Security: AIG JAN 17 2015 40.00 CALL
Date of first purchase: December 4, 2012
I am buying call options on American International Group (AIG) expiring January 17, 2015, because I think the business is substantially undervalued and the expected value of its LEAPS is very attractive. Each option is $4.26 and the strike price is $40. In my estimation, the intrinsic business value of AIG is likely $60 to $70 per share, or approximately $89 billion to $103 billion for the whole company. This compares to a current stock price of $33.32, or a market capitalization of $49 billion. So with around $100 billion of tangible book value, the entire company is on sale for half its net tangible assets, significantly below its peers and long-term historical levels. This sale price is a 45% discount to the bottom range of its true value.
It is almost impossible to overstate the extreme terror that gripped securities markets in the fall of 2008 because of the known and unknown dangers lurking in AIG’s balance sheet. After an ill-judged expansion into insuring the most toxic areas of the mortgage and derivatives markets, AIG received a $180 billion bailout from the Federal Reserve and U.S. Treasury. The Treasury has gone from owning 92% of AIG at the time of the bailouts to 77% at the beginning of this year. Through additional share sales this year, the Treasury currently owns 16% and is on the cusp of selling its remaining stake in the next few months. In the time since the bailouts, senior management and directors have been replaced and AIG’s shareholders have suffered substantial losses. The company shed major assets to help repay the government and divested international operations. It floated AIA, the Asian life insurer, and sold its non-U.S. life insurance subsidiary Alico to U.S. rival MetLife. Its businesses have been de-risked and downsized, headcount globally shrinking to 57,000 from 116,000 in 2008. And its balance sheet has been deleveraged, the derivatives book of AIG Financial Products, over $1.8 trillion on a net basis four years ago, shrinking to about $157 billion by June of this year. It is still a substantial player in its core end-markets, though, and about to be the first non-bank designated in the U.S. as a systematically important financial institution. It is similarly difficult to overstate how improbable it was to conventional wisdom on Wall Street that AIG would ever repay the government, let alone earn both the Federal Reserve and U.S. Treasury a profit.
The company’s shares have risen over 40% YTD, spurred on by successively improving quarterly results and the company repurchasing over $13 billion of its shares. Those repurchases increase share price through raising book value per share, a multiple at which insurance companies trade. But what matters to an insurance company, a complex organization even in the most normal of times, is ultimately not the excess value of its assets over its liabilities. It is its ability to earn more on its assets than it must pay on its liabilities, as reflected in its return on equity. And AIG’s mid-single-digit ROE is well below that of peers. The company will refocus on improving its debt coverage ratios in the next year, putting repurchases on the backburner. And it must improve the earning power of its core property casualty and life insurance businesses. It has a substantial surplus of equity and the operational scale to do so, making it likely to achieve average earning power of at least $5 billion per year going forward.
I am thus purchasing AIG’s LEAPS because the significant margin of safety in the company’s equity greatly favors the probability of gains versus the potential for loss at expiration. The pricing and expiration date of the options should allow ample room for error or adversity if I have wrongly appraised the true worth of owning AIG or if the business’s strengths do not soon outshine recollections of a considerably troubling period in its history.