In my investment research efforts, I've found very few attractive opportunities over the last several months. Great businesses are priced for perfection, and average businesses seem to be trading at relatively high normalized earnings ratios. Speculation is rampant in various securities with hot technologies, where the future may look bright, but the margin of safety is truly non-existent. It is in this environment that we at T&T Capital Management (TTCM) have built a concentrated portfolio with American International Group (NYSE:AIG) as our largest investment holding. The stock provides an extremely large margin of safety, attractive earnings and dividend growth prospects, along with a management team that has earned quite a bit of trust. These positives are still outweighed for many market participants by memories of 2008-2009, when the financial world was imploding and AIG became the poster-child for risk and poor corporate governance. The bottom line is that through the leadership of CEO Robert Benmosche, AIG is increasing its intrinsic value at a significant rate and the stock easily can have at least 50% upside from current levels over the next several years.
On August 2nd, AIG reported excellent financial results that highlight the tremendous progress the company has made under the leadership of Robert Benmosche. Revenues of $17.315 billion were up 7% YoY, while net income attributable to AIG increased 17% YoY to $2.731 billion. Diluted earnings per share of $1.82 were 48% better than the year before results of $1.23. After-tax operating income attributable to AIG of $1.12 per share increased 17% from the same time last year. Book value per common share was 9% greater than the same time last year, while book value per common share excluding AOCI of $61.25, was 11% higher YoY. The company achieved an ROE on book value excluding AOCI of 7.4% in the quarter, up from 7% last year at the same time. The Board of Directors approved a $.10 dividend per share and also instituted a $1 billion stock buyback authorization.
All of AIG's businesses produced quite solidly in the quarter. AIG Property Casualty generated after-tax operating income of $1.085 billion, while AIG Life and Retirement produced $1.151 billion in the quarter. The Mortgage Guaranty business is relatively small, but increasingly profitable, with $73MM in after-tax operating income in the quarter. The Direct Investment book will be lumpy, but had a nice quarter with $591MM in after-tax operating income. AIG has taken significant steps to reduce its interest expenses, which were $353MM in the quarter, down from $392MM at the same time last year.
One material headwind that the stock has been facing is the uncertainty about the sale of ILFC to the Chinese consortium that agreed to purchase it earlier in the year. ILFC is a business that requires considerable leverage, which AIG is wisely interested in getting off the balance sheet. The price the consortium was going to pay was very low at a material discount to book value, so I honestly wouldn't be shocked if AIG was able to procure a better result by divesting the business via an IPO. I certainly don't believe it will be much worse and Benmosche has been very clear about his intent on getting rid of the business, so this is truly the definition of a short-term headwind.
AIG has made a painstaking effort to reduce its interest costs, which was a major concern for the ratings agencies. Thus far, the company has created about $300MM of interest savings from debt prepayments. The annual dividend for the year at the current rate would be about $600MM. The company is taking an extremely cautious approach to its liquidity and capital management with $11 billion of cash, absent the bank lines. In the 2nd quarter, AIG received $1.3 billion in dividends from its insurance subsidiaries.
The other major disappointment for AIG over the last 5 years or so has been the underwriting performance of the Property & Casualty unit. The company has taken steps to increase prices and focus on lines where it has more of a competitive advantage. In the 2nd quarter, the accident loss ratio as adjusted was 61.9%, which was 2.9 points better than the same time last year. Net unfavorable prior year reserve developments were $154MM, with $142MM of this arising from Hurricane Sandy. There is no doubt that Hurricane Sandy was devastating and it was difficult to forecast the total damages, but you'd like to see AIG error on the conservative side based on the recent history. Importantly, premiums are growing and pricing is up as well, so I believe the combined ratio should trend down to the mid 90's range over the next few years, which would have a tremendous boost to company margins.
AIG Life and Retirement is an underrated business in my estimation. Premiums and deposits grew 24% from a year ago largely due to individual variable annuity sales, which exceeded $2 billion in the quarter. Assets under management grew 10% from a year ago. AIG wasn't burdened with a damaging legacy variable life business, like some of its competitors such as Hartford Financial (NYSE:HIG), so it has been able to increase market share with much more attractive conditions for the insurance company in terms of protections from adverse market moves.
At a recent price of $46.32 and with approximately 1.482 billion shares outstanding, AIG has a market capitalization of roughly $68.65 billion. The company trades at about 70% of book value and book value can grow by 10-13% a year, not including stock buybacks. AIG is no longer in the businesses that caused it to endure the liquidity squeeze of 2008, and management is the strongest it has been since Hank Greenberg. There is no reason this company can't trade at book value or slightly above as the combined ratio comes down. Stock buybacks at current prices will be enormously accretive and as a shareholder I certainly hope that we will continue to see aggressive repurchases in lieu of increased dividends. AIG remains a core position, with extremely attractive return potential in what is quite arguably a relatively expensive U.S. stock market.
Disclosure: I am long AIG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.