On Thursday after the close, AIG reported better-than-expected results, with a profit, excluding one-time items of 20 cents per share versus an estimate of a 9 cent loss. Shares opened up over 5% Friday and closed up over 3%.
Now that I've had the weekend to dig through the results and all the interviews the CEO, Bob Benmosche, gave, I still believe AIG is very under-valued but the story is getting more complicated. Here are my big takeaways from the company's earnings and other recent news:
Complicated and a Little Risky
The company has a lot of moving parts, which muddy the story a lot. The slide below, from the Q4 earnings presentation (pdf), illustrates this.
Of the eight metrics presented in the slide, five changed over 70% from the quarter a year ago. While it seems to be managing the changes well, changes that significant present many opportunities for mismanagement. Also, with all of these changes going on, it would be easier for the investment community to overlook aspects of the story, which could have a material impact on future earnings.
As Mr. Benmosche mentioned during a CNBC interview, the company's story is "complicated and a little risky" but has a lot of potential upside. The slide above exemplifies that.
During the CNBC interview, the CEO also discusses the fact that the stock is now the most widely-held stock by hedge funds. A surprisingly high 21% of the total outstanding equity in the company is owned by hedge funds. This piece of news makes me nervous because that 'hot money' will probably make the stock considerably more volatile and susceptible to wide swings. The stock already has a beta of 1.89. I expect this will increase over the next several months.
Components of Earnings
There were both good and bad aspects to the company's report.
On the negative side, general operating expenses continued to move higher in the property and casualty division. The ratio increased to 17.3 in Q4 2012 from 14.1 in Q4 2011. AIG noted that this increase was due to strategic investment, severance costs and other personnel costs. The company often mentions expense reduction as a primary focus so this metric should begin to decrease in the coming quarters.
Also, in the life and retirement division, it continues to face a headwind of low investment spreads and yields. This pressure is likely to continue for the foreseeable future.
On the positive side, mortgage delinquency ratios continue to drop and the company has ramped up the amount of mortgage insurance it has been writing, to $11.6 billion in Q4 2012 from $7.1 billion in Q4 2011. Tighter mortgage underwriting standards are expected to help keep the risks relatively low. Primary delinquency ratios have also continued to drop, down to 8.8% this quarter. In this division, the company did withhold additional reserves to account for future losses though. As the company continues to take share in the mortgage underwriting market, it will profit more and more from an improving housing market.
Also, AIG continues to increase insurance rates. It has previously said that while large disasters like hurricanes negatively impact that quarter's earnings, they provide a catalyst for future rate increases. Casualty insurance pricing in the fourth quarter in the U.S. was up 10% and property insurance pricing was up 14%.
The company finished the quarter with $12.6 billion in cash and short-term investments. Also, the company expects to close the sale of ILFC in the 2nd quarter of this year, bringing in another $4.8 billion. The current amount of cash and short-term investments represents 22% of the market cap of the company. AIG is putting some of that cash to work already by buying back $1.25 billion in junior subordinated debt yielding up to 8.625%. In 2012, the company paid $2.32 billion in interest expense. During the earnings call, Mr. Benmosche stated the company's highest priority now is to reduce interest expense and improve the company's coverage ratio.
Once the company is happy with its debt and capital position, it will begin returning capital to shareholders. Given the focus of investors on a return of capital, if the company doesn't announce something soon, investors and hedge funds may lose patience with the company and sell the stock. In previous quarters, the company has insinuated that a dividend should be paid in 2013. It has recently backed away from giving any estimates on when a dividend or buyback would begin.
AIG's current book value is $66.38, up from $53.53 a year ago. That represents an impressive 24% growth in book value in one year. From Q3, book value dropped $2.97 per share due to a loss the company recognized on the planned sale of ILFC. Due to similar fluctuations, the company suggests looking at book value excluding accumulated other comprehensive income, which increased 15.5% from a year ago. Either metric illustrates the continued strengthening of the company's financial position.
Hedge fund manager Whitney Tilson recently wrote an interesting letter on AIG's management incentives and how they will soon strongly incentivize management to raise the stock price. He states that management is currently trying to depress the stock price until executives are granted options, at which point they will begin to work to raise the stock price. Frankly, that is an interesting idea but I can't wrap my head around the idea that management is conspiring to keep the stock down. I will agree that the company currently has a very conservative capital allocation strategy.
The only catalyst for AIG until the next earnings release is news on a more aggressive capital allocation. This could come as soon as March. This new allocation plan may already be priced in at this point. On Friday, Sterne Agee downgraded the stock to neutral based on valuation, with a $41 price target. Since the stock is over-owned by hedge funds and has had a big run over the past three months, up almost 18% vs. the S&P three-month return of 9%, it's probably due for a pull-back.
If news of return of capital to shareholders doesn't come soon, or is not as aggressive as hoped, the shares could see a significant sell-off as hedge funds reduce holdings in the company. Also, if the market in general gets hit, the stock will suffer as hedge funds reduce exposure.
As opportunities present themselves in the coming months, investors should look to buy stock when it trades below 50% of book value (under $33). The company is in the middle of a big turnaround. There are numerous risks to the stock, both fundamental and market-driven, but investors who can handle the volatility should be rewarded as the turnaround continues.