Friday, January 18, 2013

AIG: "Bring on Tomorrow"

I was initially attracted to AIG because of the presence of a forced seller, the U.S. Treasury.  However, now most of AIG’s short-term catalysts have come to fruition in the last month and a half, including selling 80% of their airplane leasing business (ILFC) to a Chinese consortium, the Treasury selling their remaining equity stake for $7.6 billion, and selling the remaining stake in AIA for $6.45 billion.  They’ve also rebranded their Life Insurance & Retirement and Property & Casualty Insurance businesses back to AIG (from SunAmerica and Chartis respectively) and launched a prolific advertising campaign thanking America for the bailout.  Going forward AIG represents more of a post-reorganization that needs to execute the new business model for a period of time before investors will trust it again and revalue it alongside peers.

So the investment thesis for AIG is fairly simple, it trades at roughly half of book value and expects to earn 10% ROE by 2015.  If AIG is able to grow book value at 10% over the next 5 years and the valuation gap between market value and book value converges during that time, it implies a ~26% annualized return (or over 3 times the current price).  AIG has been accelerating the book value growth through buybacks recently, however these are likely to slow in the near term as the company is switching its focus to improving the company’s interest coverage ratio, by repurchasing or retiring outstanding debt.  A simpler capital structure should reduce interest expense, improve credit ratings, and reduce the overall cost of capital, all positives.  AIG has also mentioned its intention of paying a dividend in 2013, opening it to more income based managers.

There are two large risks in my mind, the first is the overheated bond market which is the primary asset class owned by AIG.  Interest rates are low, and insurance companies are leveraged due to their float, rising interest rates could be a double edged sword.  Rising interest rates will increase earnings on the float in the long term, but also put pressure on bond prices in the short term, so AIG will have to manage its duration and continue to diversify into other assets.

Secondly there is the regulatory overhang.  AIG is expected to receive designation as a non-bank systemically important financial institution (SIFI) in 2013.  If AIG is designated as a SIFI, it will be required to carry additional capital above other insurers, hampering their profitability and balance sheet flexibility to return cash to shareholders.

Robert Benmosche, CEO of AIG, should be congratulated for the job management’s done restructuring the company since the bailout.  As the business plan is executed and AIG repairs its image with the public, the shares should overtime move closer to book value resulting in a tremendous opportunity for the patient long term investor.

Disclosure: I own shares in AIG, another way to play this story is through the warrants

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