This is Part I of a series of articles discussing the returns on common stock and TARP warrants for a few financial institutions relative to the institution's book value.
During the crisis, AIG (NYSE:AIG) received aid from the government to stay afloat. As a result, the government was given long term warrants and stock in the company which they have since sold off. The government still owns roughly 2.7 million of these warrants (Source). These warrants are now publicly traded and accessible to all investors. They expire January 13, 2021. They now serve as a low cost and leveraged way to gain long term exposure to the company.
AIG has had several positive catalysts in the past few months which have been under-appreciated. The government recently sold its remaining equity stake in the company (Source). AIG also recently agreed to sell their aircraft leasing business for $4.2 billion (Source). Lastly, in December AIG sold their remaining stake in AIA, their Asian insurance business for $6.45 billion (Source). These two transactions free up a significant amount of cash - equal to roughly 20% of AIG's market cap. AIG has indicated they will focus on reducing debt (or managing coverage ratio) in the immediate term, so the vast majority of this cash won't be returned to shareholders though they do hope to initiate a dividend in 2013 (Source).
I expect any announcement on what AIG will do with the cash will serve as another positive catalyst for the stock. On the negative side, AIG is awaiting a decision by the Financial Stability Oversight Council to determine if it will be considered a Systematically Important Financial Institution. It is expected they will get this label which means they will be regulated by the Federal Reserve Board and be subject to increased capital and liquidity requirements (Source). This announcement could be a negative catalyst and cause a temporary sell-off in shares.
With the recent rally in the stock as well as its performance over the past year, it is good to put the current price of the stock into prospective relative to historical valuations. AIG still trades significantly below book value. Before the financial crisis, insurance companies traded at roughly 1.4x book value (Source). Since the AIG warrants have 8 years till expiration, they are good instruments to bet on a return to more normal valuations.
As a result of the bailout, AIG has a damaged reputation and somewhat of an investing stigma associated with it. Also, now that the government has liquidated their stake in the company, they need to prove they can operate profitably in the insurance industry. Low interest rates, which the Fed has said will be around for several more years, does hurt the company's earnings power. Also, by selling their AIA stake, the company has sold off one of the best parts of the company which further hurts their earnings power. Lastly, as with other insurance companies, an increase in the number of natural disasters, like Hurricane Sandy, is negative for the company. As a result of Hurricane Sandy, AIG disclosed that they lost $1.3 billion after taxes (Source). I don't expect valuations to fully return to the previous levels but a move up to at least book value by the warrant expiration is reasonable.
In the table below, I list the relevant information about the warrant, the current stock price, the current stated book value (from the latest quarterly report - Source), and two scenarios for warrant and stock returns based on stock price relative to future book value. I assume book value grows at 3.5% per year from current levels.
|AIG Warrant (AIG.WS)||AIG Common Stock|
|Warrant Strike Price||$45.00||--|
|Warrant Exp. Date||1/13/2021||--|
|Time until expiration (years)||8.02||--|
|Current Stock Price||$36.30||$36.30|
|Current Book Value per Share||$68.87||$68.87|
|Price if stock trades at 1x BV which grows at 3.5% per year till expiration||$45.76||$90.76|
|Historical P/B Ratio||1.4||1.4|
|Price if stock trades at historical P/B & growth in BV of 3.5% per year||$82.06||$127.06|
|Return if stock at BV||226%||150%|
|Return if stock at historic P/B||484%||250%|
One interesting aspect of the AIG warrant is that it has some dividend protection. As the annual total dividend on AIG common stock rises above $0.675, the strike price of the warrants is adjusted down by the amount above that level. To be conservative in my return estimates in the table above, I am ignoring any potential future adjustments in the strike price.
AIG has said they would like to begin paying a dividend in 2013, as noted above. But as a result of the high dividend threshold for the warrants and the long time-scale of the warrants, I'm not comfortable assuming the warrant strike price will be adjusted at all. While they may not impact the warrant returns, any dividends paid out will increase the returns on common stock over what I calculate above.
If you expect valuations to stay at or near current levels, i.e. below book value, these warrants should be avoided - or shorted in some situations. Unless the stock price increases above the $45 level, the warrants will have an intrinsic value of $0. Until that time, entire value of the warrants is time value which is subject to decay.
Using the assumptions from the table on a return to 1x book value by the warrant expiration date, the warrants will return around 225%, or roughly 16% annualized return for 8 years. Over this same time period, the stock returns 150%, or an 12% annualized return.
I believe AIG is undervalued at current levels. Investors can use common stock or warrants to gain exposure to the company. The choice between the two instruments depends on your expectation for future valuations, risk tolerance, and comfort with volatility.
AIG has had a big run since mid-November so it makes sense to buy half of a position now and wait for the market to fall on macro worries to purchase the rest of the position. Since the warrants have a strike price above the stock price, they are very volatile and should drop significantly as pessimism returns to the market. This drop in stock and warrant prices should provide a great entry point for investors who can handle volatility.
Click here for Part II.
Additional disclosure: I am also long AIG Warrants.