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We have affirmed our Neutral recommendation on American International Group Inc. (AIG - Analyst Report) following its modest operating performance during the first nine months of 2012 and the complete bailout loan repayment. However, the anticipation of fresh regulatory and execution challenges along with severe catastrophe losses projected in the fourth-quarter 2012 reflect limited upside.

AIG reported third-quarter 2012 operating earnings per share of $1.00, significantly beating the Zacks Consensus Estimate of 85 cents as well as the year-ago quarter’s loss of $1.58 per share. Consequently, operating net income surged to $1.64 billion from a loss of $3.0 billion in the year-ago quarter.

Most significantly, in December 2012, AIG completed the whole repayment of the $182.3 billion government bailout loan in the U.S. taken in September 2008. The company has no liability toward the bailout loan, while the Treasury earned an additional $22.7 billion from its investment and still carries warrants to buy shares worth 2.7 million in AIG in the future.

The sooner-than-expected complete liberation from the Treasury’s stake is further expected to add to AIG’s capital flexibility and be accretive to earnings, ROE and book value per share, while also retaining investors’ confidence in the stock. This is also reflected by management s intention to initiate dividends in 2013.

Moreover, AIG has successfully disposed of its redundant and risky businesses at attractive valuations, which in turn has helped in consistent improvement in the financial leverage along with the reduction in interest expenses. Consistent payoffs along with the strategically divested assets also led to an operating cash flow of $2.84 billion at the end of September 2012, which surged from an outflow of $1.2 billion in the prior-year period.

AIG’s unique operational focus and management discipline even amid a challenging economic and intensely competitive environment have helped its businesses regain composure sooner than expected. Meanwhile, the positive pricing trends, expense control and continued improved momentum at SunAmerica have helped in the modest growth of retirement and variable annuity products along with assets under management.

Furthermore, Chartis has been showcasing a steady performance since over a year now. Both Chartis and SunAmerica are expected to shore up the core growth and help mitigate operational risks, making AIG financially flexible once again. AIG’s slow but steady growth has helped it achieve the confidence of the rating agencies.

On the other hand, despite the complete sale of the Treasury’s stake, risk of other fresh regulatory challenges from the Federal Reserve remains. While the asset disposals have helped the company liberate itself of the severe debt, it has also shrivelled AIG’s portfolio and global market share, thereby exposing AIG to intense competition from its peer group including MetLife Inc. (MET - Analyst Report) and Prudential Financial Inc. (PRU - Analyst Report).

Moreover, higher catastrophe losses and the absence of any solid growth catalyst pose near-term financial and operating risks. As well, the 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.

Going forward, we expect the trend to continue as earnings are likely to be tempered by additional regulatory and operational challenges. Any robust growth appears overly ambitious at present although a positive turnaround in the global economy and an improved macro scenario is likely to pave the way for significant growth of AIG.

The Zacks Consensus Estimate pegs the company’s loss for the fourth quarter of 2012 at 11 cents per share, which is about 113% lower than the earnings in the year-ago quarter, owing to the projected catastrophe losses from Hurricane Sandy of over $2.0 billion during the quarter. For 2012, however, earnings are expected to escalate to $3.75 per share against $1.28 per share in 2011.

Currently, AIG carries a Zacks Rank #3, implying a short-term Hold rating with no clear directional pressure on the stock.

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