Falling stars in the nighttime sky can be wonderful and inspiring to watch. But when that falling star hits a little closer to home, say, a once-powerful technology company whose stock you own, there's nothing at all wonderful about the experience.
I thought about this recently when I heard that
American International Group
announced it would take an after-tax change of $1.8 billion in the fourth quarter of 2002 to boost reserves in its property/casualty insurance business.
Even though Wall Street had speculated for weeks that AIG would have to take a charge in the quarter, the size of the charge and its nature came as a shock. Analysts had expected that the company would have to put something extra aside to account for its asbestos liability, but they were looking for something less than the $625 million charge that
had taken for that purpose in October.
Instead, AIG delivered a charge three times as big, not for asbestos liability but for such core lines as workers' compensation, director and officer liability and medical malpractice.
The stock quickly dropped from $55.33 at the close on Feb. 3 to $51.70 on Feb. 4. And it has kept on dropping, hitting a four-year low of $46.70 on Feb. 7. It's at times like these that I find myself wondering if this is the buying opportunity I've been waiting for (I've owned positions in AIG since 1998.) But I also find myself wondering if this financial sector superstar is now so much cheaper because something has gone fundamentally wrong with the company.
1. Assess the Big Picture
Since investors can't really assess the importance of the $1.8 billion charge because the sum isn't especially large to a company the size of AIG, I recommend a four-step process to sort things out.
First, what makes the company's fundamental, long-term story so attractive?
In the case of AIG, the story runs like this. The company has won leading positions in the most attractive growth markets for financial services around the world. In the U.S., the company is the largest writer of commercial and industrial insurance, and the second-largest writer of life insurance. In addition, the company is the largest provider of variable and fixed annuities in the country.
Globally, AIG is the No. 1 foreign life insurer in Japan, the second-largest market for life insurance in the world after the U.S. The company was the first foreign insurer to receive a license to operate in Shanghai way back in 1992, and the company now sells insurance in Guangzhou, Shenzhen, Beijing and Suzhou in what is the world's largest potential market for financial services. In 2001 AIG received a license to sell commercial and personal property casualty insurance and life insurance in India.
Despite this aggressive pursuit of new business opportunities, AIG is a conservatively run insurance company. The company doesn't chase unprofitable business to build market share. It continued to make profits on its underwriting in the 1990s and early this decade as competitors cut prices to grow revenue. And the company is extremely conservative at reserving against future losses and usually extremely accurate in predicting the size of required reserves, this quarter's example notwithstanding. All this has made the company one of the few insurers with a triple-A credit rating.
That financial strength means AIG can raise capital more cheaply than almost any of its competitors. The company's global scope and market share in its key markets enables it to spread its costs over a wide base. For example, American's U.S. general insurance operations have one of the lowest expense ratios of any property-casualty insurer.
And that means AIG can be the low-cost provider of insurance and other financial services in just about any market it chooses to attack.
2. Check Out the Risks in the Story
Second, does anything that has happened recently put this long-term story at risk?
The charge to boost reserves certainly hasn't cut into AIG's dominance of key markets or its leading position in Japan, China and India. It doesn't diminish the company's global scope or its ability to keep costs low by spreading them over a huge customer base.
But there is a threat in this element of the AIG story, to the financial strength that is the company's key competitive advantage. Although insurance rating service A.M. Best confirmed its A++ credit rating, and Standard & Poor's said it wouldn't change its AAA rating or outlook, Fitch decided to put the company's debt rating under review for possible downgrade. Moody's confirmed its triple-A rating but changed its outlook to negative from stable. Another misstep that produces a surprising need to boost reserve could cost the company its top-of-the-heap credit rating. Wall Street is keeping its eyes focused on the company's airplane leasing business as the most likely source of trouble.
In the current competitive environment, a hit to AIG's credit ratings wouldn't be as big a deal as it seems. Every insurer is busy adding to reserves and taking huge charges to earnings. Many of them have done it repeatedly already and look set to take yet more charges this year. In fact, AIG's huge boost to reserves will have the effect of putting pressure on other companies to raise their reserve levels in the business lines that AIG targeted. After AIG's action, credit-rating agencies are likely to take another look at the reserves at many of the company's competitors. And that will put downward pressure on the ratings of those companies.
All in all, AIG isn't likely to lose its relative competitive balance sheet advantage. If its credit rating does get cut, it's likely that those of competitors will be cut as much or even more.
3. Work Out a Target Price
Third, if the fundamental story is intact, calculate a target price based on any changes in those fundamental strengths.
But even the risk that the company's rating will be cut, let alone an actual cut, will have an effect on AIG's absolute profitability. The company may still be able to raise capital more cheaply than its rivals, but capital will cost it more than it used to.
That higher cost of capital turns into lower returns on invested capital because the price of one key input, money, has gone up. Out pops the lower target prices that Wall Street has put on the stock since the announcement. Before the news, most analysts used a projected return on invested capital of 16.5% to 17% in the models. After the news, the range of projections now goes from 15% to 16%. At Deutsche Bank, a 15% return on equity yields a 12-month target price of $56 a share. Credit Suisse First Boston, which cuts its return on equity to 16% from 16.5%, cut its target price to $64 from $73.50. Legg Mason gets to a $65 target price with its assumption of a 16% return on equity.
The company itself told analysts that a 15% return on equity for 2003 was the minimum it expects for the year. With insurers charging and getting higher prices for most lines of insurance, that estimate seems reasonable to me.
Taking the lowball target from this group of $56 a share, that's still a 20% gain from here -- if nothing in the outside world sticks out its foot to trip the stock.
4. Take a Look at Risks and Potential Gain
Fourth, weigh the short-term risk against the long-term gain.
The decline in AIG's stock price took the bubble out of the stock's long-term record. The stock now trades at a price-to-book value of 2.1. That's close to its long-term average -- before the bubble market of the late 1990s -- of 2.2 to 2.3. The average price-to-book value ratio of AIG had climbed to well over four in the years 1999 through 2001.
This return to something like the stock's normal price range makes sense if you think about the charge against earnings the company just took. AIG was, in effect, saying that it had overestimated the profits from its business and underestimated the costs (or potential costs). Those overstated profits led to overstated rates of earnings growth, which led to an overinflated price as analysts and investors put those numbers into their calculations.
Goldman Sachs has done the math to take those overstated profits out of AIG's earnings for the years 1997-2001. The resulting returns on equity, ranging from 12.4% in 1997 to 14% in 2001, are certainly lower than the return on equity reported during those years, but they still comparatively very favorably with the 12.7% reported in 1995 or the 13.2% reported in 1994.
The average annual gain to an investor holding AIG shares for those four years (1993-1996) came to 21%. Past performance does not indicate future results, as they say, but I think it's reasonable to use that period as a rough benchmark for the long-term potential of AIG. If you want to be more conservative and factor in the assumption that the decade ahead will be a time of below-average returns, that's reasonable too. Cutting the potential return on these shares to just 10% annually still puts the stock way ahead if you've assumed that the market return on equities is just 7% or 8%.
Creating a benchmark for short-term risk is much, much tougher. As a property-casualty insurer, AIG has exposure to the results of terrorist attacks. But it's hard to judge how much exposure because we don't know what targets might be hit (none, I hope) or how much risk has been passed off to reinsurers.
Nor do we know how President Bush's new savings proposals, whatever their final form, will affect the annuities industry.
Nor do we know how even a limited war in Iraq might affect the value of the U.S. dollar or the financial health of the airline industry and its ability to pay its bills to companies such as AIG that own the planes.
To me, when I add it all up and subtract it all out, at $45 or so a share, AIG is worth a buy on its intrinsic merits.
But I think it's worth waiting until we've got more visibility, to use a Wall Street term, on the situation in Iraq. I don't think the stock is likely to run away from investors in the current stock market.
Jim Jubak appears Wednesdays on CNBC's "Business Center" at 6 p.m. EST. At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Citigroup and Hughes Supply. He does not own short positions in any stock mentioned in this column.