We were pleased to get such a strong reception when we published our first report on American International Group (AIG) back in August. We are especially pleased to see it paying back its $182B bailout that the American taxpayers provided to it during the financial crisis. The good news is that the taxpayers have received a nominal profit of $15.1B and the Treasury still holds about $8B of AIG stock representing 15.9% interest in the company. We won't spoil the mood and point out that the return on capital for this investment is only about 13% cumulative over four going on five years, which is quite low for investing in a financial institution (even if it is a government stake and even if the government has first liquidation security preference).
However, we are pleased that AIG has returned to profitability and it could potentially eliminate the government ownership of the rest of its shares next year. We think that investors should take advantage of potential Hurricane Sandy weakness in the market to enter a position in AIG or add to their stakes. That way, they don't blow their chance at picking up AIG at a 45% discount to book value.
We reiterate that when investing in turnaround companies such as AIG, we believe that investors should view their potential investments as a collection of exposures. We believe that investors should view AIG as four firms consisting of the following exposures:
- Chartis (AIG Property Casualty): Chartis is AIG's Property Casualty Division and is the largest division of AIG. It offers property, casualty, specialty and professional liability insurance to individuals and consumers. Although AIG has announced the rebranding of Chartis back to AIG Property Casualty and has already rebranded it for its financial reporting, the Chartis Insurance website is still active as of November 1st.
- SunAmerica: SunAmerica is AIG's Life Insurance and Retirement Services Division and underwrites life insurance and annuities sold to individuals and groups. It also sells third-party mutual funds and financial planning services as well. SunAmerica sells its products and services through affiliated and non-affiliated brokers, agents and non-affiliated financial institutions, as well as through direct-to-consumer platforms. Although AIG has announced the rebranding of SunAmerica back to AIG Life and Retirement and has already rebranded it for its financial reporting, the SunAmerica website is still active as of November 1st.
- International Lease Finance Corporation: ILFC generates its revenues primarily from leasing new and used commercial jet aircraft to foreign and domestic airlines. Its biggest competitor is GE Capital Aviation services, a subsidiary of General Electric Corporation's (GE) GE Capital division.
- AIG Other Operations: Consists of corporate expenses, retained interests in assets businesses sold and assets AIG is trying to shed or run-off.
Source: AIG Q3 2012 10-Q
Evaluation of AIG's Strategic Corporate Finance Performance:
AIG was able to release $1.3B of its deferred tax asset valuation allowance during the second quarter period and this allowed the company to generate a $593M income tax benefit for the period even though the company generated $1.75B in pre-tax income. In Q3, the company's tax cash expense of $199M was less than its accrual basis tax expense due to AIG's ability to utilize net operating loss deferred tax assets during the quarter.
AIG repurchased $5B worth of its stock during the first half of 2012 and followed that up with a $3B repurchase program in August and a $5B repurchase program in September. AIG's shareholders' equity decreased by $3.115B in Q3 2012 versus Q2 2012 as the company's $1.86B in net income and $3.1B in net unrealized gains on its securities held on its balance sheet was offset by the $8B of share repurchases. We'd like to see AIG repurchase the rest of the Treasury's stake as soon as possible because AIG can certainly afford to do so and it would give itself a nearly 14% boost in its EPS for FY2013 by doing so if it can do it by December 31st 2012.
Source: Bloomberg LP and Saibus Research Scenario Analysis
Evaluation of AIG's Business Segments
AIG Property and Casualty: AIG Property and Casualty saw a slight decline in its net premiums earned for the quarter and for the year to date periods versus last year's comparable periods. It saw a strong benefit from reduced claims and claim adjusted expenses (9% for Q3 2012 and 14% for YTD 2012). This was partially offset by a 7% in Q3 2012 underwriting expenses (11% for YTD 2012). This enabled AIG to reduce its Q3 2012 underwriting loss to $441M from $532M in the prior year's period. Net investment income and realized gains jumped by 28% in Q3 2012 versus Q3 2011 and this enabled Chartis to rack up $949M in Q3 2012 pre-tax income, which was comparable to the $961M in Q2 2012 and was a 72% jump from the prior year's period. Chartis's reduced claims and claim adjusted expenses was due to lower catastrophic losses and underwriting improvements. It will be interesting to see what Q4 2012 brings thanks to Hurricane Sandy.
AIG Life and Retirement: AIG Life and Retirement had better results for Q3 2012 versus Q2 2012 period. In Q2 2012, the company saw its pre-tax income increase by only 1% year-over-year due to weakness in its Retirement Services business. In Q3 2012, the Retirement Services division benefitted from strong capital markets in Q3 2012 versus Q3 2011 to increase its operating income by 163% and go from a -$126M loss in Q3 2011 to $336M in Q3 2012.
The division saw a slight decline in premiums for the quarter and year-to-date period, which was offset by increased policy fees during this time period. The division benefitted from strong increases in net investment income and a sharp increase in realized capital gains. The division saw a steady reduction in operating expenses, which was offset by a negative impact from the change in benefit reserves and DAC, VOBA and SIA related to net realized capital gains.
International Lease Finance Corporation: The good news for ILFC is that its revenue registered a slight increase in Q3 2012 and YTD 2012 based on an increase in interest and other revenues. ILF's pre-tax segment income increased by $1.3B on a year-over-year basis for Q3 2012 and H1 2012 versus the respective 2011 time periods due to sharply reduced impairment charges resulting from unfavorable trends affecting the residual values of certain aircraft types. Another piece of good news for ILFC is that its competitor GE Capital Aviation Services saw its Q3 2012 revenue slip by 1% for Q3 2012 and 50bp for YTD 2012.
The bad news is that despite GE Capital Aviation Services having only ~9% more revenues than ILFC in Q3 2012, GE Capital Aviation Services has earned 2% more profit in Q3 2012 than ILFC earned in the first nine months of 2012. Even if we add back the impairments ILFC incurred in 2012 to its pretax income, ILFC's YTD 2012 adjusted pre-tax income is only 54% of GECAS's YTD 2012 pre-tax income. GECAS and ILFC both saw lower lease revenue due to early returns of aircraft by bankrupt lessees and lower lease revenue earned on re-leased aircraft in its fleet. Based on this negative disparity between AIG's ILFC Unit and GE Capital Aviation Services, we believe that AIG needs to take proactive steps to improve profitability, sell it to another firm like GE Capital or Steve Udvar-Hazy's Air Lease Corp. (AL) or spin it off to AIG shareholders.
AIG Other ("run-off assets"): We expect that this segment should "just not screw things up" and since this segment gained $891M in the quarter and $3.5B year-to-date, we can see that our expectations are being met here. The segment benefitted from $406M in gains from its direct investment book and $196M in profits from its Mortgage Guaranty and Global Capital Markets businesses. It also generated $857M in realized and unrealized gains on its Maiden Lane III retained assets interests and a positive change in the value of its AIA securities.
In conclusion, we are intending to hold on to our stake in AIG, as well as looking to selectively accumulate a larger position. Due to the market weakness and deep discount from market price relative to its tangible book value, we will be looking to opportunistically add to our position. The basis for our accumulate recommendation and positive outlook for the company is based on the following observations:
- ~45% discount for its market price relative to its book value
- $13B in net share repurchases YTD as of September.
- World-Class business operations subsidiaries
- Eventual sale or spin-off of International Lease Finance Corporation
- Revenue stability in business unit subsidiaries
- Reduced expenses for policyholder claims and benefits (reduced underwriting loss)
- Steady progress towards deleveraging
- Strong equity capital base
- Potential further share sales from US Treasury
- Rebranding of Chartis and SunAmerica back to AIG
Additional disclosure: This article was written by an analyst at Saibus Research. Saibus Research has not received compensation directly or indirectly for expressing the recommendation in this article. We have no business relationship with any company whose stock is mentioned in this article. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.