(Published Feb. 21 by Bob Ciura)
American International Group (AIG, Financial) stock tanked 9% on Feb. 15 after posting a huge $3 billion net loss for the fourth quarter.
This was due mostly to a massive $5.6 billion charge to cover future claims.
AIG was nearly ruined by the financial crisis, but it has slowly brought itself back from the brink.
It even resumed paying a dividend. After suspending its shareholder payout during the Great Recession, the company started paying dividends again in 2013.
The company has significantly grown its dividend since then. The quarterly dividend has grown from 10 cents per share in September 2013 to 32 cents per share for its most recent payout.
While AIG has a long way to go before it becomes a Dividend Achiever – you can see the full Dividend Achievers list here – it is well on its way.
The recent share price dip could give value investors a buying opportunity.
Business overview
Any time a company loses $3 billion in a single quarter, investors are right to be nervous. However, long-term investors have reason to see beyond the short-term challenges.
The huge loss stems from AIG’s approximately $10.2 billion payment to a unit of Warren Buffett (Trades, Portfolio)’s Berkshire Hathaway (BRK.B, Financial) in January 2016.
Under the deal, Berkshire will absorb significant long-term risks pertaining to U.S. policies that AIG had previously written.
Source: 4Q Earnings Presentation, page 7
While the move caused a huge upfront expense for AIG, the trade-off is that the deal meaningfully reduces its long-term reserve risks from these policies.
AIG is now only 20% exposed to the reserve risk from its legacy commercial policies.
At the end of 2016, AIG’s legacy portfolio accounted for 18% of shareholder equity, down from 24% at year-end 2015.
Source: 4Q Earnings Presentation, page 14
It now has $6.7 billion of legacy investments remaining on the books, compared with $10.2 billion at the beginning of the year.
2016 was a transformational year for AIG. It conducted over 10 divestitures that will generate approximately $10 billion in future liquidity for the company.
It accomplished several other goals in addition to lowering its long-term reserve risk profile through divestitures.
For example, AIG returned billions of dollars to shareholders and also launched a major cost-cutting program.
Source: 4Q Earnings Presentation, page 4
The actions taken in 2016 will allow AIG to reduce its expenses by $1.3 billion annually. In addition, the company announced a $3.5 billion share repurchase plan.
Finally, thanks to its lower risk profile and smaller legacy portfolio, there is a chance AIG could be removed from the government’s list of nonbank systematically important financial institutions (SIFI).
If AIG were no longer considered a SIFI, it could help the company with lower regulatory costs, which leaves more money for shareholders.
Collectively, AIG’s initiatives set the table for earnings growth in 2017 and beyond.
Growth prospects
AIG’s difficult year in 2016 at least sets up the company well in 2017. It has many growth catalysts to look forward to, most importantly a refocused business model.
AIG has transformed its business model to de-emphasize the legacy portfolio. This should lower future risk of impairments to book value and help lower the company’s cost of capital.
Furthermore, it allows the company to focus on the core operations, which are performing well.
For example, AIG’s consumer insurance business generated $3.8 billion in pretax operating profit last year, up 31% from 2015.
Source: 4Q Earnings Presentation, page 27
The consumer insurance segment consists of individual retirement, group retirement, life insurance and personal insurance products.
The consumer business stands to benefit from higher interest rates. The Federal Reserve has resumed monetary tightening, in light of the improving U.S. economy.
A rising interest rate cycle would be a tailwind for AIG because it allows the company to generate higher investment income.
Thanks largely to the Fed’s interest rate hikes in 2016, investment income rose 11.7% in the fourth quarter.
AIG’s other growth catalysts include cost cuts. AIG has taken significant costs out of its operating structure. In 2016 alone, the company cut operating expenses by $1.2 billion, or 10.7%.
Source: 4Q Earnings Presentation, page 12
Its ongoing cost synergies should be similar to 2016, which will help make the company more profitable.
Next, share repurchases will help boost earnings by reducing the number of shares outstanding.
All told, future earnings growth could easily reach the mid- to high single digits.
In 2016, AIG generated a 9.5% return on equity, and management predicts a higher ROE in 2017.
With higher-quality, more stable earnings, AIG stock could enjoy an expanding valuation multiple.
Valuation and expected total returns
The good news from AIG’s recent share price dip is that it has brought the valuation of the stock down to more modest levels.
AIG’s financial results in 2016 were marred by the charge taken against earnings in the fourth quarter. But on a forward-looking basis, AIG shares are cheap.
AIG stock trades for a forward price-earnings (P/E) ratio of 10. This is significantly below the S&P 500 Index average valuation.
Separately, AIG trades for a price-book (P/B) ratio – a key metric for insurance companies – of 0.74. This means the stock is currently trading at a discount to its book value.
On a relative basis, AIG is cheap as well. Consider the P/B values of AIG’s biggest competitors in the insurance industry:
The valuation spread between AIG and its industry peers could contract because AIG continues to grow its book value.
Source: 4Q Earnings Presentation, page 16
Going forward, the P/B ratio could rise, since AIG has less risk in its commercial insurance portfolio.
This could result in significant returns going forward. If AIG held a P/B ratio of 1.4, which would still be below average, its share price would nearly double.
Aside from an expanding valuation multiple, AIG’s future returns will be comprised of earnings growth and dividends.
Even with fairly modest assumptions, AIG could generate satisfactory returns:
- 2% to 4% revenue growth.
- 2% earnings growth from share repurchases.
- 1% earnings growth from cost cuts.
- 2% dividend yield.
Combined, this would result in 7% to 9% annual returns with an upside opportunity for better-than-expected results.
Final thoughts
Insurance stocks can be very rewarding investments. AIG had a tough time in 2016, but the huge loss helps pave the way for a better future.
AIG stock has a cheap valuation, and a firm growth outlook up ahead. The company is arguably in better shape than it has been at any point since the financial crisis.
The combination of a rising valuation multiple, earnings growth, and dividends, makes AIG an appealing stock for value and income investors alike.
Disclosure: I am not long any of the stocks mentioned in this article.
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