Monday, December 17, 2007

AIG - A valuable franchise on sale

With the global credit crunch and housing slowdown, many financials have suffered falls in their share prices. I believe that some financials represent good value but you must pick carefully. Some of the investment banks and mortgage and financial guaranty insurers in my view have very questionable balance sheets and some may only survive through large dilutive capital raisings. I believe the housing downturn in the US will be hard and last for several years, so picking financials with international exposure where economic growth remains favourable, which are not simply focused on housing and have excellent businesses is really the key to riding out this credit storm.

My favourite financial stock at the moment is American International Group (AIG).

Why do I like AIG? To put it simply…AIG possesses the best global insurance franchise in the world and it is trading at its cheapest valuation in over a decade.

Very few companies have attracted so much scandal over the last couple of years as AIG, yet this has not affected the underlying business performance which continues to be excellent.

AIG is a global financial powerhouse. It’s most important business is insurance . Around 80% of AIG’s earnings are split evenly between property and casualty insurance and life insurance and the remaining 20% of earnings come from funds management, leasing and other businesses. AIG’s international operations account for more than half of AIG’s profits.

General Insurance operations

AIG’s strength in insurance comes from its diverse product offerings by product line as well as its geographic reach. In its US general insurance P&C operations, AIG has over 300 products under each product category. This is an advantage because it allows AIG to focus on only those products which are the most profitable and use its capital most effectively. AIG is constantly innovating, introducing dozens of new products each year. Of note, AIG owns Lexington, one of the best excess and surplus lines businesses and its Private Client Group serves over one third of the Forbes 400 rich list. To demonstrate AIG’s competitive advantage over competitors, AIG’s large capital size allows it to offer wealthier individuals high policy limits for example with kid-nap & ransom insurance, also AIG offers its own fire emergency service to Clients.

AIG’s foreign operations are extensive and cover 11 regions and 130 countries. AIG’s presence in fast developing countries in Latin America and South and North east Asia will continue to provide big growth opportunities. Its foreign premiums grew at a decent 13.7% pace in 2006.

Whilst the insurance market is softening with rates falling by 10% generally across most non-catastrophe lines and 20% for catastrophe exposed lines, this is likely to be offset by continuing favourable loss exposure trends and higher invested assets leading higher investment income.

Life Insurance

AIG’s life insurance earnings grew 10% in 2006.

Overseas AIG has strong life insurance operations particularly in Asia. It is the largest foreign owned life insurance business in Japan and has a strong brand recognition with American International Assurance(AIA) throughout south east Asia.
In the US , AIG American General , is a leading life insurer and AIG Sun America is a big provider of retirement products and services as America’s baby boomers move to retirement.

Other businesses

Through International Lease finance corporation , AIG owns one of the largest lessors of aircraft in the world.

AIG Global Investment Group manages over $75 billion in non-afflilated client assets, making it the sixth largest asset manager in the world. It increased AUM at 21% during 2006 so this is a promising growth business for AIG.

AIG owns other financial service businesses including AIG Financial Products (customized finance and risk), Imperial A I Credit(finance insurance premiums) and American General Finance(consumer lending).

Great brand

AIG’s brand was nominated as the 47th best brand in the world and valued at over $8 billion. AIG’s logo can be seen on the famous red shirts of the Manchester United football team. I believe this is an excellent piece of marketing given the popularity of soccer particularly in many Asian countries where it is the number 1 sport.


Martin Sullivan has done a solid job as CEO since taking the reigns from Maurice (Hank) Greenberg. Greenberg was the driving force behind much of AIG’s growth over the last few decades and is widely regarded as an insurance visionary, filling his shoes is a big ask not to mention his political contacts and networks. But Sullivan’s pedigree is good. He has worked with AIG for over three decades so he knows the performance driven culture. Greenberg had previously ear marked him as a replacement even before the scandal that enveloped Greenberg. Importantly many of Greenberg’s key lieutenants stayed even after Greenberg left AIG.

Hank Greenberg has recently indicated he is not happy with AIG’s management and believes new changes need to be made. While I have no doubt Hank Greenberg could do a better job managing AIG (his record speaks for itself) I would tend to believe Hank as well as wanting more from management is also playing politics with his comments, after all AIG & Greenberg are in the midst of a big legal fight.


I believe that AIG’s foreign operations with strong economic growth continuing in Asia and Latin America and AIG’s non-insurance related businesses will continue to do well and help offset domestic weakness due to softening in insurance premiums and losses from AIG’s housing exposed businesses and mortgage investments. AIG’s non-reliance on the commercial paper markets to fund its operations is a key strength given the unsettled credit environment ikn their ability to hold their mortgage bonds to maturity. AIG could be expected to face claims from subprime lawsuits, these may be substantial but these are unlikely to be material to AIG , on the positive side they could also result in hardening of premiums in D&O & E&O lines.

Why investors currently don’t like AIG

AIG’s exposure to subprime debt and the housing market has resulted in AIG recording large unrealized losses in its mortgage guarantee business and mortgage investment portfolio. This has resulted in investors questioning AIG’s balance sheet.

AIG has been very open about its exposures and has provided a continuing dialogue. On December 7 , AIG indicated that since September 30, its credit default swaps sold through AIG Financial Products which provide insurance against defaults had unrealized losses of $1.1 billion. AIGFP insures super senior rated debt in which the likelihood of non-payment is very remote even under severe recessionary conditions. AIG maintains it is unlikely these unrealized losses will actually result in actual loss. Also AIG stated its mortgage bonds have lost $2.6 billion. This is a total of $3.7 billion in unrealized losses although AIG says its unlikely that all these losses will be actually realised. The exposure is large in my view but still manageable given AIG’s $100 billion in shareholder equity. Also it is worth bearing in mind that during the fourth quarter AIG’s foreign owned bonds and investments would have increased with the fall in the US dollar while its US treasuries would have likely increased in value.

United Guaranty (mortgage insurer) and American Financial Guaranty(mortgage provider) are two AIG businesses which will continue to post losses as the housing market worsens, my back of the envelope calculations put a worst case result for the two companies to post further losses of around $1.2 billion, depending on housing price depreciation. Again a hit that AIG is big enough to withstand.

So if you throw in the issue of subprime and housing correction, more headline scandals in the form of AIG/Greenberg lawsuits, a softening insurance market and a share price that hasn’t gone anywhere over 10 years and its no wonder investors aren’t buying AIG stock.

My valuation of AIG

Over the last 10 years since 1997, AIG’s book value has increased from $12 to around $40 today. That’s compounded return of around 13% p.a (Please note that this does not include reinvested dividends which would make the return higher, the current dividend yield is 1.3%. Over 10 years AIG’s net income has also compounded at around 13% annualised from $1.68 to $5.72 today.

But since 1997, AIG’s stock price has increased from $36 to just $56 today. That’s a compounded return of only 6% a year.

The reason why the stock price has not grown at the same pace as AIG’s intrinsic value is because AIG was overvalued in 1997. In 1997 the price to book value was 3.2 and PE was 23 whereas today in 2007, the price to book value is a much lower 1.4 and the PE is 9.7.

Management believe that AIG can continue to grow earnings at 10-12% over the next few years. That seems fair and even conservative, given AIG has managed 13% over the last 10 years. So I’m going to assume 12% growth.

If AIG grows earnings at 12% then in 2010 they should earn $8.43. If we apply a 13 PE multiple you would expect the share price would be $109, that would give a share price return of around 26% per year + 3 years of dividends would take it closer to 28%.

Using a price to book analysis. Given the high quality nature of AIG’s insurance business, considerable value in its non-insurance businesses that could potentially be spun off and its real estate holdings which would be stated at cost, a price to book value of 2 seems reasonable. If they grow book value at 12% over 3 years that’s $56, at 2x book value you would expect share price of $112 in 2010, double today’s price.

I believe the fair value of AIG today is $80-$85. Based on the current share price of $56 , the shares have close to 50% of upside in my opinion.

Maurice (Hank) Greenberg recently filed a 13D urging management change and a review of strategic alternatives for AIG. No-one knows AIG from the ground up better than Hank Greenberg. So for Greenberg to say the shares are undervalued is far more telling than some analyst from a brokerage house!


There are several

1. Value is its own catalyst. AIG is cheap at 9x earnings & 1.4x book, AIG’s insurance businesses & funds management operations continue to perform well and earnings continue to rise at a good clip. Looked at another way, if you put a value of 15x earnings on AIG’s large non-insurance businesses , then AIG’s insurance businesses are valued at just 7-8x earnings which is really cheap, as Chris Davis pointed out in Value Investor Insight May’07.

2. As investors become more comfortable that AIG’s subprime exposure and mortgage security writedowns are manageable, doubts about AIG’s balance sheet risk will dissipate. Even if AIG takes a $10 billion hit, that’s really just a few quarters of earnings and once the storm passes, those unrealized losses could reverse as valuations of mortgage securities are re-appraised.

On a recent conference call, CEO Sullivan said that AIG will be okay provided house prices do not fall 30% or more such that the Loan to value on mortgage securities drops. While I am not an economist or soothsayer, this kind of “depression” like outcome is very unlikely in my view.

Warren Buffett on a recent CNBC interview when asked is this like 1974? and he gave the short answer of “no”. So the Oracle of Omaha doesn’t believe a depression is likely but he does believe a recession is possible, I’m happy to bet that Warren’s right.

3. Another catalyst would be higher revenues from overseas operations with growth in emerging markets such as China & foreign exchange effects leading to higher revenues and earnings driving the bottom line even while US operations slow.

4. A final catalyst could be from activist shareholder Hank Greenberg who with his recent 13D filing is putting pressure on management for a splitting of AIG. There are two things here, the spin off or sale of AIG’s immensely valuable funds management, real estate and leasing operations could unlock considerable value for shareholders. Also there is a slight chance , Hank Greenberg could become a lot more involved in the running of AIG. The re-emergence at AIG of Greenberg ,who is such a shrewd operator in the insurance business, could result in AIG’s shares taking on more of a “Greenberg” premium.

But even if this possibility does not emerge I think AIG represents a good investment anyway at its current price.

Please note: The opinions expressed above reflect authors own point of view and are not intended as investment advice and should not be relied upon as such.

Disclosure: I own AIG stock


BuyLow said...

Right on; you must have read or heard the Dec 5 investor conference wherein AIG showed they know every "dot" in the portfolio FICO scores. The street I believe perceives AIG as a bank and not an insurance company.

Insurance companies, this one no exception, know how to manage and judge risk and typically invest as though they will hold the portfolio.

Big banks have historically looked for any pig to put on lipstick and then auction off for fees. No longer. I know I've worked for both.

Good post

Tarn P Crowe said...

thanks for your feedback buylow

Chus said...

This is what I think: AIG stock

Bean said...

Yes, a valuable franchise to the Fed!!! Hindsight is always 20/20, but I think this shows that you had no knowledge of their CDS exposure. That's amateur.