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We have maintained our Neutral recommendation on American International Group Inc. (AIG - Analyst Report) following its modest operating performance and steady bailout loan repayment during the first half of 2012. However, the top line remains sluggish given the lingering macro-economic concerns and low interest rates.

AIG reported second-quarter 2012 operating earnings per share of $1.06, outshining the Zacks Consensus Estimate of 59 cents as well as year-ago quarter’s earnings of 68 cents per share. Consequently, operating net income surged 49.8% to $1.86 billion from $1.24 billion in the year-ago quarter.

Results reflected an improved top line along with enhanced operating performance across segments. Moreover, a higher fair value for Maiden Lane III LLC boosted earnings.

AIG’s ongoing business restructuring process has enabled it to focus on quality insurance and investment products and services. In addition, lower catastrophe losses improved the combined ratio, while stability has been retained through higher assets under management (AUM) in SunAmerica. These factors have driven the company’s operating cash flow, book value per share and return on equity (ROE) so far in 2012. The company has also managed to reduce the interests held by the Treasury during the quarter, thereby enhancing capital efficiency.

AIG has been persistently reducing the US government’s $182.3 billion bailout loan amount. Excluding profits, the company repaid $35.6 billion to the government in the first half of 2012. The latest stock sale, early this month, reduced the Treasury’s stake in the company to 53% from 61%, while it still owns about 871.1 million shares of AIG. Currently, the company owes about $25 billion to the U.S. government.

Going forward, we believe that stability in ratings, operating cash flow and capital position bode well for long-term growth. In addition, business de-risking, focus on core operations and repayment of a major chunk of debt appear beneficial for stock buybacks and other capital deployment efforts.

On the flip side, despite the latest stock sale, the Treasury owns more than 50% of AIG and a further decline of the Treasury’s stake could raise other fresh regulatory challenges for AIG from the Federal Reserve, which still supervises the company.

Moreover, higher operating expenses, absence of any solid growth catalyst and intense competition from arch-rivals such as MetLife Inc. (MET - Analyst Report) and Prudential Financial Inc. (PRU - Analyst Report) pose near-term financial and operating risks. Also, volatile equity markets, widening credit spreads and reduced interest rates continue to showcase declines and persistently undermine margins. These factors also hampered the premiums growth in SunAmerica and Chartis as well as reduced the fair value of American International Assurance Co. Ltd (AIA).

Overall, AIG is poised to accentuate its operating and capital leverage upon dilution of the government's stake and economic recovery. Based on the pros and cons, the Zacks Consensus Estimate pegs the company’s earnings for the third quarter of 2012 at 68 cents per share, which is much higher than the loss of $1.58 per share recorded in the year-ago quarter. For 2012, earnings are expected to escalate to $4.13 per share against $1.28 per share in 2011.

Currently, AIG carries a Zacks Rank #2, implying a short-term Buy rating, while its long-term recommendation remains Neutral.

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