A New Chapter For AIG

Jun.20.14 | About: American International (AIG)

Robert Benmosche, CEO of AIG (NYSE:AIG) was confident that the sale of International Lease Finance Corporation (ILFC) to AerCap Holdings N.V. (NYSE:AER) would close:

We're very confident that this transaction will in fact close in the second quarter.

His confidence was well placed. On May 14, 2014 AIG announced it had completed the sale [Source] for $3.0 billion of cash and 97,560,976 newly issued AerCap common shares for a total of approximately U.S. $7.6 billion based on the price of AerCap's shares. AIG will own a 46% stake in AerCap subject to a lock-up which expires over 9-15 months following the closing date. This last major divestiture of AIG's noncore holdings was a four year challenge for the company.

Share Buybacks Resume in Earnest:

Then on June 5, 2014 AIG announced that its Board of Directors authorized the repurchase of an additional $2.0 billion of AIG Common Stock. Since the end of the Q1 2014 AIG had already repurchased $418 million of shares. The remaining share repurchase authorization including the recently announced authorization is approximately $2.1 billion as of June 5.

During Q1 the more aggressive share repurchases were a welcome surprise. This coupled with the continued purchases after the quarter and the new authorization is a positive development and a sign of shareholder friendly capital management. At the current share price of about $54, the equity dollars spent on share repurchases buys AIG assets worth $71.77 for each share purchased. That's a 33% return on those equity dollars invested and quite an improvement over the 6.5-7.5% return on equity (ROE) currently being earned from the businesses.

Changing of the Guard:

On June 10, 2014, the company announced Robert Benmosche will retire as CEO and President to assume an advisory role with the company effective September 1, 2014. His retirement has been widely expected and the Board of Directors named Peter D. Hancock as AIG's new President and Chief Executive Officer. Peter Hancock currently serves as Executive Vice President of AIG, and Chief Executive Officer of AIG Property and Casualty unit.

Thank You Mr. Benmosche for a Job Well Done:

AIG hired the former MetLife Inc., Chairman and CEO Robert Benmosche in August 2009 after AIG's near death experience during the financial crises. At that time many wondered if the company could be revived. We too waited on the sidelines before making our first investment in AIG's turnaround [Source] after Benmosche demonstrated his ability to get things accomplished there. The company was showing significant progress in restructuring itself, repaying the government's $182 billion bailout and moving forward with plans to sell assets. Even with evidence of the turnaround underway the company was still selling at a large discount to intrinsic value.

Robert Benmosche's style of telling it like it is; rolling up his sleeves; and getting his hands dirty seemed to be just what was needed to rally the troops and the wide ranging views of stakeholders around a direction for the company. It was interesting to watch. He showed courage and leadership coming out of retirement and fighting health issues to steer AIG through the crises. His insight and wherewithal helped save a company many gave up as a lost cause. It turned out to be the largest corporate turnaround in history and an amazing accomplishment given the mess inherited. As shareholders we owe Robert Benmosche a huge debt of gratitude for changing the discussion from can they survive to one of how much more can they achieve? A job well done!

New CEO's Challenge: Operation Improvements:

The new CEO and President, Peter D. Hancock, joined AIG in 2010 and was named Chief Executive Officer of AIG Property and Casualty in March 2011. Previously he was AIG's Executive Vice President, Finance, Risk, and Investments. Prior experience was in financial services including 20 years at J.P. Morgan in the Global Derivatives Group, Global Fixed Income business and Global Credit portfolio, and as the Chief Financial Officer and Chief Risk Officer.

Like Robert Benmoshe, Peter Hancock joined AIG with a lot of uncertainty prevailing and helped revive the company. His new job though will be to answer the question; how much more can they achieve? Although AIG is out of critical care; challenges remain. AIG's 6.5-7.5% ROE is below peer company ROE that is averaging about 10.5% and a key reason the share price continues to trade at an unacceptable discount to book value.

The Board of Directors seems to agree that operations improvement is a priority and Peter Hancock may just be the right guy. Robert S. Miller, Chairman of AIG's Board of Directors in describing Peter Hancock [Source] said in part:

…a strong risk manager; his understanding of the AIG enterprise and the insurance business as a whole; his success in revitalizing AIG's property casualty business; and his strong leadership and inclusive relationship skills position him perfectly to lead the company.

On Peter Hancock's tenure at AIG:

… his tireless focus on creating sustainable value via a strategy that achieves the right balance between growth, profitability, and risk has led to a shift to more high value business, better loss ratios, stronger risk management practices, and a stabilization of reserves in AIG's property casualty segment.

Peter Hancock's focus has been on improving operations. In a May, 2014 investor presentation he said;

The single biggest weapon for managing a soft market is focus on fixed costs. If you have high fixed costs, the temptation is to try and write dumb business to try and cover your cost base, and you'll regret it later.

In the property and casualty unit (P&C) his team improved accident year loss ratios from 69% in 2011 to 64% in 2013. They invested $1 billion in company systems to improve efficiency and risk management during the same period. Bloomberg [Source] reported the company is expected to cut about 1,500 jobs, partly in an effort to reduce management layers and relocate about 4,000 staff to lower-cost cities by 2015.

Jay Wintrob, the EVP, Domestic Life and Retirement Services (L&R) runs the other half of the company with excellent results. During the 1Q14 his segment reported:

Over $1.4 billion of operating earnings, achieving the highest level of quarterly earnings in our history. Operating income was driven by strong growth in fee income and enhanced spread income. Higher account balances due to strong sales and equity market appreciation generated increased fee income. Interest rate sensitive businesses continued to benefit from disciplined pricing on new business, reduced renewal crediting rates and a run off of older business crediting relatively high interest rates.

Jay Wintrob joined AIG in 1999 when his company, SunAmerica Inc., was acquired by AIG. In an insightful interview in early 2012 he was very supportive of Peter Hancock's work at AIG. Wintrob said he believed the restructuring and transformation going on at [the P&C unit] led by his regarded colleague Peter Hancock is going to be very successful, but he added that it would not happen overnight:

[Hancock] is asking all of the right questions, and is off and running with a very well thought out long-term strategy of improving performance that I'm very optimistic will be a successful endeavor.

As there often is, some speculate Wintrob may leave AIG, because he was not chosen as AIG's new CEO. During the AIG crises Jay Wintrob rolled up his sleeves and chose to help AIG's through its darkest hours. It is up to him of course but you have to wonder why he would not stay on to enjoys the fruits of his hard work, a much brighter future and the awards that follow.

The Value of Operation Improvements:

AIG's share repurchases are spot on and should continue aggressively as long as the share price is discounted to the growing book value or intrinsic value of the company by more than the 6.9% return earned from the business. The economic attractiveness of other investment opportunities should always be considered, but until returns on the business improve, reinvesting in the shares creates more value than investing in the business.

It appears AIG's capital generation is strong enough to allow for continued buyback authorizations at the rate of $2 billion per year. The regulation of AIG by the Federal Reserve as a non-bank Systemically Important Financial Institution (SIFI) can impact this. However, the current share buyback authorization was not done in a vacuum; prior discussion with regulators certainly and management indicated they would. By virtue of the buyback approval they must be reasonably close or surpassing the pending expectations of the regulators.

The graph below illustrates an estimate of book value per share for three cases assuming all else constant:

  1. No share buybacks, ROE stays at 6.9%.
  2. Share buybacks at $2 billion/year, ROE stays at 6.9% (operations don't improve).
  3. Share buybacks at $2 billion/year, ROE improves to 10% (operations improve to peer average).

Click to enlarge

In addition to the share buybacks the company needs to focus on their (previously shelved) aspirational goals; one of which was a 10% ROE. Prevailing historic low interest rates make it a tough environment for insurance company's return on investments and equity. Interest rates will surely rise someday and improve returns over time, but interest rates are out of management's control. Management is paid to spend their time on creating shareholder value through operations with the objective of always maximizing value for continuing shareholders.

The graph below illustrates the potential impact of ROE improvement on share price. As the ROE improves the market affords a higher share price to book value multiple, currently about 1.2X for peers generating an average 10.5% ROE. It shows the return to shareholders is huge if the new leadership continues to improve the return on equity.

Potential Share Price with Improved Returns on Equity:

Click to enlarge

Debt Reduction to Compliment Share Repurchase

Then as a bonus on Jun. 12, 2014 AIG announced it commenced cash offers for certain junior and senior notes for up to $1.5 billion. The company has been reducing debt to improve its credit rating and prepare the company for Federal Reserve oversight. Chief Financial Officer David Herzog said about 40 percent of AIG's debt is from the 2007 and 2008 financial crisis where borrowing cost were much higher. The offer includes securities where AIG is paying more than 8 percent.

There will be bumps on the road but improving operations helped along with rising interest rates will improve ROE and just getting to the peer average of 10% is potentially worth about $60 billion in share price appreciation or another $45/share to shareholders.

Summary:

The last major asset sale and changing of the guard closes another chapter in AIG's long history. Peter Hancock and Jay Wintrob are in position to create a very positive new chapter. They are improving operations and seem to be the right guys to keep that momentum going. Robert Benmosche demonstrated that with the right leadership amazing turnarounds can occur. It's exciting to start exploring the question; how much more can the new leadership achieve?

Disclosure: Long AIG