Unfavorable Risk/Reward For Hartford Financial And AIG

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Includes: AIG, HIG
by: Takeover Analyst

As a result of the economic turmoil, many financials, in my view, have been overly depressed (see here). American International Group (NYSE:AIG) and Hartford Financial Services (NYSE:HIG) are two insurers with stressed fundamentals and significant volatility. From weak ROE to poor operational performance, these companies warrant a "hold" currently. I find that even though Hartford trades below intrinsic value, uncertainty will prevent meaningful value creation and benefit investors who look elsewhere.

From a multiples perspective, AIG is the cheaper of the two. It trades at a respective 2.3x and 8.8x past and forward earnings - depression levels. Hartford trades at a respective 7.3x and 4.5x past and forward earnings, but offers a dividend yield of 2.6%. Over the last 12 months, the former has lost more than half of its value while the latter has lost more than two-fifths of its value. The Street currently rates Hartford around a weak "buy" and AIG a "hold" - a sentiment that I more or less agree with.

At the third quarter earnings call, management of both insurers were frank about poor performance and macro pressures. Says Hartford's CEO, Liam McGee:

"The macro environment in the third quarter was the most challenging since I joined The Hartford. The economic recovery has been very weak, and we experienced nine different catastrophes during the quarter. Capital and credit markets were volatile, the S&P 500 dropped 14%, 10-year treasury yields were as low as 1.7%, and the yen strengthened by 4.6% in the quarter. However with these challenges, the quarter was a good test for the improvements we've made throughout the organization. Despite these events, the underlying performance of the businesses was good. The capital position remains strong, and the investment portfolio held up well. Results for the quarter were pretty much in line with what we provided in early October, with a combination of factors collectively impacting results. The third quarter was breakeven on a net income basis. Core earnings were $33 million and included several items we preannounced, including catastrophe losses of $134 million and $227 million of DAC unlock charges. While I'm disappointed with this quarter's bottom line results, I am proud of what the team has accomplished. If we had faced similar economic and market challenges when I joined the company 2 years ago, The Hartford's results would have been significantly worse".

Third quarter EPS of $0.05 was well below expectations and although the firm meaningfully de-risked the business, risk is still relatively high, even for the industry. ROE of 8.2% is low and needs substantial improvement to inspire investor entry. That management is now showing reservations about share repurchases only adds to liquidity concerns. Non-recurring expenses - deferred acquisition charges, industry assessment, etc. - ravaged earnings while DAC unlocking, in specific, negatively impacted wealth management. Aside from the one-time charges, a decline in capital and property casualty results gave me pause.

Consensus estimates for Hartford's EPS are that it will decline by 36.3% to $1.84 and then turnaround to grow by 82.6% and 11.6% in the following two years. Assuming a multiple of 7x and a conservative 2012 EPS of $3.31, the stock could have 48% upside. The firm is being valued essentially at 5x 2012 EPS that is 15% below the consensus, which illustrates the amount of fear surrounding the company.

AIG similarly has seen its brand name tarnished beyond what is reasonable. The firm has top positions in U.S. Life Insurance and Global P&C and has improved its pricing power in the latter. ROE could increase to 8% by 2015 - still low - given savings initiatives, capital management, and organic growth. With that said, third quarter earnings were dismal. Third quarter EPS came to -$1.6, far below the consensus of -$0.22, as all important segments showed weakness. SunAmerica - due to declining premiums and investment income - had operating profits below half of what was anticipated at $444M and Chartis margins declined by around 250 basis points. In addition, book value declined by 7% sequentially.

Consensus estimates for AIG's EPS are that it will decline by (-$14.49 in 2010 and) $0.86 in 2011 then increase by 203.5% and 10.7% in the following two years. Assuming a multiple of 8x and a conservative 2012 EPS of $2.54, the firm is fairly valued. If the multiple were to decline by 5x and 2012 EPS turns out to be 8% below the consensus at $2.40, the stock would fall by 38.4%. This unfavorable risk/reward warrants holding out for now.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.