Description

            We believe that AIG is among the strongest and best positioned companies in the world and that its EPS can continue to grow at a 10+% average annual rate.   Yet, its shares currently are selling at less than 10X next year’s estimated EPS.  Using the S&P 500 Index as a proxy, over the past 30-40 years, a typical larger U.S. company has grown at a 7-8% annual rate and has sold at an average of about 15X earnings.  Based on this benchmark, we believe that AIG is worth in excess of 15X earnings.  Therefore, we conclude that, a year from now, AIG’s shares will be worth 50+% more than their present price – and thus that the shares currently are a bargain.

            We first became interested in AIG in 2005 when the shares were under pressure due to the company’s regulatory problems.  At that time, the shares were trading at about $60.  After speaking with the CEO’s of a number of AIG’s competitors and customers, we concluded that the regulatory problems would be solved quite quickly and that the new CEO, Martin Sullivan, was very capable.  Furthermore, we were comforted by the knowledge that the company’s board took the opportunity of Hank Greenberg’s departure to conduct a through review of the company’s reserves, internal controls, and financial reporting.  Thus, we were buying shares of a company that was being carefully vetted.  I note that all the company’s recent news has confirmed our earlier thoughts: the regulatory problems have been solved, Martin Sullivan appears to be doing an excellent job, there have been no material adverse reserve or other developments, and recent earnings have been strong.

            We agree that insurance is a competitive business – and that a typical insurance company earns a relatively modest return on equity – maybe 10-11% before the use of financial leverage, and 12+% with modest leverage.  However, our conversations with the CEOs of other insurance companies have led us to conclude that, in normal times, AIG should continue to earn ROEs in excess of 15%.  Reasons for this, given to us by AIG’s competitors, include:

1. AIG’s size gives it efficiencies of scale (its expense ratios are materially below average);
2. the company’s large capital base and geographic spread give it a competitive edge when writing large, complex cases that involve risks in many parts of the world (one AIG policyholder told me that AIG was one of the very few insurers it could go to that had the capability to write a large and complex policy to insure receivables against political and other risks around the world);
3. The company’s very strong credit rating (AA) reduces its borrowing costs;
4. The company has fee based businesses (asset management) that require relatively little capital and that, therefore, that earn high ROE’s;
5. Over the years, the company has pioneered into areas of the world where competition is less than normal (Taiwan, Japan, Vietnam, China, Philippines, etc.) and therefore where margins and returns are higher than normal;
6. The company’s diversity permits it to pull back from soft markets and re-deploy its capital into stronger markets.

With respect to earnings and earnings growth, in a normal year, we estimate that about 35% of AIG’s operating earnings comes from property and casualty insurance, 15-20% from life insurance in the U.S., 30% from life insurance outside the U.S., and the remaining 15-20% from such non-insurance businesses as investment management, airplane leasing, and consumer finance.  The property and casualty business is quite mature and has been growing at only a mid-single digit rate.  AIG’s U.S. life insurance business is increasingly focused on the sale of “retirement” products (such as variable and other annuities).  Currently, such retirement products account for roughly 2/3rds of the segment’s profits.  As our country continues to transition away from defined benefit plans and toward 401Ks and other defined contribution plans, AIG and the other companies that offer retirement products enjoy good growth opportunities.  Over the past several years, AIG’s annuity business has been hurt by the flat yield curve.  However, in more normal times, we believe that the company’s domestic life business can grow at close to a 10% annual rate.  Over the past decade, the foreign life segment has been growing at a mid-teens annual rate – and, given the company’s opportunities in emerging countries, we believe that the segment can continue go grow at rates materially in excess of 10%.  It is difficult to project the growth rates of AIG’s non-insurance businesses, but considering the opportunities in the airplane leasing and investment management businesses, I would imagine that the non-insurance segments can continue to grow at 5-10% rates.

On balance, using the above estimates, we believe that AIG’s operating earnings can grow organically at an 8-9% annual rate.  When thinking about EPS growth, one must also consider that the company is generating large quantities of surplus capital that can be used for acquisitions and/or share repurchases.  If the company’s ROE is in excess of 15%, if its dividend payout is about 2% of shareholders’ equity (which it is), and if its organic growth rate is 8-9%, then, all other things being equal, the company annually should be generating surplus capital equal to 4+% of its equity base.  In February, management announced that, using conservative assumptions, the company had $15-20 billion of surplus capital and that $5 billion would be used this year to repurchase shares (this should reduce the number of outstanding shares by about 2.7%).  After consideration of surplus capital that is being generated, we conclude that AIG’s EPS should grow, on average, at a rate of 10+%.

There are some short term considerations.  The property and casualty market has been very firm since 9/11.  Thus, AIG’s P&C earnings have been at above trend-line levels.  However, insurance executives have told us that the reserve assumptions used for the 2003-2006 accident years likely were far too conservative – and thus that the P&C industry’s current earnings do not fully reflect the market’s recent strength.  We also were told that, in all likelihood, AIG’s earnings soon will start benefiting from positive adjustments to reserves.  Of note, in 2006, AIG reported roughly $2.5 billion of positive reserve developments for accident years 2003-2005 that were about offset by roughly $2.5 billion of adverse developments for accident years prior to 2003.  In a year when the P&C market was tight and earnings were strong, AIG had every incentive to make conservative reserving assumptions.  While investors likely will not “pay” for earnings derived from the release of reserves, the fact that AIG’s reserves were over-stated should give investors increased confidence in the quality of the company’s earnings and book value. 

      AIG’s reported 2006 EPS were $5.88 (before such non-recurring items as realized capital gains).  We believe that AIG had good reasons in 2006 to use conservative assumptions when calculating earnings, especially because P&C results benefited from abnormally high rates and abnormally low catastrophes (there were no hurricanes and earthquakes).  Looking ahead, we estimate that AIG’s EPS will grow at a 9% rate over the next two years to about $7.00 in 2008.  Negatives could include declining P&C rates (rates started declining last year) and a more normal level of catastrophes.  Positives could include a return to normal assumptions when calculating reserves, etc. and a material reduction (maybe 5+% over the two-year period) in the number of shares outstanding.  Also, AIG will benefit materially if the yield curve returns to a more normal slope.

In our opinion, the shares AIG, Hartford Financial, GE, 3M and many other high quality “growth” companies currently are out of favor because hedge funds and other aggressive investors have been focusing on stocks that are benefiting from near-term developments.  However, we believe that, over the longer-term, the stock market is a “weighing machine” – and that AIG’s risk-to-reward ratio is so compelling that we will earn a high return on the shares even if they remain out of favor for quite a while.  Thus, we are happy to be contrarians!

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