|Shares Out. (in M):||1,485||P/E||0.0x||0.0x|
|Market Cap (in M):||71,280||P/FCF||0.0x||0.0x|
|Net Debt (in M):||19,000||EBIT||0||0|
Last Friday, AIG sold off from $52 and is now trading at $48 after providing a disappointing outlook. We believe the sell-off was over-done and has created an attractive entry point for long-term investors. We believe this is a when not if story, with a CEO who has done it before, including a massive multi-year share buyback plan, and a turnaround strategy that seems achievable. There could be 60% upside over 2 years if the thesis plays out as expected.
AIG has been written on the past on VIC and we refer you to those write-ups for more detail.
AIG is a compelling risk/reward as it in the midst of a successful turnaround to improve its core P&C business and return substantial capital to shareholders, while still trading a depressed normalized multiple.
Despite good stock performance since exiting government ownership a year ago, the business still is undervalued because the market is not willing to look past timing uncertainty with regard to both the operational turnaround and capital return. We believe these are both a question of when, not if, and if willing to look forward sufficiently long, an investment here could be highly rewarding.
AIG has a BVPS of $67, or excluding a large DTA, $52. To that, adding back the NPV of the DTA of ~$10, AIG has an economic BVPS of ~$62. At the current price it is trading at ~0.8x this number.
If the business can be improved, this is a cheap valuation that is not going to last. P&C comps trade at 1.2-1.3x book value, and Life comps trade at 1.1x. AIG on a normalized basis should be a ~60/40 blend of P&C/Life. AIG has the opportunity to improve its ROE and thus the multiple it deserves to peer levels, and this impact is magnified by a growing book due to earnings and accretive share buybacks.
Under non-heroic assumptions, we think BVPS less DTA will grow to ~$75 by YE 2016 and the valuation should approach 1x BVPS + the remaining NPV of the DTA will be $6-$7, for a total of over $80, up over 60% which we think is achievable sometime in the next 2 years. If the BV multiple begins to price in more of the turnaround before it is actually achieved, but as confirming signals emerge, you generate this return quicker.
AIG sold off last week on disappointing quarterly results. While there is a lot of noise in the earnings, the key disappointment was that management backed off their 2015 “aspirational goals” that were first laid out in early 2011. These goals called for a 10% or more ROE in 2015.
In the past, they had always remained committed to this goal without any further qualification but in this call, managmenet said they are going to stop talking about the goal because as we get closer to 2015, it starts to sound like guidance and they don’t want to break out more details on the plan. Although they remain committed to the goals and think they will get there, they did say that they are not sure they’ll get to the goal by 2015. The CEO said “it might be a little later.” Specifically, here is what the CEO said, which actually seems re-assuring to us long-term:
“And we are still, as I said, committed to them, but we are not sure whether we will get them done by 2015. And so, once we get closer and begin to comment on it, that is where the theory of guidance comes into play. So, I do want you to understand we are committed to them, we are working hard to get there and we will get there as quickly as we can.”
Another area of disappointment was that of the $1bn share repurchase authorization which started on August 1. In the quarter, they did only $192mm. They did get a late start in the quarter due to the board authorization but still, this indicates a slow pace. With the stock sell-off post the quarter, we can’t help but hope the buyback pace will improve materially in the Q4, which could make this Q3 blip a welcomed opportunity.
Finally, results in the business are uneven and progress is not linear, which is to be expected. In the P&C business, accident year combined ratio was 98%, slightly higher than the first 2 quarters and it is hard to see in the numbers a strong trend downward trend which is central to the P&C turnaround and improved ROE. Peers are showing total combined ratio in the low 90 so there is still a lot of work to do, and given the uptick this quarter for AIG, short term investors fear that the turnaround is not working. Also, the results from the legacy financial products areas (DIB and GCM) are lumpy based on mark to market activity. After several exceptionally strong quarters, these areas came down to earth and some street numbers had these areas continuing to deliver exceptional profit.
We think the concerns brought up above are short term and when looking out longer, these are all things that will get better and should drive significant stock performance.
P&C business is fixable
We believe that AIG is investing heavily in improving underwriting results. AIG had suffered from years of underinvestment in the years leading up to the financial crisis. The management team is creating world class technical and analytical systems to modernize the business and turn it into more a science, improving areas such as pricing, product innovation, claims management, and reserving. Expenses are continuing to run high until the modern systems make certain costs redundant. In other words, new systems and legacy systems are being run side by side until the legacy systems can be replaced. Our research indicates that there is no reason that AIG, given its mix of business, cannot earn peer like combined ratios in the low 90s. We do acknowledge that this is a long, difficult job, and do not expect a quick fix, but our research indicates improvement is achievable.
Significant excess capital and capital generation
The company has $17bn of parent liquidity. Less $10bn related to credit and contingent credit facilities and future maturities and stress needs of the DIB/GCM, that leaves about $7bn available. ILFC should sell in the near term for net proceeds of ~$3.5bn. This leaves over $10bn in parent liquidity, a significant portion of which is likely deployable.
On top of that, the insurance operations should generate conservatively $4-5bn in dividends to the parent each year, and because of the DTA, there should be another $1-$2bn a year available. Effectively, this is most of the pretax operating earnings of the business. Consensus type numbers are for $18bn in pretax earnings for 2014-2015, most of which should be available for capital return.
The aspirational goal calls for $8-$13bn in additional buybacks from 2013-2015. Given starting excess liquidity + earnings power of the business (without paying taxes), this looks conservative. Because the Fed is regulating AIG under an unclear framework for non-banks and because the company has recently not been aggressive in capital return, the market is only willing to give credit for relatively modest capital return. It also makes sense that the company doesn’t want to talk about bigger numbers right now. We think the aspirational goal number understates the true excess capital here available for capital return over time, but even so, this yields good upside.
Beyond 2015-2016 –there is still room for improvement
For the truly long term, just focusing on when AIG hits the old “aspirational goal” of 10% ROE understates the true earnings power of the business. With a rise in interest rates over time(benefitting the life business and overall investment returns) and continued improvement the P&C business, the business should eventually earn a 12% ROE, similar to historical industry returns over long periods of time. The industry pricing trends have been strong lately and the cycles are longer in nature typically.
We come up with a range of scenarios in 2016 where AIG could be earnings an 8-12% ROE. Year end BVPS in 2016 less the DTA will be ~$75 + the NPV of the remaining DTA would still be $6-$7. If AIG can get to the 10% ROE and receives a 1x BVPS multiple, the stock should be worth over $80 at that point. This represents over 60% upside, which we think can be achieved sometime in the next 2 years.
For a downside scenario, given the low current valuation, starting excess capital, and strong capital generation, we think any significant permanent capital loss is unlikely.
We and our affiliates are long AIG securities (AIG) and may buy additional shares or sell some or all of our securities, at any time. We have no obligation to inform anybody of any changes in our views of AIG. This is not a recommendation to buy or sell securities. Our research should not be taken for certainty. Please conduct your own research and reach your own conclusion.
|Entry||12/05/2013 04:16 PM|
I appreciate the writeup for not getting too 'bogged down in the details, but wanted to clarify a few things
a) Combined ratio target of the low 90's - conceptually, I get how they get there in the next 2-3 years, but it has been very hard to know how much is coming from improved loss ratio vs expense ratio for example and how long it takes to phase in (given rolling over of legacy business, walking away from some business & simply pricing new business smarter) etc. You say it won't be easy or short term, but would love to get some more color on how you got conviction this is achievable in the next 2-3 yrs.
b) Bridge of book value ex DTA of $75 - so going from $52 to $75 by YE '16 implies $23 of book value growth driven primarily by earnings. To make the math simple, let's say they earn $1 in Q4 '13, so that means they need to earn $22 over 2014-2016, or roughly $7 per year, which simply won't happen (the implied ROE is unthinkable at this point). So you must be factoring in material buybacks in your roll forwards driven by cash converted from the DTA as well as dividends from the subs. Can you clarify how much each factor is driving in that bridge to 2016 YE underlying book value. I ask b/c I want to make sure we aren't double-counting here.
c) Scenarios for 8-12% ROE - would it make more sense for a tighter range/steady state ROE for Life and then scenarios for Chartis? Are you holding leverage constant across those scearnios such that improvement in ROE is really an improvement in ROA, which in turn is driven off the combined ratio improvements?
d) Any specific names you think are attractive hedges to mute some of the equity market and rate risk that influences the stock?