Did American International Group Make a Huge Mistake By Ignoring Its Dividend?

Source: AIG.

It's always nice when you come into some extra cash, but finding the best use for it can sometimes be a troublesome endeavor. With American International Group's recent sale of its International Lease Finance Corp. to AerCap, the insurer found itself with $2 billion in proceeds. But did adding the funds to reinforce its current share repurchase plan make the most sense for shareholders?

Burning a hole in its pocket
There's been a lot of speculation surrounding the uses for the $2 billion in proceeds AIG received from its sale of ILFC -- and now we know where it's going: share buybacks. The insurance behemoth's board of directors announced last week that it had approved a $2 billion increase to its current buyback authorization, resulting in $2.12 billion available to purchase shares. The company has already spent $867 million on share repurchases this year.

But with a so-so 0.9% annual dividend yield, some shareholders may be discontent with management's focus on reducing outstanding shares. Let's take a look to see which distribution methods really serve AIG shareholders best.

A little dividend math
If AIG applied its current authorization toward dividends instead of buybacks, it has two options: It could pay out a one-time special dividend of $1.45 per share, which is 3% of the company's closing share price on Wednesday of $54.78; or it could devote the funds to quarterly dividends, which would allow for 11 quarters of doubled payouts ($0.25 per share versus current $0.125).

Despite the appeal of doubling its payout to shareholders, the cautious approach of AIG's management toward its dividend payments hardly jives with setting up a commitment to continue the $0.25 quarterly payout once the current surplus of cash runs out -- since decreasing the dividend after those 11 quarters would hurt its share price -- so we'll ax that option.

Though special dividends are one-time items, they usually aren't included in dividend yields, but we want to gauge the company's payouts to shareholders. So, if we look at the special dividend option, AIG's 2014 dividend yield would jump to 3.6% -- not bad, but it's just for this one year.

Does that one-time boost in payouts beat the benefits of repurchasing shares?

More purchases through share buying
In short -- no.

As of Wednesday's close, AIG's stock trades at a 31% discount to its book value. By focusing on share repurchases, the insurer's management is able to reduce the number of outstanding shares by 2.7% (assuming the entire authorization is used) at a big discount to its internal valuation.

The company's buyback yield (repurchases/market capitalization) hits 3.8%, including the $867 million of shares already purchased during the first quarter. On its own, the buybacks already pose a greater return to shareholders on their own than a special dividend, but when you add in the 0.9% yield from regular dividend payments, AIG's shareholder yield for 2014 could hit 4.7%.

Other benefits
Thanks to the discounted share price, AIG is able to return more value to its shareholders through its share repurchase program. On top of the yields for this year, the potential share buybacks provide longer-term benefits for both AIG and its investors. Investors will see positive results from the buybacks in three ways:

  • Ownership gains: With the number of outstanding shares on the decline, you'll own more of the company without having to shell out more of your own money.
  • No taxes: A special dividend would be heavily taxed, whereas the ownership gains you receive from buybacks are not.
  • EPS growth: Thanks to the share repurchase, EPS will be boosted, which can be a big attraction for new investors -- potentially leading to higher share prices (aka, gains for you).

For the insurer, the buybacks reinforce its balance sheet and may actually make paying dividends easier as higher earnings are paid out to fewer investors.

Right choice
Investors may like more cash on hand, but the renewed emphasis on share repurchases from AIG's management actually serves its shareholders better than providing a special one-time dividend or taking the risk of increasing quarterly payouts from sales proceeds instead of true operational growth.

The opinion battle over which capital distribution method is superior for investors will continue on, but for now, AIG and its shareholders are best served by management's big share repurchase strategy.

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The article Did American International Group Make a Huge Mistake By Ignoring Its Dividend? originally appeared on Fool.com.

Jessica Alling has no position in any stocks mentioned. The Motley Fool recommends American International Group. The Motley Fool owns shares of American International Group and has the following options: long January 2016 $30 calls on American International Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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