- AIG reported earnings that exceeded estimates thanks to strong investment income and increasing premiums.
- Underwriting results continue to lag, but growing premiums will drive revenue and earnings growth in 2014 and beyond.
- AIG is wisely focusing on life insurance, which will benefit from rising interest rates.
- A strong capital position allows AIG to grow the dividend and buyback while expanding the business.
- With up to $5 in earnings power, AIG should trade to 90% of book value or $60, suggesting 20% upside.
Shares of American International Group (AIG) popped 2% after the company reported strong earnings, hiked the dividend, and increased the buyback (press release available here). CEO Robert Benmosche and his team delivered another quarter of strong results as the financial crisis moves further into the rear-view mirror. Under Benmosche's leadership, AIG has shed extraneous businesses, cut unnecessary risk, paid back the government, and is now rebuilding the core PC (property and casualty) and life insurance businesses. After this quarter, shares should rally even harder and are extremely attractive at current prices.
Excluding items related to workforce reductions, AIG earned $1.15 while analysts had been looking for $0.96, and revenue of $4.62 billion also beat estimates of $4.56 billion. Year-over-year comparisons also are very strong, though Superstorm Sandy negatively impacted last year's results when the company only earned $0.20. Full year after-tax operating income per share was $4.56, which was up from $3.93 last year. To streamline operations, AIG is letting go approximately 3% of its headcount with the cuts focused mainly in PC operations. As a consequence, there was a $265 million severance charge, though operating expenses will be lower going forward. Let's start by looking at each segment's results.
Beginning with property casualty, we are finally seeing improvement in a unit that has struggled over the past 24 months. Net premiums written increased 3% to $8.03 billion, which will power revenue growth in coming quarters. Thanks to a robust stock market and rising bond yields, net investment income grew 17% to $1.42 billion. While AIG is improving underwriting standards, results are still lagging peers. The company's combined ratio stood at 103.8. For those who don't know, the combined ratio measures the profitability of the underwriting process. A ratio of 100 is the breakeven rate while a number higher indicates losses. In other words, the underwriting profit margin was -3.8% this quarter. While that was a marked improvement from last year's 125.1 (driven in part by Sandy), investors would like to see a number right at or just below 100.
If we adjust out for catastrophe and other unusual losses, AIG's combined ratio deteriorated to 102 from 100.8 last year. Now as AIG gets paid premiums before it pays out claims, it makes a significant amount of money from investing, which more than offsets this underwriting loss. PC operating income was $1.09 billion before tax even with a weak combined ratio. Still to lose money on underwriting is always disappointing. Insurance is lumpy quarter to quarter, and there seemed to be some bad luck with a higher accident rate, and over time, stricter underwriting standards improve the combined ratio, which should hit 100 by the middle of 2015. All in all, PC had a good quarter investing and generating new business but underwriting left something to be desired.
There was a similarly mixed picture in commercial insurance. Net premiums written jumped 10% to $4.84 billion but the combined ratio was weak at 107.7. While this was better than last year's 130.3, that is because of Sandy. The adjusted combined ratio was 97.1, up from 95.8 last year. While this figure was higher, the unit is turning an underwriting profit, which is a positive. In this business, AIG insures many large buildings and factories, and unfortunately, it faced more large claims with severe losses jumping $197 million. Again, investors can be heartened by strong premium growth, which will translate to stronger profits in future quarters, but underwriting was a little disappointing.
AIG cut its marketing expenditures in consumer insurance, and as a consequence, net premiums written dropped 6% to $3.189 billion. The overall combined ratio improved to 103.3 from 111.2, but the adjusted combined ratio was weaker at 103.6 from 101.3, continuing a trend we've seen elsewhere. AIG has been focusing its resources in PC, which is a reason for lower premiums written. Private client, accident, and health claims drove the weakness at this unit. While PC and commercial are poised for strong growth, this unit's performance was lacking.
However, AIG life and retirement delivered fantastic results. AIG has refocused on this business, and in an era of rising rates, now is the perfect time to get into life insurance. With rising rates, the present value of future claims declines, and higher rates will also increase investment income. While insurers who afford annuity and life products were slammed from 2008 to 2012, we are at an inflection point that AIG is wisely taking advantage of. Reflecting its push into the business, premiums and deposits increased 54% to $8.04 billion. A strong investment environment also helped increase investment income 6% to $2.87 billion. As rates rise, base investment yield will increase from the current 5.29%. Total pre-tax income was up 29% to $1.4 billion. AUM also increased 10% to $318 billion, which will power strong investment income next year. Life is a major growth center for AIG, and its performance continues to be exceptional.
With $100.5 billion in equity and excellent liquidity of $17.6 billion (including cash and short-term investments of $13.1 billion), AIG has the financial capacity to keep growing its business. This financial flexibility is why AIG is able to grow its net premium written and life business. While underwriting is still lagging, AIG reported a solid quarter and is setting the stage for significant growth in 2014. After this quarter, analyst consensus of $4.35 in 2014 seems too low, and I continue to expect AIG to earn $4.75-$5.00 this year. Also, book value increased 3.4% to $68.62 while book value excluding AOCI increased 11.1% to $64.28. Full year return on equity (using after-tax operating income and book value ex AOCI) was 7.5%, up from 7.2% last year.
Also, AIG is using its strong capital position and asset divestments to return more capital to shareholders. The company increased the dividend by 25% to $0.125, though the annual yield is still a paltry 1%. It also added $1 billion to its buyback authorization and can now repurchase a total of $1.4 billion in stock. Even with the after-hours rally, AIG is trading at a 22% discount to book value, so buying back shares is accretive to BV/share and EPS. In total, AIG is now planning to return about $2.1 billion to shareholders this year, and it certainly has the capacity to do more without angering regulators. In the second half of the year, I expect AIG to raise the dividend or add $1 billion to the buyback.
AIG has turned the corner and is growing the business. Further, AIG is starting to return more capital to shareholders. With these factors, I continue to believe that AIG should trade to at least 90% of book value or $58-$61 (depending on your measure of book value), which would translate to about 12x 2014 earnings. At $50, AIG is an extremely attractive value stock with 20% of upside.