A feature of many of the TARP warrants that were created as a result of the financial crisis is that the strike price adjusts downward when dividends above a certain level are paid out. The adjustment mechanism is quite complicated so this article explains it as clearly as possible. The Hartford (NYSE:HIG) warrants that currently trade have had several downward adjustments to the strike price resulting from dividends paid to common stock shareholders, which I'll focus on in this article. Other warrants, which could have their strike price reduced by dividends, include the Wells Fargo (NYSE:WFC) warrants, JPMorgan warrants (NYSE:JPM), AIG (NYSE:AIG) warrants, and Bank of America (NYSE:BAC) Series A warrants.
Hartford Warrant Adjustment Model
Here's a link to the Hartford Warrant prospectus, which summarizes over several paragraphs how adjustments are made. The dividend adjustment threshold is $0.05 per quarter. HIG currently pays a dividend of $0.15 per quarter and has paid a dividend above the adjustment threshold since Q1 2011. HIG has added a table to their investor relations site, which shows all previous adjustments.
To better understand the warrant adjustment process outlined in the prospectus, here's the formula for calculating the new warrant strike price that resulted from the dividend paid on September 3, 2013:
Instead of the strike price of the warrant being adjusted downward by the amount each dividend is over the adjustment threshold, the strike price is adjusted downward by the percentage the stock yields excluding the portion of the dividend that is under the threshold. As a result, the total adjustment to the HIG warrant strike price to date is $0.26.
Given the adjustment method, it is hard to extrapolate what the total future adjustment will be because you must know not only the dividend paid but also the closing price of HIG when the dividend is paid - or a ratio between the two. In an effort to keep the analysis simple while estimating the future warrant strike price, I calculated the total dividend adjustment with the assumptions that the share price stays constant and the dividend stays constant - which gives equivalent results to saying the ratio of dividends paid and share price stay constant. I know this is not a feasible scenario - but it serves to illustrate what level of total adjustments to expect. Given this scenario, the total adjustment through Q2 2019 is $0.97 - so the final warrant strike at expiration would be $8.82. Depending upon the relationship between the dividend paid and the share price, the actual adjustments will be more or less than that - but not by a significant margin unless the dividend yield meaningfully changes from current levels.
Additional Warrant Adjustment
There is a second adjustment, which is made to the warrants. The number of shares each warrant can purchase increases each time the warrant strike is adjusted downward. When the warrants were initially issued, each warrant represented the right to purchase 1.00 common share of stock. Each time the warrant price drops, the number of shares each warrant is entitled to is multiplied by the ratio of the old warrant price to the new warrant price (generally 1.001 to 1.003). This is shown below in equation form.
Upon each decrease in the strike price, the new warrant share value is calculated as shown above. Until the new number of warrant shares is greater than 1.1, the ratio of warrant prices is multiplied by 1.0 warrants as shown above. After that, a value of 1.1 warrants is used. As of September 3, 2013, each warrant held the right to purchase 1.02685 shares of HIG. At the current stock price, this additional fraction of a share adds $0.84 to the value of the warrant. Using the assumptions above for warrant strike changes, each warrant will be worth roughly 1.105 shares of HIG at expiration - implying an additional value of $2.46 above current levels.
By extrapolating the two different warrant adjustments discussed above though expiration, there is an additional $3.17 of value per warrant that will be realized over current levels. That amounts to roughly 14% of the current warrant price in unrealized (and unappreciated) value. With current HIG stock and warrant prices, there is only $0.65 of time premium in the warrants. In addition, these warrants don't expire for 5 years and 9 months. This time premium is equal to only 20% of the value of expected future adjustments to the warrants.
The very complicated nature of warrant adjustments has left the value of these adjustments under-appreciated. As a result, the HIG warrants are undervalued when compared to the current HIG stock price.
Additional disclosure: I am long AIG, BAC, and JPM warrants.