We were pleased to get such a strong reception when we published our first report on American International Group (AIG) back in August. We were especially pleased to see it pay back its $182B bailout that the American taxpayers provided to it during the financial crisis. The good news is that the taxpayers have received a nominal profit of $22.7B and the Treasury has sold off its position in AIG. We won't spoil the mood and point on that AIG's annualized return on equity in Q1 2013 is only 8.9%, which is quite low for investing in a financial institution. However, we are pleased that AIG has returned to profitability and it has even stabilized its insurance premium and policy fee revenues. We think that investors should take advantage of potential weakness in the equity markets to enter a position in AIG or add to their stakes. That way, they don't blow their chance at picking up AIG at a 35% discount to book value.
We reiterate that when investing in turnaround companies such as AIG, we believe that investors should view their potential investments as a collection of exposures. We believe that investors should view AIG as four firms consisting of the following exposures:
- AIG's Property Casualty (Formerly Chartis): AIG's Property Casualty is the largest division of AIG. It offers property, casualty, specialty and professional liability insurance to individuals and consumers.
- AIG's Life Insurance and Retirement Services Division (Formerly SunAmerica): AIG's Life Insurance and Retirement Services Division underwrites life insurance and annuities sold to individuals and groups. It also sells third-party mutual funds and financial planning services as well. The division sells its products and services through affiliated and non-affiliated brokers, agents and non-affiliated financial institutions, as well as through direct-to-consumer platforms.
Although AIG rebranding this division from SunAmerica back to AIG Life and Retirement, it kept the SunAmerica brand name for its retirement services business operations
- International Lease Finance Corporation: ILFC generates its revenues primarily from leasing new and used commercial jet aircraft to foreign and domestic airlines. Its biggest competitor is GE Capital Aviation services, a subsidiary of General Electric Corporation's (GE) GE Capital division.
AIG is trying to sell ILFC to a Chinese consortium but the buyers failed to meet the deadlines twice on May 15 and Jun 14, due to the delay in attaining regulatory approvals. Hence, AIG extended the closure of sale by Jul 31, 2013. However, the company would have to go with its plan to launch an IPO if this deadline goes void too.
- AIG Other Operations: Consists of corporate expenses, retained interests in assets businesses sold and assets AIG is trying to shed or run-off,
Source: AIG Q1 2013 10-Q
Evaluation of AIG's Strategic Corporate Finance Performance
AIG repurchased $13B worth of its stock in 2012 in conjunction with the U.S. Treasury selling off its stake in the company and it repaid $2.7B worth of its outstanding debt in Q1 2013. AIG's shareholders' equity increased by $1.5B in Q1 2013 versus Q4 2012 as the company's $2.2B in net income was offset by $750M in the change of unrealized net appreciation/depreciation on its investments held. Now that the Treasury no longer holds any shares of AIG, the company is now primarily regulated by the Federal Reserve because it has a savings and loan subsidiary. Even though insurance companies like AIG are not normally regulated by the federal government, AIG expected to be regulated by the Federal Reserve as a systematically important financial institution. At least AIG isn't the only company with this designation; Prudential Financial (PRU) and GE Capital were also tagged as SIFIs. AIG is also looking at strategic options for its savings and loan subsidiary.
Evaluation of AIG's Business Segments
AIG Property and Casualty: AIG Property and Casualty saw a slight decline in its net premiums earned for the quarter and for the year to date periods versus last year's comparable periods. It saw a strong benefit from reduced claims and claim adjusted expenses (8% for Q1 2013 after an 8% decline in FY 2012). AIG Property and Casualty was also able to reduce its combined acquisition and operating expenses by1.5% year-over-year. This enabled the division's underwriting income to swing from a loss of $180M in Q1 2012 to a profit of $231M in Q1 2013. Net investment income and realized gains jumped by 11% in Q1 2013 versus Q1 2012 primarily due to the strong performance in equity partnership investments and this enabled Chartis to rack up $1.6B in Q1 2013 pre-tax income, which was a 76% jump from the prior year's period. Chartis' reduced claims and claim adjusted expenses was due to lower catastrophic losses and underwriting improvements.
AIG Life and Retirement: AIG Life and Retirement's revenue inched upward by 2.7% year-over-year. The division benefitted from positive operating leverage as operating expenses increased by less than 1.2% year-over-year and this helped operating income grow by 6% year-over-year. The division's pre-tax operating income surged by 82% on the strength of a $622M in its net realized capital gains and losses (From a loss of $466M in Q1 2012 to a gain of $156M in Q1 2013). Both its retail and institutional operational businesses saw mid to high single digit operating income growth and huge positive swings in its net realized capital gains and losses year-over-year.
The division saw a slight increase in premiums for the quarter, which was complimented by a 5% increase in policy fees during this time period. The division benefitted from stable levels of net investment income and the aforementioned swing in net realized capital gains.
International Lease Finance Corporation: The good news for ILFC is that since AIG classified it as available for sale, it no longer accrues depreciation and amortization expenses. That enabled it to offset a negative $456M swing in its net gain/loss on sale as well as its 6.8% revenue decline. The company benefitted from $21M in reduced operating expenses year-over-year as well as $7M in reduced income taxes in Q1 2013 and this helped its after-tax net income increase by $29M.
Another piece of good news for ILFC is that its competitor GE Capital Aviation Services saw its Q3 2012 revenue slip by 1% for Q3 2012 and 50bp for YTD 2012.
The bad news is that despite GE Capital Aviation Services grew its revenues by 4% in Q1 2013 while ILFC saw its revenues declined by 6.8%. GECAS's pre-tax income of $348M in Q1 2013 was more than double the $160M earned by ILFC having only ~9% more revenues than ILFC in Q3 2012, GE Capital Aviation Services has earned 2% more profit in Q3 2012 than ILFC earned in the first nine months of 2012. Based on this negative disparity between AIG's ILFC Unit and GE Capital Aviation Services, we believe that AIG needs to take proactive steps to improve profitability, execute the sale of ILFC to the Chinese consortium that agreed to buy it or spin it off to AIG shareholders.
AIG Other ("run-off assets"): We expect that this segment should "just not screw things up" and since this segment only generated $414M in pre-tax losses during the quarter after realizing and $2.7B in pre-tax gains in FY 2012, we can see that our expectations are being met here. The segment benefited from $329M in gains from its direct investment book and $268M in profits from its Mortgage Guaranty and Global Capital Markets businesses. Most of its losses were due to a $340M charge for the extinguishment of debt resulting from the redemption of, and cash tender offers for, certain securities in the first quarter of 2013.
AIG Warrants: As part of a series of integrated transactions to recapitalize AIG in January 2011, AIG's Board of Directors declared a conditional dividend on January 6, 2011 to holders of record of AIG common stock as of January 13, 2011, the record date. The dividend consisted of 10-year warrants to purchase up to 75 million shares of AIG common stock in the aggregate at a price of $45 per common share. The warrants were distributed on January 19, 2011. Investors who are super-bullish on AIG and who may not necessarily be interested in committing their capital towards purchasing AIG's shares outright should be purchasing AIG Warrants instead of directly purchasing AIG's shares. For those who are worried that they would miss out on potential dividends, the warrants have anti-dilution adjust protections for the following events:
- Future stock dividends, distributions, subdivisions or combinations.
- The issuance of below market rights, options or warrants entitling the holder to purchase AIG common stock for a period of sixty days or less.
- Dividends or other distributions of capital stock (other than AIG common stock); rights to acquire capital stock, debt or other assets (subject to certain exclusions).
- Per share cash dividends in excess of $0.675 in the aggregate in any twelve-month period.
- Certain above-market issuer tender offers for more than 30 percent of the then-outstanding AIG common stock.
- For those that don't want to pay $18/unit for the AIG Warrants, they can pay $7/unit for AIG's January 2015 Call Options.
In conclusion, we are intending to hold on to our stake in AIG, as well as looking to selectively accumulate a larger position. Due to the market weakness and deep discount from market price relative to its tangible book value, we will be looking to opportunistically add to our position. The basis for our accumulate recommendation and positive outlook for the company is based on the following observations:
- 35% discount for its market price relative to its book value
- $13B in net share repurchases in FY 2012 and $2.7B in debt retirements in Q1 2013
- World-Class business operations subsidiaries
- Eventual sale or spin-off of International Lease Finance Corporation
- Revenue stability in business unit subsidiaries
- Reduced expenses for policyholder claims and benefits (reduced underwriting loss)
- Steady progress towards deleveraging
- Strong equity capital base
- U.S. Treasury no longer owns AIG shares
- Chartis and SunAmerica were rebranded back to AIG