved underwriting margins. The accident year loss ratio, as adjusted, was 63.3%, which continues to show progress. AIG Life and Retirement generated a solid $1.090 billion and $4.16 billion in after-tax profit in the 4th quarter and full year, respectively. Assets under management were $290.4 billion at the end of the 4th quarter, compared to $256.9 billion at the end of the 4th quarter of 2011. Variable annuity sales were up 50% from 4Q 2011. The Mortgage Guaranty business lost about $45MM in the 4th quarter, and made about $9MM for the year. Net premiums written in the 4th quarter in the Mortgage Guaranty business were $236MM, up from $200MM YoY. Domestic first-lien new insurance written totaled $11.6 billion of principal amount of loans insured for the quarter compared to $7.1 billion for the same period in 2011. The mortgage insurance market is a mess right now due to weakly capitalized companies, so AIG's stronger division has every opportunity to enhance a leadership position. If the GSEs ever step away from the market, a company such as AIG could have a wide runway of growth ahead of it.

Because of AIG's financial strength, excess liquidity, and normalized earnings power, it is very difficult to imagine the long-term investor losing money buying the stock at 57% of book value. Stock buybacks below tangible book value will meaningfully boost book value per share, as will retained earnings. I believe that AIG has the opportunity to average book value per share growth of 10% per annum over the next 5 years. During that time, the company should see a steep climb in return on equity, which should bring its valuation much closer to the industry multiple, which hovers at or above book value. Keep in mind that AIG has Net Deferred Tax Assets of $16.7 billion, as of 12/31/3012, which will substantially improve profitability over the short-term. If the company can accomplish these initiatives, the stock could triple from current prices. AIG is by far and away our largest position, and we have continued to add aggressively through both buying stock and selling puts. While it might make sense to maximize leverage through warrants or strictly buy the stock, we understand that timing can be complicated, so to make the process easier for our clients who might not have the same stomach for volatility that I do personally, we employ the strategy of selling long-term put options in addition to our stock purchases to lower the cost basis and generate income. The global and U.S. economies are still extremely challenged, and rarely in my experiences as an investor have stocks done nothing but shoot up, so a patient and disciplined approach is always advisable.

Source: AIG Offers Extreme Upside With Margin Of Safety