Is AIG A Sinking Ship?

The announcement on March 1^st that American International Group (NYSE: AIG) has agreed to sell AIA Group, its Asian insurance business, to British insurer Prudential plc (NYSE: PUK) for $35.5 billion ($25 billion in cash) was taken by many analysts as a cause of celebration. For example, an analyst at Societe Generale called the deal “very good news for AIG and a major step toward quickly repaying U.S. taxpayers.” What nobody seems to be focusing on is what the deal means for AIG common shareholders.  Sure, the stock rallied 4% Monday on the news, but I’m not cheering.  I think the AIA sale means that the stock may very well be worth zero. 

Could the Stock Market Be Insanely Inefficient?

As I write this, the common stock is trading at more than $25 per share.  So you may think me a bit loony to be even asking the question whether AIG should be trading at zero.  After all, while one can reasonably argue that the stock market is inefficiently priced (inefficiency is a religion to value investors like Warren Buffett and Seth Klarman), such INSANE inefficiency is another matter.  Yet, hear me out and let me know where my thinking goes astray (if it does).

History of a Horror Show

First, some basic background; AIG is the insurance company that was ground zero for the financial meltdown of 2008.  For decades it was run by Maurice “Hank” Greenberg and was considered a blue-chip financial services company that offered a full range of insurance (both life and property & casualty) and asset management products. Between 1971 and 2007 AIG’s stock increased in value by 80 times and as late as November 2006 a Morningstar analyst called AIG “a premier financial services firm” and “one of the market’s great wealth compounding machines.” The company’s “ace in the hole” was AIA Group, its high-growth and unparalleled insurance distribution network in the emerging markets of Asia. You know, the business that just got sold on Monday. But I digress.

What Morningstar and other Wall Street analysts didn’t realize was that Joseph Cassano, the former head of the company’s London-based “Financial Products” division, was – with the full blessing of CEO Martin Sullivan — engaged in derivatives trading that would bankrupt the company. In essence, his team was selling insurance against a fall in real-estate prices to anybody that wanted such protection. Because the insurance was in the form of credit default swaps (CDS, a form of derivative), it was unregulated with no requirement that AIG have sufficient collateral to back up its liabilities. This resulted in AIG selling far more derivatives than it could possibly honor if things went bad – which they did.  The result was a massive U.S. government bailout that began as $85 billion in September 2008 but by May 2009 had expanded to $182 billion dollars. The government currently owns 80% of AIG.

Two Ways to Value a Company

Legendary value investor Seth Klarman, in his out-of-print classic “Margin of Safety,” wrote that there are two main ways to value a publicly-traded company: (1) as a going-concern, in which case you perform a discounted cash flow analysis, or (2) as a liquidation, in which case you look at the balance sheet and calculate what would be left over for shareholders after all assets have been sold and all liabilities paid off.

The choice is critical, because on a liquidation basis AIG’s common stock looked worthless from Day No. 1 of the bailout. Remember from accounting class:

Shareholder equity = Assets minus Liabilities

As of the end of June 2008, common shareholder equity was $78.1 billion, less than the initial $85 billion in additional debt incurred three months later. Consequently, the company’s shareholder equity should have gone negative by the end of September 2008 and AIG’s common stock would have lost all of its value if the company had been liquidated. The fact that AIG’s financial statements since September 2008 have continued to show positive common shareholder equity is a mystery onto itself and reveals the accounting games that companies can play when they want to.

Negative Equity Companies Can Have Value, Too!

But AIG was not liquidated and (so far) continues as a going concern.  Consequently, AIG’s common stock could still have value based on estimated future cash flows. There are many examples of publicly-traded companies with negative shareholder equity that retain value. For example, the natural cosmetics company Bare Escentuals (Nasdaq: BARE) was laden with significant debt at its 2006 IPO and had a negative book value from 2006 through 2008 and yet had enough cash-flow generating capacity to dig itself out of a hole and score an $18.20 per share takeover offer from a Japanese company this past January.  Other current examples of negative-book-value firms include solid companies like Clorox (NYSE: CLX) and Dun & Bradstreet (NYSE: DNB). In their cases, the negative equity was self-imposed based on significant share buyback activity (treasury stock is subtracted from shareholder equity). Clearly, AIG’s situation is not similar to Clorox or Dun & Bradstreet, but the question remains whether AIG can follow in the footsteps of Bare Escentuals.

Feinberg v. Kelly Smackdown

Based on a fascinating New York Times Magazine expose by Steven Brill, the answer suggests no. Both AIG management and the U.S. government argued back in September that AIG’s stock was “worthless.” What prompted this shocking admission was the proposal by Kenneth Feinberg – who was in charge of setting executive compensation for recipients of federal bailout money — to pay AIG executives their bonuses in AIG stock rather than cash. AIG Vice Chairman Anastasia Kelly told Feinberg that many executives – including her — would quit rather than get paid in AIG stock. In an October 22^nd letter, Feinberg relented and agreed to pay the AIG executives their bonuses in stock units reflecting the book value of a “basket” of the four AIG insurance subsidiaries that were profitable (AIA Group, American Life Insurance, Chartis, and AIG Domestic Life & Retirement Services Group) and without regard to the billions in liabilities owed to the U.S. government. 

AIG, Please Make Up Your Mind!

This story would seem to have finally answered the question of AIG’s common stock value except that . . .it didn’t. The reason? An SEC filing from December 31^st reveals that AIG changed its mind and decided it wanted executive bonuses paid in AIG common stock after all.  Since the AIG stock is not redeemable for cash for at least two years, it’s difficult to understand why AIG changed its mind unless it thought that AIG stock might actually have real value.  Granted, Vice Chairman Kelly resigned on December 30^th presumably because she still thought AIG stock was worthless, but other AIG executives must have been more optimistic to overrule her.

Secret Talks with Hank Greenberg?

One possible explanation for the change of heart is that AIG executives were betting that the government would agree sometime in the future to forgive some of the debts owed by AIG. Obviously, if AIG owed less money, its common stock would be worth more. Crazy as this sounds, debt forgiveness was precisely part of a proposal former AIG CEO Hank Greenberg made to Congress just two months ago in January. Under Greenberg’s plan, Goldman Sachs and the other investment banks that were inexplicably paid 100 cents on the dollar for the credit default swaps they had purchased from AIG would be required to repay the $32.5 billion received. The recovered money would be reinvested in AIG.  The government would also agree to extend its loan term by 10 years and reduce the dividend yield on its preferred stock by half to 5%.  Last but not least, a critical component of the plan was ending plans to divest AIG of any of its remaining core businesses. 

No AIA Group Means No Long-Term Stability

Oops. This brings us back full-circle to AIG’s decision this past Monday to sell off AIA Group.  In the October 22^nd letter where Ken Feinberg agreed to pay AIG bonuses in special stock units based on the four profitable subsidiaries, he stated:

“The Company, the Federal Reserve Bank of New York, and the Department of the Treasury have identified [the four subsidiaries] as critical to the future of the company.”

Later in the letter, he reiterates that these four subsidiaries are “critical to AIG’s long-term stability.” Nobody would dispute that AIA Group is the crown jewel subsidiary of AIG. 

One must conclude that the sale of AIA Group means that current AIG CEO Robert Benmosche has given up trying to save AIG as a going concern and is in full-swing liquidation mode.  If AIG executives didn’t regret taking their 2009 bonus in AIG stock before, they certainly do now. Not only does the sale of AIA Group make Hank Greenberg’s revitalization plan unfeasible, it logically follows from the Feinberg letter that AIG has lost any chance of long-term stability.

Honey, I Shrunk Shareholder Equity

Perhaps CEO Benmosche saw the writing on the wall by analyzing AIG’s own financial statements. Take a look at the progressive deterioration in common shareholder equity over the last three quarterly reports:

As mentioned earlier, I would argue that common shareholder equity has, in fact, been negative since 2008, but the fact that even AIG’s creative accountants are finally writing the common equity down to near zero says the gig is up. Anyone who still owns the stock should feel lucky that they have a chance to sell it for $25.

AIG stock is worthless. There, I answered my own question.

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