On Wednesday, Goldman Sachs (NYSE:GS) upgraded American International Group (NYSE:AIG) to a buy, with a $63 price target. Shares are up 18% over the past year, and sit at multi-year highs. In other words, it would be fair to say that Goldman was late to upgrade AIG. Still, I believe this is a case where it is better late than never. On a fundamental basis, AIG is still a very cheap stock. While the fact that its transformational CEO, Bob Benmosche will be leaving at the end of the year should cause some pause, AIG's improving fundamentals and strong capital position will buoy results over the next few years. I expect AIG to use its strong cash generation to buy back shares and invest in its business, which will push its return on equity towards 10% by late 2015 or 2016. In the next 12 months, I expect shares to push towards a book value of about $65.
Goldman argues that AIG can deploy its excess capital in accretive ways, even if the government does not permit it to make a large share buyback (details available here). I believe this assessment is correct, but I also think AIG will be able to continue buying back at least $750 million to $1 billion in stock per quarter. Book value as of last quarter stood at $65.49 (financial and operating data available here), so with shares trading around $53, AIG can buy back stock well below book value, which is accretive for EPS and book value per share. When shares are at such a discount to book, a buyback is the most attractive use of excess capital. With the recent sale of its aircraft-leasing unit, AIG will have even more capital to return. Even in a strict regulatory environment for systemically important financial institutions, AIG has the financial capacity to repurchase shares.
Even with the recent buyback and dividend policy, AIG is generating excess capital every year. AIG can use this excess capital to fund new ventures or retain more risk on its balance sheet. Over the past year, we have been seeing the company move aggressively into the life insurance space, which can be more capital-intensive than Property Casualty. I think this is the right strategy for the company, and AIG's push into life insurance gives it better growth potential than other insurers, making its stock very attractive. Last quarter, assets under management at its Life unit increased to $324 billion, up 9% year-over-year. This increase was powered by a 28% jump in deposits and premiums to $7.13 billion. Thanks to a growing asset base, pre-tax income reached a record of $1.42 billion. Expanding its life insurance asset base requires that excess capital, but is generating higher profits.
Importantly, I believe this push into Life will generate significant profits in the coming years. Life insurance is the ultimate bet on rising interests. Customers pay premiums to AIG every month for years, and when they die many years down the road, their beneficiaries can make a claim. This future claim is a liability. As rates rise, the present value of these claims falls. At the same time, AIG can invest the cash premiums in long-term bonds, meaning income increases as interest rates rise. Rising rates increase investment income, while cutting the present value of liabilities. This is a double benefit that makes life insurance a great business to get into as rates are about to rise.
Now, over the past few months, the 10 years' rates have stayed surprisingly low, even with the Federal Reserve tapering its bond purchases. While I cannot say when rates will rise, I do believe that an increase in yields is inevitable as the Fed steps away. With some inflation and positive growth, the 10-year yield and eventually even the Fed funds rate have to increase. This increase in yields is not just a short-term benefit, but a long-term theme that will increase AIG's earnings power over several years. Last quarter, the base investment yield was 5.3%, and a 1% increase in the Fed funds rate will gradually increase AIG's EPS by around $1.50.
Between some share buybacks and the capital required to further grow the Life business, Goldman is right that AIG is still a buy at the current levels. Shares are trading well below book value, and its investment in life insurance will power earnings growth for the next few years. With strong capital and growth prospects, I expect shares to trade at 90-100% of book value, or $60-$66, which is in line with Goldman's price target. AIG has further room to run, and while Goldman's call may have been a bit late, it is correct. AIG is a buy.
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.