AIG: Not as Simple as It Seems

Investors should understand what they buy. That's why Warren Buffett generally shuns technology companies, and why, back in the day, Fidelity's Peter Lynch bought stock of company that made the pantyhose his wife liked. "Buy what you know" is a good rule of thumb -- and one that's difficult to follow for investors who want to buy shares of American International Group (symbol AIG).

AIG sounds simple. It is the largest underwriter of commercial and industrial insurance in the world. The New York-based company has various divisions that offer a wide range of financial products from aircraft leasing to life insurance to real estate investment management. It operates in 130 countries and jurisdictions, and runs the only insurer in China that's entirely owned by a U.S. company. In sum, when it comes to insurance, AIG's reach is unmatched.

But oh how the mighty have fallen. AIG's first-quarter results missed the mark big time. The company posted a net loss of $7.8 billion, or $3.09 per share. Executives blamed the usual trifecta of unfortunate financial events: the decline of U.S. home values, tight credit conditions and a sagging stock market. When you exclude asset writedowns and one-time charges, the company lost $1.41 per share. That's nearly double the loss of 76 cents per share that analysts had expected. The bulk of the writedowns came from derivatives used as a hedge against credit risk.

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Meanwhile, credit-rating agencies pounced on the financially weakened insurer. Both Fitch and Standard & Poor's downgraded AIG's credit rating from AA to AA-, citing the unexpected first-quarter losses. The moves will raise AIG's cost of capital. But, says Friedman, Billings, Ramsey analyst Bijan Moazami, "These downgrades will have little impact on core operations."

The massive first-quarter losses mask the health of AIG's main businesses, Moazami says. He dismisses the poor performance as a function of the volatility in the credit markets and not an indicator of weakness in the company's insurance operations. Losses were exacerbated by market-to-mark accounting practices that make them seem worst than they actually are. That's because accounting rules require AIG to value its derivative portfolio at fire-sale prices even though it has yet to sell those investments. Much of those writedowns may be reversed in the second quarter as the cost of credit hedging drops, Moazami says.

Amid the bad news, AIG's stock has taken a beating. The stock closed at $33.93 on June 6, which is the lowest price adjusted for splits and dividends the shares have traded at in ten years. The stock is down 24% since the first-quarter results were announced May 8. AIG, a component of the Dow Jones industrial average, is down 67% since 2000.

The stock seems attractively priced given AIG's leading position in the insurance business. It trades at 12 times the $2.79 per share that analysts expect the company to earn this year and just 6 times 2009 forecasts of $5.78 per share, according to Thomson First Call.

But the opaque nature of AIG's finances raises the question of how seriously you can take forecasts that go out well beyond the next couple of quarters. And that makes AIG hard to value. If there's more fallout from the credit crisis, earnings could deteriorate further, putting additional pressure on the shares.

The company also is a frequent target of state and federal regulators. For example, the Wall Street Journal, citing anonymous sources, reported on June 6 that the Securities and Exchange Commission is investigating AIG over how it values contracts linked to subprime mortgages. AIG shares plummeted 6.8% that day, when the Dow Jones industrial average fell 395 points as oil prices surged to more than $138 a barrel, and the May unemployment rate unexpectedly jumped to 5.5%.

Still, there' no arguing that AIG has plenty of advantages over its rivals. "No insurer has anywhere near the capitalization or the massive market presence as AIG," Moazami says. He rates the stock an "outperform" and gives the shares a 12-month target of $63.