By Brian Pitkin :
Target Price and Rationale
At a 1.5x our estimate of Book Value Per Share, excluding AOCI and DTA corresponding with warrant maturity in early 2021, AIG's ( AIG ) stock price would double, and the warrant value would increase by a factor of four from today's $18.61 to over $82.
As for the business itself, book value is stronger with less downside risk today, and the business is able to post sustainably higher returns given the Berkshire (BRK.A) ADC, the significant fourth quarter reserve strengthening, and the dramatic reductions in the historically problematic casualty lines.
Expense controls, capital return, and underwriting discipline will also contribute to drive higher and ultimately more normalized returns and earnings power as warrant maturity approaches.
There are times when valuation work can be overly complicated. But if you need a highly complex spreadsheet to figure out if a company is undervalued, you already know the answer. Value should hit you in the face. We are paying below 80% of book value for a profitable insurer that operates at scale around the world with deep levels of both capital and liquidity. Combining normalized returns well above current levels with a return to more normalized valuations yields outsized return potential in the coming years. And, the TARP warrants allow for a potential quadrupling of value to maturity leading to annualized returns in excess of 45%.
The valuation of AIG and the duration and structure of the warrants afford strong margins of safety for an investment in the warrants of AIG. While investors are clearly dismayed yet again and AIG has lost credibility with many, the opportunity remains for those willing to see past the noise of the day.
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History May Not Repeat, But it Does Rhyme
In 2014, I spoke of an opportunity to earn four times your money in four years (in a talk that lasted four minutes). JPMorgan ( JPM ) was trading around $60 and its TARP warrants below $20. I spoke of late 2018 value of $120 per share bringing a fourfold increase in warrant value by its late 2018 maturity. I spoke of JPMorgan's dominant franchises in enduring business, historically strong capital and liquidity levels, best in class management team led by the best CEO in all of banking, all clouded under the seemingly intractable headwinds of regulation, litigation and low interest rates. (See below).
While there remains more to come for JPM and its business, today, AIG, in striking resemblance, is trading around $60 per share and its TARP warrants below $20, with a little less than four years to warrant maturity in early 2021. While AIG is better characterized as having good, rather than dominant, franchises in enduring businesses and has legitimate questions surrounding management and leadership, its capital and liquidity levels are strong, and it is aggressively returning capital, mostly in the form of buying back undervalued shares. As with the JPM warrants in 2014, we see opportunity in AIG's warrants to return four times your money in less than four years, summarized in these four pages. We will also share potential paths to value creation within one year while understanding the most appropriate investment thesis remains longer in duration.
As with any longer-term investment, highlights and lowlights were (and are) inevitable, and there has been a deluge of lowlights for AIG in recent months. But let's consider where we are. Book value per share (BVPS) ended the year at $76.66, and BVPS ex AOCI and DTA ended the year at $58.57. While its DTA is certainly not worth zero, we can use BVPS ex AOCI and DTA as a conservative foundation to consider where AIG goes from here.
Assuming BVPS ex AOCI and DTA grows 10% annually to the end of 2020, this measure of BV would be $86. In the broadest of strokes, returns on BV ex AOCI and DTA of 9% over time and DTA consumption less current dividend levels bring 10% growth, before the impact of highly accretive buybacks. And, the remaining DTA will have value. The ADC transaction with Berkshire also has a built in deferred gain which is recognized over time and additive to book value and returns.
As it pertains to the warrants, for dividends above a quarterly threshold, the strike price declines and the conversion factor increases. The exact calculation can be found in the warrant prospectus, but in broad strokes, the amount of change is dependent on both the quarterly dividend and the stock price prevailing at the time of dividend, so there are a range of outcomes for the eventual strike price and conversion factor. (By way of reference, the most recent quarterly change dropped the strike price by roughly $0.135 and increased the conversion factor by 0.003.) If we assume AIG trades only our most conservative metric of book value and assuming the strike has moved from $45 to $42.50 and the conversion factor has increased from 1.0 to 1.04 (both changes assume current dividend levels through 2021), we see warrant value increasing from today's $19 to near $46 (10% book value growth, 1x book value valuation). Higher than current dividends between now and maturity in 2021 would drive even further lowering in the strike price and a still higher conversion factor.
I would characterize this as the downside (but not draconian) scenario. As for potential upside, it would not be out of line with historic norms for AIG to post 12% ROEs and corresponding valuations in the 1.5x book value range where its better regarded competitors trade TODAY. (Also of note, over the 20 years before the crisis from 1988 to 2007, AIG's average price to book value was 2.5x.) At a 1.5x book valuation at maturity in early 2021, the stock price would double and the warrant value would increase by a factor of four. We would see a stock price at or above $120 which would correspond to value in warrants above $82. This is a more than fourfold increase from today's level of $19. While most important that the investment can bring good returns in downside scenarios, you can clearly see how historically reasonable scenarios can lead to significant upside results.
To consider this future valuation from an earnings perspective, consider that 12% returns on our more conservative measure of book value would drive earnings per share above $10 in 2021. Applying a historically reasonable 12x multiple to those 2021 earnings would bring us back to that same $120 per share value at warrant maturity. Measures of returns around 12% and value surrounding 1.5x book or 12x earnings are more than historically reasonable and have been well exceeded in the past.
As for the business, the most frustrating question has been AIG's reserve profile, and this was laid especially bare in its Q4 results. While a lot of ink has spilled about the oversized charges and the ADC deal with Berkshire, it is more instructive to consider where it leaves the company today. While penalizing, the reserve charge and ADC serve to strengthen and derisk what has historically been the most troublesome aspect of AIG: its reserves. Book value is now stronger with less downside risk enabling and higher, more normalized returns and greater BVPS gains. At year-end 2015, AIG had $35.7 billion of reserves in its long tail lines (those lines covered under the ADC). Berkshire has taken on 80% of the losses above a $25 billion attachment point up to a $50 billion detachment point. Thus, there is significant headroom for future adverse developments that would be largely covered by Berkshire, dramatically reducing reserve risk for AIG.
The Q4 2016 reserve strengthening and the Berkshire transaction clearly changed the dynamics for the company. But I would make another important and arguably underappreciated point which has further contributed to a lesser overall risk profile: the biggest problem area for AIG in recent years has been its long tail casualty business. Importantly, the Berkshire transaction covers casualty and financial lines from 2015 and backwards. But what is striking is how much casualty Net Premiums Written (NPW) shrunk beginning in 2016. To frame the magnitude of the shrinkage, consider that in 2004 casualty NPW were $15 billion and declined only modestly on a year to year basis through 2015. But dramatic reductions began in 2016 with NPWs shrinking nearly 40% from 2015 levels to $3.3 billion in 2016, a significant reduction year to year and even more dramatic considering the change from $15 billion in 2004. Additionally, AIG is expecting NPWs of only $2.5 billion in 2017. So there is significant cover from the ADC for business up to 2015 and dramatic reductions in business written thereafter. This is a dramatic reshape of AIG's business and risk profile. Book value is stronger with less downside risk today and the business is able to post sustainably higher returns given the Berkshire ADC, the significant fourth quarter reserve strengthening and the dramatic reductions in the historically problematic casualty lines. Finally, AIG increased its loss picks for both 2016 and 2017 which further adds to the strengthened nature of its reserve profile.
The scale of AIG's capital return program also deserves mention. After significant capital return in 2015 and prior, AIG committed to an additional $25 billion in capital return in 2016 and 2017 (including repurchasing outstanding warrants). These two years of capital return comprise 40% of AIG's current market cap of $60 billion. That is an astounding figure and cannot be looked past or dismissed. It should also be noted the Berkshire ADC transaction is estimated to release about $2 billion in capital over time which can used to drive additional capital returns. Buybacks can be either value destructive or value creative depending on the price at which they are done. At today's price levels, buybacks are highly accretive to intrinsic value.
Furthering actions under its control to enhance returns and building on recent years, AIG further reduced operating expenses in 2016 by $1.1 billion. The Company expects further expense reductions in 2017, which, along with continued capital return and improved underwriting performance, will provide important tailwinds to improved return metrics. Company-wide normalized ROE for the full year 2016 was 7.5% while the core operations posted normalized ROE of 7.8% (normalized results exclude prior year adverse development which clearly hurt reported results in 2016 but which, as described above, have been largely neutered going forward). For 2017, AIG expects its core operations to post normalized ROE of 9.5%, a sizable bump up from 2016. Importantly, the company has decent line of sight into these anticipated 2017 results as much of what will be earned in 2017 was actually written in 2016. Also, remember 2016 was a year of great change with dramatic reductions in casualty NPW. The company expects further ROE improvements in 2018 and beyond as expense controls, capital return, and underwriting discipline continue to bear fruit.
The valuation of AIG and the duration and structure of the warrants afford strong margins of safety for an investment in the warrants of AIG. While investors are clearly dismayed yet again and AIG has lost credibility with many, the opportunity remains for those willing see past the noise of the day.
What are the foundations of the opportunity?
Enduring Businesses - Insurance is a business that stands the test of time.
- Significantly More Durable Balance Sheet - The balance sheets and risk profile of AIG have undergone dramatic change since the crisis. AIG has substantially higher capital relative to assets, much higher liquidity and has largely eliminated short-term funding sources. The Company has essentially no notional derivative exposure. Since 2007, total assets are down over 50%. Total debt is down over 80% while its debt to equity ratio is down over 80% and its leverage ratio is down 50%. As above, its reserve risk has been substantially lowered.
- Simpler Operating Model - AIG has refocused back to its core functions by reshaping and simplifying the overall business. Multiple lines of businesses have been sold or wound down and the risks that led to its crisis have largely been eliminated. The Financial Products division that was at the core of its crisis era problems is gone. AIG exited the aircraft leasing business through a sale to AerCap ( AER ). In 2016 alone, AIG completed or announced over 10 transactions generating approximately $10 billion in liquidity. This is not the same AIG.
- Normalized Returns Well Above Current Levels - Expense controls, capital return, and underwriting discipline will drive higher and ultimately more normalized returns and earnings power as warrant maturity approaches.
- Historically Attractive Valuation - There are times when valuation work can be overly complicated. But if you need a highly complex spreadsheet to figure out if a company is undervalued, you already know the answer. Value should hit you in the face. We are paying below 80% of book value for a profitable insurer that operates at scale around the world with deep levels of both capital and liquidity. Combining normalized returns well above current levels with a return to more normalized valuations yields outsized return potential in the coming years.
- TARP Warrants Allow for Amplified Return Potential - The TARP warrants allow for more than a quadrupling of value to maturity leading to annualized returns in excess of 45%.
What about the next 12 months?
While I don't believe in the durability and sustainability of my ability to successfully invest with one-year horizons, let me offer a few thoughts on what could accelerate appreciation in the coming 12 months. Angst and noise are hallmarks of when profitable seeds are planted. For AIG, there is angst, and it is noisy, clouding investors to its historically attractive valuation.
There is clear frustration and fatigue amongst AIG's investors, some of which have the clout to drive change. There is clear emphasis on higher returns, and even greater levels of expense reductions may come if returns do not move higher. In short, it is highly unlikely investors will continue to stand by while the company posts subpar returns. While unlikely, what if AIG is sold this year? Or what if a new CEO (with a mustache) brings sufficient credibility for a valuation rerating comparable to its better regarded peers?
At 1.0x full BV (inclusive of AOCI and DTA) which will run to $80 this year, the warrants would double. At 1.5x full BV (below the Chubb/ACE multiple, near where some of its better regarded competitors trade currently and below historical valuation averages), our $120 share price and fourfold increase in warrant value comes this year.
In our more conservative stab at book value, we have excluded the value of AIG's DTA. Much talk has been made about the virtue of separating the life and retirement business from the P&C business, but a loss of the life and retirement earnings would degrade the value of the DTA by delaying its consumption. One thought to consider, however: given much of the separation challenge lies in the DTA, such challenges could be overcome by a buyer who would value the DTA higher than AIG.
What about the talk of Berkshire buying AIG? While I consider this unlikely, Berkshire has come closer to AIG with the ADC. Peter Eastwood, formerly of AIG, is playing a commendable role building a new line of business at Berkshire. Berkshire has the earnings power to more rapidly consume DTA. The life and retirement business does not seem to fit well, but the DTA impediments to a separation of that business should go away. Berkshire also has in place unencumbered equity to back P&C reserves, so the float could be invested at higher rates of return than currently possible at AIG.
Beyond and more important than these potential catalysts, on AIG's current strategic path, expenses will continue to decline, the aggressive capital return program should continue, newly reduced and more conservative underwriting should persist, returns should grind higher, and gains in book value per share will continue. Combining higher returns with higher levels of book value and more normalized valuations will allow time to be the ultimate catalyst for AIG and its warrants. In fact, a short-term win in the next 12 months has the potential to underwhelm the larger opportunity between now and warrant maturity.
The most significant challenge facing the company today is leadership turmoil. Compared to most other industries, businesses in the financial industry are served worst by a rudderless executive team. AIG runs great risk of being a rudderless ship at a time when staying the strategic course is imperative (cost control, disciplined pricing and underwriting, shareholder return). Other risks include:
Dramatic Step Up In Rates - While gradual increases in rates will help AIG, particularly in the life and longer tail casualty lines of business, a sharp and sudden upward movement in rates could cause problems as they tempt life policyholders to surrender existing policies. This could also coincide with investment portfolios reporting unrealized losses due to such higher rates, hurting capital levels. However, most products incorporate penalties for early surrenders making it more difficult for policyholders to withdraw their money working to limit the challenges in this scenario.
AM Best - AM Best is currently reviewing their ratings for AIG's operating subsidiaries. A downgrade of the P&C unit would likely cause AIG to downstream capital to that unit to regain a better rating causing a slowdown of its capital return plans. While AIG would likely overcome these challenges between now and warrant maturity in 2021, a downgrade would likely cause stock price declines and at least short-term business disruptions.
Reserves - Will Lucy pull the football away YET AGAIN in the form of additional reserve strengthening? The risk associated with materials charges is clearly not zero, but the significant changes discussed above bring added confidence (but no certainty) that the worst is over.
(Editors' Note: This is a republication of an entry in the Sohn Investment Idea Contest . All figures are current as of the entry's submission - the contest deadline was April 26, 2017).
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.