American International Group (NYSE:AIG): Downgrade to Underperform, $6 target

Keefe Bruyette & Woods is downgrading American International Group (NYSE:AIG) to Underperfrom from Market perform with a $6 target.

Rate the Shares Underperform. From a fundamental perspective, KBW views that AIG continues to own some very valuable businesses, however, in its totality, under the current operating and financial structure, they view that the publicly traded shares are grossly overvalued. They would caution investors that due to the highly volatile nature in which the shares trade, a short-term position in the shares, long or short, is highly speculative.

No Real EPS. KBW expects no net real EPS near term. After liquidity needs are met, they expect that earnings generated by the underlying operations are obligated to be used to make Series E dividend payments. While the company may report positive EPS, the firm believes these earnings cannot be valued in the normal sense because these earnings do not accrue to the common shareholder but to the preferred shareholder.

The False Premise of Tangible Book Value
In normal equity analysis, tangible book value is a natural starting point. Tangible book value is viewed to be a measure of the store of value created by a company over time, or an approximation of a run-off value. However, AIG’s capital structure is so unusual that we believe it does not fall under this definition. Would AIG be in business today without government aid? Or consider the CEO's public admission that selling all of the pieces of AIG would not be enough to fully repay AIG's debts. Doesn't this imply negative real worth, despite a positive book value calculation?


They illustrate the difference in capital structure between AIG and a typical insurer above. The typical insurer, P&C or life, carries debt loads at 20-30% debt-to-total capital. While AIG’s business model and capital structure were always different from the typical insurer, today, AIG’s debt levels are enormous. If one were to include the Series E preferred stock as debt (formerly, this was simply TARP debt), then the total AIG debt level is $188 billion versus diluted common equity of just $23 billion. Debt is more than 8 times greater than equity! In comparison, most insurers have the inverse relationship at a four-to-one level and even the “old AIG”, at its most highly leveraged, was less than 2-to-1 of debt-to-equity.

Can AIG Stand Alone? It's Unrealistic in KBW's View.
While one of the few routes available, and therefore most likely, KBW views that the Series E & F conversion scenario is difficult to execute. The process would normalize the ownership structure but even with all forms of government debt gone, they believe AIG’s capital structure would remain highly unusual with operating debt 3-4x larger than tangible equity. Upon government exit, how would rating agencies view such a structure? How would customers? Would the company avoid bankruptcy but still essentially have to go into run-off, unable to write new business? The past destruction of real equity value may yet still prove to be too much to overcome, in firm's view.

Total Earnings. Using KBW estimates, AIG's earnings power is in the range of $2.8 billion after tax. Firm note that this “normalized” earnings power is before interest costs associated with government debt. On a fully diluted basis, this implies EPS of approximately $3.97.

However, one should keep in mind that AIG has not been paying its 10% dividend on its $41 billion of noncumulative Series E preferred stock. So even if AIG does report earnings, the income will not be accruing to the common shareholder. After liquidity needs are met, AIG has a legal obligation to the preferred owner to pay this dividend, effectively eliminating any real EPS.

Price Target
In attempting to assess the value of the common shares, KBW views that they must attempt to value the company post a government exit and as a result, they use the scenario of converting Series E & F. Firm will suspend their skepticism regarding the feasibility of executing a Series E & F conversion and allowing AIG to stand alone without government support. In addition, they will favor the P/B and P/E methodologies below simply because they yield the more positive results.

Price to Book. Allowing for a 25% discount on the common stock from today’s market price, KBW estimates a pro forma tangible book value (assuming the successful AIA/ALICO sales) of approximately $14.02 per share. In this scenario, AIG would be left in an extremely levered financial position which would require either extensive public capital raising to remedy or else current business would face the risk of going into forced run-off. In addition, the balance sheet risk would remain. Furthermore, publicly traded insurers already trade below book value, on average. As a result, KBW would expect a trading valuation at a sharp discount to book value near 0.4x, yielding a price of approximately $6 per share.

Price to Earnings. On an earnings basis, using their earlier after-tax estimate of $2.8 billion, the impact of Series E & F conversion would result in EPS of $1.23 per share. Again, with peers like CB trading at just 9x and HIG at 7x 2011 EPS and considering the issues facing a stand-alone AIG, a heavy discount to peers must be applied. A 5x price-to-earnings multiple derives a $6 target.

Quick Sum of the Parts Yields Negative Worth. In a quick sum-of-the-parts analysis, the value of the operating units appears to be less than the total debt outstanding. A 10x PE multiple applied to the P&C and Domestic Life operations, using KBW's earlier earnings estimates, would indicate $46 billion of value. If they assume the accuracy of the carrying value of the Financial Services units, their value is $10.8 billion. Finally, one would need to add the coming gain-on-sale for the ALICO & AIA transactions of $22.2 billion (assuming zero taxes). The grand total is $79 billion, substantially below the total debt outstanding at 12/31/09 of $141 billion.

Notablecalls: As Keefe points out much of AIG's fate hinges on what the Government thinks about the situation and also how well the asset sales will go.

Note that this morning Times Online is reporting that Prudential’s biggest shareholder has been moving behind the scenes to orchestrate a potential break-up of the insurer as a radical alternative to its $35.5 billion Asian AIA acquisition.

http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article7108969.ece

This should create additional uncertainty regarding the whole AIG situation and rhymes rather well with the current KBW downgrade.

I think AIG will trade down today, maybe to the tune of 6-7%, putting at least $42 level in play.

Could go lower, though.