- Numerous one-time items will obscure the company's actual earnings this quarter.
- Expect a big jump in book value per share due to one-time items.
- Traders will make first moves based on the combined ratio of P&C Division. Look for a ratio below 101.2.
- Investors are looking for concrete plans for future capital deployment - but may not get it.
American International Group (AIG) is scheduled to report earnings after the close on Monday, August 4th. The conference call will be the following morning at 8:00 EDT.
On July 22nd, Travelers (TRV), one of AIG's competitors, reported disappointing earnings. This weighed on the insurance sector for the rest of the week. The big problems with Travelers earnings report were larger than expected catastrophe losses. Additionally, Chubb (CB) reported lower than expected earnings on Friday and lowered full year 2014 guidance. AIG is also on a run of below-expectations reports with three disappointing earnings in a row. Following these three reports, shares fell 4%, 1%, and 6.5% the subsequent day. All of these factors suggest AIG could miss earnings when they report.
Since the last quarterly report, there have been numerous settlements, announcements, and sales which will impact the upcoming report. Here's a run-down of the big events at AIG this quarter. These changes will serve to muddy the water and make it hard to figure out how the company is doing.
On May 14th, the sale of ILFC (AIG's aircraft leasing business) to AerCap Holdings (AER) finally closed. As part of the sale, AIG received $3 billion in cash and a 46% stake in AerCap equity worth roughly $4.4 billion today. AIG has been trying to sell this business for several years. In 2012, AIG agreed to sell the business to a Chinese consortium for $4.8 billion. Luckily for the company, that deal finally fell through in late 2013 and was finally sold for much more this quarter.
This transaction gave AIG net cash proceeds of $2.4 billion. The sale will be recorded this quarter as a $2.2 billion gain (pre-tax) and will result in a book value increase of $0.97 due to the higher sales price and removal of around $25 billion in ILFC-related debt from their books. As a result of this transaction, the earnings should be extremely good - but only after accounting for this one-time item. Expect AIG to focus on this positive improvement in their balance sheet in the press release.
Another implication of this sale and subsequent change in the balance sheet is the potential for a credit rating upgrade. In each presentation made during the quarter, the company has highlighted the fact that this transaction is very credit-positive and they are expecting some sort of reaction from the ratings agencies. None of the agencies have acted yet to increase the ratings and all have a stable outlook.
On June 5th, AIG began deploying some of the cash they received from the ILFC sale. The company increased the share repurchase authorization by $2 billion. Also in this announcement the company updated the public on the status of the previous repurchase agreement. Through June 5th, the company repurchased $418 million in stock in Q2 or roughly 8 million shares. This is welcome news because many analysts were disappointed at the pace of repurchases in the first quarter of the year. If the company continued buying shares at that pace through the end of the quarter, they would have repurchased close to $600 million in stock. If the repurchases in the quarter come in below this level, look for continued analyst disappointment.
Lastly, the big news of the quarter was the announcement that AIG's very well-respected CEO, Bob Benmosche, will be retiring on September 1st. He has guided the company though a rough period and has gotten the company pointed in the right direction going forward. The new CEO, Peter Hancock, should keep the company moving in the direction Benmosche has gotten the company pointed. I don't expect any meaningful changes resulting from the change in leadership. There will probably be a good portion of the conference call devoted to well-wishes for Mr. Benmosche - deservedly so.
Since the end of Q2, there have been a few announcements which will begin to complicate the Q3 report as well. On July 1st, AIG announced they were redeeming close to $2 billion in bonds due in 2016 and 2017. These bonds paid interest rates of between 3.8% and 4.875% so this should free up incremental cash flows over the next few years. On July 21st, it was reported that AIG had received roughly $2 billion in settlements related to crisis-era MBS - including $650 million received from Bank of America. Some of the $2 billion will probably be recognized in the Q2 report while the rest, including the Bank of America settlement, will be recorded in Q3.
As a result of the changes noted above, the company's book value will probably report a big jump. I would not be surprised if the company reports a 4% to 5% increase quarter-over-quarter - to a level above $68 per share. Book value has been growing at around 10% per year.
Note that AIG has a lot of business in Japan. The typhoon that hit Japan in early July will impact the Q3 report in November - and could cause executives to tamp down expectations for that report during the Q2 conference call. For those with a bearish thesis on the stock, this typhoon could serve as evidence that the company's loss ratio won't meaningfully improve any time soon.
In addition to the news this quarter, the company has a number of strategic initiatives and capital management changes which are in progress. As the initiatives are executed, they will also result in one-time charges or gains.
One of the strategic initiatives that AIG is working on to streamline their business is winding down their direct investment book that is held at the parent-company level. During the Q1 report, it had $7.9 billion in equity allocated to it. The company expects the wind-down to be completed by 2018 which will free up this equity for other uses. The $2 billion in bond repurchases announced on July 1st was funded with cash from the direct investment book, so the company is making progress with the wind-down effort. As the wind-down progresses, additional capital will be freed-up and gains or losses will be recognized on assets sold out of the portfolio.
On a capital management note, AIG has mentioned that they are planning to monetize their stake in AerCap once the 15 month lockup expires. This should give the company an additional several billion dollars to deploy.
One of the positives for AIG over the past several years has been the company's deferred tax assets (DTAS). This has allowed the company to minimize taxes to a large extent for the past several years. The company expects these assets to provide nearly a $1 billion boost to earnings this year and at least this amount going forward until they run out. The DTAs will run out in 2020 or 2021, at which point the company's earnings will drop to reflect taxes paid. Until then, these assets meaningfully boost the company's earnings and free cash flows.
These recent moves to deploy capital are good steps in the right direction but investors are going to be expecting more concrete information about the company's plans going forward. With the large influx of cash this quarter, they will have plenty of capital to deploy. If the company is vague about plans, shares could come under pressure. The company has been vague about capital plans in past calls. They have stressed numerous times that they don't want to make any plans until they work with credit ratings agencies to make sure they get a ratings upgrade. One additional overhang on the company is still present - the implications of the non-bank SIFI designation. The stress test criteria and minimum capital levels have not been set. The company could hold off on broader capital deployment planning until these rules are set to ensure they don't do something regulators would not approve of.
From a high level prospective, AIG is still cheap - trading at a forward PE ratio of 10.8. The stock is up just over 6% this year and trades at only 83% of book value. The company's valuation may provide a floor under the stock if earnings don't turn out well - but the stock had a big 2013 so the floor may be lower than most are comfortable with. If this quarter turns out badly, expect to see a lot of discussion on AIG as a value trap or dead money because the company has already had three disappointing quarters in a row.
One continuing disappointing aspect of AIG is the high loss ratio. It has continued to be over 100 meaning they pay out more in claims than they receive in premiums. AIG has provided guidance that the ration should drop by 2% to 3% per year for the next several years - but they have warned that it will not be a linear drop. AIG has not reported a profit in P&C underwriting since Q1 2013.
Given all of these one-time items to obscure the earnings from continuing operations, I expect investors will largely ignore the actual earnings reported and make their first move based on the combined ratio of the company's property and casualty division during the quarter. During Q1, the combined ratio stood at 101.2. If that number does not change much or goes up, expect more selling in the stock.
Longer-term investors should not make any moves until after the conference call to hear about the longer-term trends in the business and capital planning. Regardless of the earnings reported this quarter, AIG still has a lot of capital they can deploy and the stock trades at a very cheap valuation. Once this capital deployment starts in earnest, I expect the stock will again be a very poplar investment.