(By Mani) American International Group, Inc. (NYSE: AIG) appears as a high beta risky name, but the stock continues to hold attractive upside without significantly more risk than other insurers.
The bearish investors are focused too heavily on the low return on equity (ROE) and low EPS at AIG, ignoring the significant value to be unlocked by cash-generating assets that don't produce GAAP after-tax income.
The bear case assumes that AIG cannot improve underwriting margins, loss reserves continue to bleed deficiencies and the Fed will prevent AIG from engaging in share repurchase.
"If we assume a catastrophe-normalized 103% combined ratio, 1.5% reserve fortification and an inability to reduce sharecount below 1.5B all in perpetuity, we arrive at GAAP EPS from insurance operations of $2.60," Deutsche Bank analyst Joshua Shanker wrote in a note to clients.
Meanwhile, discounted cash flow from the deferred tax asset (DTA) contributes an incremental benefit to shareholders above insurance earnings power, less corporate expenses.
AIG has $24.7 billion of deferred tax assets. Currently, there is an $8.0 billion valuation allowance in place as the current outlook suggests that AIG will not be able to make use of the entirety of its deferred tax assets before they expire. However, that leaves $16.7 billion poised for AIG's use in defraying new tax burdens.
The DTA does not lower AIG's effective tax rate. Rather, in place of using cash from EBT (earnings before taxes) to pay its tax obligations, AIG can instead use its DTA.
In addition to not paying cash taxes for likely the next decade, the DTA also means that operating cash flows at AIG, for the next decade, are more closely related to earnings before taxes than net income.
"If AIG were to earn $5 billion of EBT, it would have a $1.6 billion tax obligation that would be cancelled with the DTA and not cash. Ostensibly, that is an additional $1.6 billion in the shareholders' pockets," Shanker noted.
The company holds significant global market share and continues to invest in growth geographies. As AIG continues to grow in consumer lines and international business, it is growing in markets where it already earnings are better margin than the areas where it has stopped growing, domestic and commercial.
AIG's underwriting margins will improve over time given the trends of naturally higher adoption of insurance in emerging markets.
"We believe recent underwriting and pricing initiatives that have been underway at AIG for two years will bear fruit in 2013," the analyst said.
The risk associated with being named a non-bank SIFI may have some impact on capital return, but it seems that fears are overblown. The Federal Reserve is not anxious to impose the SIFI appellation upon the non-banks.
In the meantime, AIG may buy back stock, just as General Electric Company (NYSE:GE), a company also likely to become a SIFI, is doing so. In the near-term, the stock awaits clarity on what it means for AIG to be a SIFI before appreciation accelerates again.
AIG is one of the largest property & casualty (P&C), life insurance, and retirement services companies in the world. The company proposed a lofty goal of targeting a 10 percent plus return on equity (ROE) in 2015. This involves execution, cost-cutting, capital management and high interest yields.
AIG investors demand stability for the time being. If the company is able to show quarterly consistency, implementation of a nominal dividend and deployment of cash into interest bearing investments, the stock can appreciate.
"As the company monetizes assets for the purpose of share repurchase, we believe ROE can move closer to 8%, while BVPS grows faster," Shanker added.
There is additional upside associated with improved operations at its United Guaranty subsidiary, actualization of deferred tax assets and gains in its diminished derivatives portfolio.
AIG shares, which have been trading between $27.18 and $39.90 during the past 52-weeks, trade 11 times its 2013 consensus earnings estimate. Investors don't like giving AIG a P&C insurance multiple because a significant portion of its income is derived from its life insurance and asset management business. Life insurance peers The Hartford Financial Services Group, Inc. (NYSE: HIG), MetLife, Inc. (NYSE: MET) and Prudential Financial, Inc. (NYSE: PRU) trade around 7-8 times.