AIG Warrants: Leverage On A Book Value Bargain

| About: American International (AIG)

Summary

AIG shares trade at 0.79x book value as investor skepticism and below average ROE persist.

Share buybacks and operational improvements should drive book value and ROE higher over the next several years.

AIG warrants let current investors leverage this opportunity.

Insurance giant American International Group (NYSE:AIG) is best known for its role in the financial crisis bailouts. But after being reprivatized, AIG has made significant strides in rebuilding shareholder value.

For investors that expect the valuation gap between AIG and peers to close over the next several years, AIG Warrants (AIGWS) represent an attractive option.

Hunting value

Since the financial crisis pushed AIG to the brink of collapse, AIG shares have traded well below both their book value and tangible book value. The table below sums up the discount to peers.

Share Price to Book Value
American International Group 0.79
Prudential Financial Inc (NYSE:PRU) 0.89
MetLife Inc (NYSE:MET) 0.85
Hartford Financial Services Group (NYSE:HIG) 1.03

But there are two main factors holding back AIG shares. The first is a return on equity that lags those of peers. This largely stems from a less than optimal combined ratio and much of the book value being tied up in a deferred tax asset. Clearly there is the potential for progress in the ROE area given the combined ratio is beginning to improve and the DTA can be monetized over time. Additionally, rising interest rates could help AIG boost its ROE by increasing returns on the investment side.

The second factor is lingering skepticism from investors due to AIG's troubled past and some concerns over reserving issues. Over the next several years, time alone will distance AIG from the bailout era. Reserving is another issue but more time should allow AIG to better resolve this issue.

Interest rate tailwind

The last several years have been a difficult environment for income focused investors due to extremely low interest rates. For insurance companies like AIG, this means lower yields from the investment side of their business.

There are already indications of interest rate hikes coming in the future and this should help to boost overall ROE by increasing investment income. However, central banks are also indicating that rate increases will be slow meaning AIG investors will need to hold for a long-term period of time to fully benefit from a change in the rate environment.

Earnings estimates

At this time, AIG trades at a reasonable 11.7x est. 2015 earnings; in-line with peers and well below the S&P average. Analyst estimates also expect earnings to see significant growth with shares trading at 10.9x est. 2016 earnings and 9.6x est. 2017 earnings.

While these estimates are a major discount to market averages, I do not see AIG as particularly undervalued based on forward earnings unless the industry as a whole can achieve a higher average multiple.

Catalysts

The bull case for AIG rests on a long-term value appreciation play. Nonetheless, there are some potential catalysts that could push shares higher sooner.

First is the beginning of interest rate hikes which stands to increase AIG's investment income. There is now an entire industry of analysts trying to predict the first Fed rate hike but most estimates center around late 2015 or early 2016.

A dividend increase could also push AIG shares higher as it would bring the current yield more in line with the 2-3% yields of rivals. While this could push AIG shares higher in the near-term, I do not expect any huge dividend increases since the company appears more focused on stock buybacks to capitalize on its book value discount.

Shares could also move higher if AIG announces another larger buyback. In the past, these buybacks have been well-received by the market and have made progress in reducing the number of outstanding shares and boosting book value.

Common shares vs. Warrants

AIG warrants currently trade with a 15.3% time premium so shares will need to see significant gains for the warrant total return to exceed that of the common shares.

For this model, I assume AIG reaches a 1.0 times book value valuation by January 2021. I view this valuation as reasonable given other insurance companies trade near this level and the 5.5 years until the warrant expiration date can give AIG time to close this gap.

Analyst estimates forecast AIG to have a 2015 year-end book value of $84 per share and increase book value 8.6% annually from there. With these estimates, AIG's book value at expiration would be roughly $127 per share. Using a 1.0x book value valuation, shares would be worth $127 each.

Under this scenario, common shares would gain 96.8%. Assuming a constant dividend rate would add another $2.75 in dividends bringing the total return to 101.0%.

At the same time, this scenario would produce a total return of 178.9% for the warrants.

Important to note is that if the total annual dividends rise above $0.675 per year, the warrants stand to receive adjustments to the strike price and number of shares each warrant can purchase. With the current dividend rate being $0.50 annually, the adjustment level is within reach but will require further adjustments to achieve. Meanwhile, AIG has been more heavily focused on share buybacks to take advantage of the discount to book value and boost book value and earnings per share.

Because of this, I view the buybacks as a good move from AIG management but do not expect the dividend adjustment feature to have much of an impact of the AIG warrants.

Risks

While I am bullish on AIG and see the warrants as providing superior returns, there are still risks investors should be aware of. First is that if AIG does not keep improving operations and ROE, its valuation may not be able to catch up to rivals.

AIG also has the potential to be negatively impacted due to its status as a non-bank SIFI. Further regulation could be imposed in this area potentially lowering ROE and valuation.

Warrants also require a timing element not required in common shares. A general market drop could push AIG shares lower alongside other stocks and if AIG shares were to fall below $45 at the expiration date, the warrants would be wiped out with no recovery potential.

AIG warrant takeaway

Warrants from American International Group provide a way for long-term investors to gain leverage in AIG's valuation recovery. While some risks still exist, risk-tolerant value investors may want to consider AIG warrants for their portfolio.

Disclosure: I am/we are long AIG WARRANTS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author does not guarantee the performance of any investments and potential investors should always do their own due diligence before making any investment decisions. Although the author believes that the information presented here is correct to the best of his knowledge, no warranties are made and potential investors should always conduct their own independent research before making any investment decisions. Investing carries risk of loss and is not suitable for all individuals.

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