AIG - Undervalued And Misunderstood

Apr.17.12 | About: American International (AIG)

If you do what everybody else is doing, you will get what everybody else is getting. And that is not what you want. This was, is, and will continue to be my guiding investing principle. In fact, in its purest form you would want to position yourself in a way that is most contrary to the mainstream opinion, as price inefficiencies are largest. It often helps to look for markets, sectors and companies whose prospects are clouded by uncertainty.

To make things perfect, prices just collapsed and common stock investments are shunned by the average investor. This is the time to buy. The more noise in the market, the greater the uncertainty, the better the value to be found by skilled value investors. It takes some experience and certain boldness to buy when everybody is selling or neglecting a stock. However, this is the place to fish.

It often pays to look for alternative fishing spots, where there is less competition for whatever reason. In fact, the best personal investment decisions I ever made were totally against mainstream opinion and where I used to purchase more of an investment when it got even cheaper. I have no idea about market timing, and I do not overly believe in diversification. All I do is look for common stocks that are deeply unloved, preferably hated, off the radar (not being covered by analysts) and equally important: distressed. These criteria often go hand in hand.

I do receive an occasional e-mail from a sophisticated investor who asks me about the assumptions that I use in my financial model or my EPS estimates for next quarter|year. With full respect, these investors do not understand what I do. I do not care about whether a company's EPS 2012 will be $1.70 or $1.85. It simply doesn't interest me. Point estimates provide just too much error potential rendering your financial model meaningless if you miss.

Rather than asking "what is the EPS in 2012?," investors should ask: "Can I buy a common stock today at a price that gives me a reasonable chance of performing well even if the EPS will only be $1.70?" This leads to margin of safety investing which should seem very accessible, but unfortunately it is not. In addition, we are in for the long-term and couldn't care less, provided of course, we invest in a quality business.

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AIG (AIG) common stock

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AIG metrics

  • Market capitalization $61.61bn
  • Forward P/E 11.24
  • PEG 0.43
  • P/B 0.59
  • Discount to book 41%

My readers know that I first purchased AIG common stock in 2010 and was awarded option dividends in the context of the recapitalization of the company in 2011. A lot has changed since then, both the company's progress as well as my attitude for the investment itself. Truth be told, I wished I had invested more in AIG. Even though AIG's share price increased substantially over the last quarter, there is still a lot of despise for the company tainted by the government bailout in 2008.

Investor sentiment seems to be changing bit by bit (only because prices are rising) which I don't like at all. I like a stock that unloved und shunned to stay low longer so that I can buy more. With feelings of unease I was made aware that certain hedge fund managers in the US are loading up on AIG and pitching their purchase on CNBC, the market proxy. I would have liked AIG to be shunned a little more so that I would have a chance to invest more of my money in this fabulous but fallen icon. I think it is getting clearer now by the month, that we are in the later stages of an early economic expansion and could reasonably expect that stocks are going to do well. Especially the cyclical ones.

I think I do not add any value to the investment decisions of my readers if I just give a repetitive discussion of the events that led to AIG's fall. The 2008 annual report highlights a comprehensive discussion as to why AIG faced a liquidity crises and the managerial decisions that led to this situation. Instead, I would like to reduce the uncertainty surrounding AIG and demonstrate the value that is inherent in the company.

AIG consists of two main insurance subsidiaries, a property casualty unit, Chartis, and a life insurance unit, SunAmerica. Both subsidiaries have been profitable during the financial crisis. This is an important but overlooked fact in the evaluation of the company. Those two insurance subsidiaries are estimated (based on management guidance) to produce $4-5 billion a year in dividends that are being paid to the AIG parent.

The losses, and their sensational dissemination, resulted from AIGs Financial Products division that sold credit default swaps (CDS) on mortgage bonds to hedge funds and banks without reserving for it. In fact, huge deficiencies in risk management led to magnifying losses once credit events were declared and the company was supposed to pay out huge sums to their counterparties. This particular event triggered the government bailout.

I want the reader to understand that AIG has almost completely wound down the AIGFP unit, dramatically reducing CDS exposure as can be seen in the following chart.

The insurance units, meanwhile, did just fine.

The mortgage bonds that AIG insured, which became illiquid during 2008, were bought by the New York Federal Reserve. In fact, the New York Fed financed so called special purpose vehicles (SPVs) that purchased and were secured by AIGs bonds. AIG kept a residual interest in both Maiden Lane II and III SPVs and is likely, in my opinion, to capitalize on the recovering CDO values.

What the market not truly seems to appreciate is that there is a lot of value in the SPVs left. Maiden Lane II consisted of residential mortgage backed securities and Maiden Lane III of CDOs that continue to receive principal as well as interest payments of the underlying mortgages. In addition, the Fed always has the possibility to sell the SPV assets and can apply those cashflows against the outstanding principal. Interesting to note is, that the interest in these assets has been increasing recently, leading to rising prices which in turn leads to a faster than expected reduction in the Feds SPV balance.

According to the waterfall structure, AIG will participate in the recovery of the CDO asset prices once the Fed interest has been retired. AIG keeps a $5.7bn equity interest in Maiden Lane III. The following chart is from the Federal Reserve Bank of New York and indicates the progress AIGs assets made in reducing the Fed balance.

I assume, just based on the increased interest and competitive bidding for the CDOs in ML III, that the outstanding balance will be reduced to zero this fiscal year and the equity interest will exceed $5.7 billion. Even if it takes longer, the message is quite clear: The company if freeing itself from the Fed and the Treasury department that still holds 70% of AIGs outstanding common stock (already been reduced from 92%). ML III is the only SPV left holding debt instruments. ML II was already fully repaid in March. The progress the assets made in terms of paying down the balance with principal, interest and sale proceeds can be seen in the following chart:

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In addition to ML II and III, AIG made huge progress in reducing its debt by retiring the AIA SPV preferred interests which were secured by shares in the Hong Kong listed AIA insurance company of which AIG owned 33%. In order to repay the Fed interest AIG reduced its AIA stake to around 20%. The bottom line is that AIG has made significant progress in repaying the Treasury and the Fed.

The outstanding balance now owed to the government and the Fed by AIG amounts to roughly $45bn of which $36bn consist of common stock and around $9bn in ML III outstanding balance ($10bn based on FY2011 numbers from December, so CDOs will have continued to pay down the balance for another three month and proceeds from ML II will have been applied to MLIII).

From a capital infusion and capital management point of view, AIGs aircraft leasing unit plays a crucial role. Defined by management as non-core, AIG already filed an S-4 with the SEC indicating its intent to sell the subsidiary in an IPO over the next year. I assume the proceeds from the ILFC sale to be around $7bn based on Air Lease Corporations (ILFC competitor) IPO book valuation.

Furthermore, based on past net operating losses that occurred during 2008, the company will be sheltered for years against paying taxes. This has a significant NPV impact and truly is an asset.

Summary

AIG's insurance subsidiaries are healthy, established and continue to grow revenues and profitability. Dividends to be received by the parent company are expected to be between $4bn and $5bn dollars. If the investor applies a conservative multiple of 12 of its midpoint of earnings estimate the value of the company should be around $54 per common share. In addition, the company currently trades at a discount from book value of 40% providing a comfortable margin of safety.

In the past and in more normal environments AIG was trading with significant premiums to book value. My guess is, that AIG as a financial stock will again trade not only at book value but at a premium, like almost all financial stocks have been in the past.

One last point: The one main issue that hangs over the stock is what commentators call share overhang. Since the Treasury owns 70% of common stock, they say, the supply of stock will be highly depressing the price of the stock for a long time to come or at least function at a ceiling. Let them believe that and let them stay away from the stock. Instead, let them buy when the Treasury has sold all its shares.

The points I have outlined above have actually already been made by AIG's management time and again, but since the stock is unloved and tainted by its huge sensationalist publication of its bailout, managements explanation falls on deaf ears. The share overhang will not be a problem. The share overhang will be insignificant and it will be irrelevant.

For one thing, AIG's CEO, Benmosche, has a proven track record of under-promising and over-delivering. The capital that is available to the company from the IPO of ILFC ($7bn), the residual interest in ML III (at least $5.7bn), the shares in AIA ($8bn), the dividends from the insurance companies ($4-5bn) free up cash to repurchase shares directly from the Treasury and are shareholder value accretive as long as the company can buy back common stock at a market price below book value.

This is an important issue: As long as AIG can buy back its own shares for less than book value, which is currently around $56 per share (likely to be higher now as Q1 2012 is not reflected yet), the book value per share will increase. The book value per share is an important value metric for an insurance company. For the value investor this means: Ceteris paribus, the margin of safety increases through capital management.

In fact, AIG has already begun repurchasing shares from the Treasury in March by committing $3bn. I personally propose, that AIGs management is eager to reduce the Treasury stake as fast as possible pursuant to certain liquidation constraints and timing of cash inflows. In the end, a significantly reduced amount of shares will be sold to the public, if at all, marginalizing any discussion today of what might or could go wrong. Like in life in general, as in investing, most problems are purely imaginary and simply do not materialize.

To be able to buy a market leading insurance company with healthy, profitable insurance subsidiaries at half book value seems to be a very interesting investment. I have recognized, though, that interest in AIG has been increasing lately. A good (in this case a bad) indicator is always the number of sell-side analysts coming around. The more a company is covered, the more investors are interested bringing the company into spotlight. Yet, we are only at the beginning of a recovery and financial stocks should do fine over the cycle. The share repurchase program should function as a major catalyst.

My experience-based prediction is, that the intelligent investor who buys today at roughly half book value will be astonished by the sudden interest of institutional and retail investors in AIG once the headline reads that the company again is in private shareholder hands. I also consider it highly likely, that once AIG announces that it is no longer owned by the government, a true media frenzy and coverage storm about the company is going to propel AIG to all newspaper headlines in the world. I do believe, though, that a smart investor should rather buy today at these reasonable valuation levels.

Disclosure: I am long AIG.