- Leon Cooperman is bullish on AIG, seeing 25% upside.
- Improving underwriting standards and rising rates will improve ROE over the next three years.
- AIG is returning capital to shareholders, which is accretive at current prices.
- AIG should trade within 90% of book value or $60.
Noted value investor Leon Cooperman affirmed his optimism in American International Group (NYSE:AIG) on Monday, arguing that shares could rally 25% within the next 18 months (details available here). Shares are trading at roughly 80% of book value, which stood at $64.28 excluding accumulated other comprehensive income (mainly unrealized gains on bonds) at the end of last quarter (all financial details available here). Investors can buy AIG at a discount to its net asset value, which provides a strong margin of safety while leaving significant upside. In fact, Cooperman is only targeting a price to book value of 1.00x, which is not overly aggressive.
Last year, return on equity was 7.5%, which was up from 7.2% in the prior year. Cooperman sees a potential ROE of 10%, which would translate to over $6 in earnings power. I don't expect that large of an increase in 2014 and am looking for closer to 7.8% this year, which would be about $4.75-$5.00 in earnings this year. However, looking over three years, an ROE of 10% is certainly achievable. While AIG's investing performance has been great, its underwriting is still lagging. While standards have certainly improved under CEO Robert Benmosche, there is further progress to be made.
Property and casualty are still generating an underwriting loss with an adjusted combined ratio of 102 last quarter (100 represents breakeven, above 100 is a loss). Commercial insurance underwriting was profitable at 97.1 last quarter, though that represented a year over year weakening. Similarly, consumer insurance ran an underwriting loss with a ratio of 103.6. By 2015, I expect all units to be running even on underwriting. Insurance profits are primarily driven by investing premiums and earning interest on investments, but running a profit on underwriting can further juice profits. Higher rates and improved underwriting will generate a higher ROE and net income.
AIG has also made a strong push into life insurance, which is beginning to pay dividends. Premiums and deposits jumped 54% last quarter to $8.04 billion, which pushed pre-tax income up 29%. As rates rise over the next 2-3 years, I expect base investment yield to increase from the current 5.29% rate while AUM is $318 billion, up a strong 10%. AIG is pushing into the life insurance business at the right time. Higher rates will power stronger investment income while more deeply discounting benefits that will be paid in the distant future, powering strong profit growth for several years. With slow underwriting improvements and a heavier reliance on life insurance, AIG is well positioned to push its ROE higher, potentially nearing 10% towards the back half of 2015.
For investors who suffered through its collapse in 2008, it is important to note AIG is also extremely well capitalized with over $100 billion in equity and $17.6 billion in liquidity. It also has exited non-core and risky businesses that drove the weakness during the financial crisis. In fact, AIG is in a position to return capital to shareholders. It has a buyback authorization of $1.4 billion and $0.125 dividend (still a small 1% yield). Following the ILFC sale, AIG will also hold a 46% stake in AerCap (NYSE:AER), which it can gradually sell down. It can then use these proceeds to buy back more of its own stock.
Given its strong earnings power and capital position, I expect AIG to increase its buyback authorization further and would not be surprised to see $4-$5 billion returned to shareholders over the next 12 months. Moreover, it is wise for AIG to focus its resources on a buyback rather than a dividend at current levels. Buying back stock is extremely accretive when shares are less than book value. In fact, it will push book value per share even higher as the share count declines faster than book value. This will power AIG shares even higher.
A company that generates an ROE of 8% should trade at roughly book value. I expect AIG to be slightly lower this year at around 7.8%, which is why I am looking for shares to move to around $60, which still suggests another 18% of upside this year. With its ROE likely to climb higher in 2015 and 2016 towards a peak of around 10%, shares could reasonably trade 25% higher than book value. In other words, a price to book of 1x is not the final destination but a level AIG should hit this year and surpass over the next two years as it continues to improve its operating performance. Leon Cooperman is right to be bullish on AIG. AIG will benefit from continued cost-cutting and improving underwriting standards while its shift into life insurance will be profitable as rates rise. Capital returns will further improve returns and book value per share. AIG's fair value is at least $60, and investors should follow Cooperman at current levels.