How American International Group Becomes A 5-Bagger In 7 Years

| About: American International (AIG)

It is very unusual when one can plot a course for a large cap stock to quintuple in value, but with AIG, I aim to do just that. The stock is significantly undervalued, trading at around 50% of book value. AIG has no doubt earned this discounted valuation because of the global financial crisis, and the fallout from the company's bailout. The bailout left the company with a huge stock overhang (now amounting to over $30bn), an uncertain earnings picture, and a big mess to clean up for management. However, time heals all wounds, and valuations gravitate to equilibrium. Over time, AIG's valuation will move towards equilibrium, and a lot of money will be made in the stock.

Depressed Valuations are Temporary

AIG, as well as the whole insurance industry, has over time traded at an average multiple that is significantly above book value. Currently, many players in the sector (including AIG) trade below book value. This is a function of several issues: First is that the fact that the whole financial sector valuation is depressed (many large cap players trading below book). Second, the insurance industry earnings picture has been rocky as players slowly recover from the financial crisis. Third, and most unappreciated, is that AIG has over $30 billion of stock set to come to market at 50% of tangible book value. All the abovementioned factors are depressing valuation. However, over time, these three issues will be overcome. When the above issues are resolved, I am confident that AIG stock will slowly but surely approach, and then trade above, book value.

Projected Book Value per Share of $150

AIG's book value is now approximately $60 per share. Management has made several statements stating that they are confident that the government will be able to dispose of its $30 billion shareholding by the end of the year. This will be done through buybacks combined with secondary offerings (my feeling is that at least 1/3 of the stock will be bought back by AIG). Since the buybacks will most likely be done at close to half of book value, they will be accretive (increasing book value per share). Below are some brief figures on how AIG will be able to fund over $10bn worth of buybacks by the end of the year:

1. Remaining Proceeds from Maiden Lane III - $7.5bn

2. Disposal of AIA shares - $6-7bn

3. ILFC IPO - Uncertain

4. Earnings - $2-4bn

Based on the proceeds from the abovementioned, AIG can comfortably buy back even half the shares owned by the government. Displayed below is the book value of AIG after completing the buybacks at approximately 30/share.

1. AIG buys back $10bn - Book Value goes to 75

2. AIG buys back $15bn - Book Value goes to 85

Then if we look at earnings, and assume a 10% compounding return on book value, the book value per share would double in 7 years taking the stock to $150-$170/share. That is how AIG stock becomes a 5-bagger, with upside if the stock trades above book.

What if AIG Misses the Targets Above?

The 5-bagger scenario is highly dependent of some major assumptions. AIG may not be able to grow book value at a compounded rate of 10% per annum. The company may also not be able to buy back shares at such a discount to book value. There is also a chance that the stock does not trade at book value for over 7 years. Even if you ratchet down these assumptions, you can still make good gains in the stock at today's prices. The beauty of it is: the longer the stock stays down, the more accretive the buybacks will be. It the stock pops you make money in the short term. If the stock stays down, there are greater chances for significant increases in book value leading to outsized gains in the long term.

AIG Warrants - A 10-Bagger in 7 Years

If you feel that the AIG 5-bagger scenario will play out, and you want some leverage, you can buy the warrant. The warrants were issued when the government took its shareholding in AIG, and allow the holders an option to purchase shares at a price of 45, with expiration being January of 2021 (8.5 years). So at today's price of 10.5, you are looking at a ten bagger in 7 years. This is why the warrants are my largest position.

Disclosure: I am long AIG.

Additional disclosure: Exposure to AIG is through the Warrants