AIG Warrants Or AIG Common Shares? An Update On The Math

Jun. 5.14 | About: American International (AIG)

Summary

The warrants have outperformed the common shares in recent months, but the warrants are still the bigger bargain.

A sensitivity analysis shows that the warrants are not nearly as risky as a normal call option.

The warrants are trading at a discount for all the wrong reasons, creating a perfect opportunity.

The year 2014 has been a decent year for American International Group (NYSE:AIG) shareholders, with the shares returning just over 7% so far this year. But meanwhile the AIG warrants have performed even better, up about 25%. So with that in mind, does the common stock now have more upside?

A refresher

For those of you unfamiliar with the warrants, they were issued back in January 2011. The following are the most significant provisions:

  • A strike price of $45 and an expiration date of January 19th, 2021.
  • An anti-dilution adjustment for dividends paid by AIG above $0.675 in any 12-month period.

So with AIG shares trading at $54.87, the warrants are already in the money. But with the warrants selling for $25.34, AIG stock will have to increase to $70.34 just for warrant holders to break even from this point forward. So are they still worth buying?

Some Base Case Assumptions

As Warren Buffett has rightly pointed out, the Black-Scholes model is practically useless for valuing long-dated options. In this case in particular, using AIG's stock price volatility to value warrants expiring in 2021 simply has no merit.

A more appropriate analysis involves estimating what the warrants would return under various long-term scenarios for the company.

With that in mind, let's take a look at what rate of return both shareholders and warrant holders would get using the following base-case scenario:

  • AIG earns an annualized return on equity of 7.5% every quarter starting next year. For the year 2014, analyst estimates for EPS shall be used.
  • By the time the warrants expire, AIG will be trading at book value.
  • The quarterly dividend will be raised to $0.16875 per share at the beginning of next year. This is the maximum payout that does not trigger any anti-dilution provisions.
  • Book value per share increases every quarter by earnings per share less the dividend. The only exception is the current quarter, where BVPS has been adjusted upwards by $0.97 to reflect the gain from the ILFC sale.

This last assumption means that the model does not incorporate the effect of share buybacks, which does make the model much cleaner. The effect of share buybacks will be examined later on.

The result

Under this scenario, AIG shares will trade at $112.61 by the time the warrants expire, making the warrants worth $67.61. This would result in a 16.1% per year return for the warrant holders. The AIG common shareholders would only earn 12.7% per year, including dividend payments.

AIG Base Case Scenario

Quarter Ending

BVPS

EPS

Dividends / Share

Jun-14

$73.67

$1.05

$0.13

Sep-14

$74.59

$1.04

$0.13

Dec-14

$75.51

$1.21

$0.13

Mar-15

$76.59

$1.44

$0.17

Jun-15

$77.85

$1.46

$0.17

Sep-20

$110.70

$2.08

$0.17

Dec-20

$112.61

$2.11

$0.17

Click to enlarge

Results

Ending BVPS

$112.61

Book Value Multiple

1.0x

Ending Stock Price

$112.61

Warrant Value

$67.61

Warrants Rate of Return

16.1%

AIG Common Shares ROR

12.7%

Click to enlarge

(source: AIG filings, author's calculations)

So using these assumptions, the warrant holders will outperform the common shareholders by 3.4% per year.

Most observers would view these assumptions as quite conservative; as interest rates eventually rise, and AIG is able to implement numerous operational improvements, a 7.5% ROE should be very achievable. And if this does play out, then there's a strong argument that the company should trade above its book value too. It should be noted that Travelers and Allstate trade at 1.3x and 1.2x book value, respectively.

Anyone looking for more colour on AIG's future should read this article on Seeking Alpha, written in mid-May.

Changing the numbers

The two most important projections in this analysis are the ROE assumption and the Price/Book multiple at expiration. The following table looks at what happens to the warrant holders' return when adjusting these numbers.

Warrant Holders' Hypothetical Rate of Return

(source: AIG filings, author's calculations)

And this is how that same table looks for the common shareholders.

Common Shareholders' Hypothetical Rate of Return

(source: AIG filings, author's calculations)

Some Observations

As could be predicted, the warrants are more of a levered bet, and thus come with more risk. But there are a few reasons why they are still a better option than the common shares.

  1. Using this model, the warrants would still outperform the common shares if AIG ends up trading at 0.8x book value by 2021. Most observers would view this as a very poor outcome for AIG, and thus a very conservative assumption.
  2. With AIG's book value per share already at $71.77, you really only need the AIG share price to catch up to its current book value by 2021 in order to break even. While this would still be a poor outcome, it does underscore the fact that these warrants do not have the same risk profile as a regular call option.
  3. The analysis above ignores the effect of buybacks, which is examined below.

The Effect of Buybacks

Incorporating share buybacks into the model above would require forecasting AIG's share price over the coming years, which of course is impossible. But the effect of buybacks cannot be dismissed, especially since AIG is currently buying back stock.

It should be obvious that any buybacks made while AIG is trading below book will compound BVPS, and this is a bigger plus for the warrant holders than the common shareholders. With AIG currently trading at 0.76 times book value, this will be the case for the foreseeable future.

AIG's current buyback program has $537 million remaining. Although this can only be used to buy back about 10 million shares at current market prices (there are more than 1.4 billion shares outstanding total), buybacks can be much larger in the future.

Warrant holders should be hoping for AIG to place an ever-increasing emphasis on buybacks, as long as the shares trade below BVPS. And interestingly, if anyone is truly serious about holding the warrants long-term, he should hope for AIG shares to languish over the next few years, allowing the company to compound BVPS that much faster through buybacks. The same thing could be said, to a slightly lesser extent, about long-term oriented common shareholders.

Risks

The model above has two major inputs: return on equity and terminal book value per share. But those two variables are not independent of each other; in other words, if AIG struggles for the next 7 years, not only will its BVPS languish, but the shares may continue to trade at a discount. And with the company's 2008 disaster still fresh in everyone's mind, this is a very legitimate concern.

It would certainly not take a 2008-style disaster to wipe out the warrant holders. If even one or two more Black Swan-type events occur, like Hurricane Katrina, and AIG is overexposed, the shares could suffer greatly and take a long time to recover. And if the common shares just stay flat until 2021, warrant holders will lose over 60% of their money.

But these are extremely unlikely events; as the model above shows, most reasonable scenarios show the warrants as a better option than the common shares, and a great option by most other standards too.

So why aren't the warrants trading higher?

There are a few reasons why this opportunity exists. First of all, plenty of investment funds cannot or will not hold warrants. Likewise, there are plenty of individual investors, especially those seeking dividend income, who would be more comfortable with the common shares.

The warrants are also much more thinly traded, partly because Bruce Berkowitz holds a third of the warrants outstanding, and suffer from a lack of coverage. Most investing websites cannot even give you an updated price for the warrants (for those of you looking for this information, Bloomberg has it here).

But most importantly, AIG's past misdeeds are still fresh in everyone's mind, and are without doubt a major reason why the shares are trading at a discount to BVPS. Such memories likely have an even larger effect on a riskier alternative like the warrants.

But none of these issues are a truly acceptable reason for the warrants to trade at a discount.

Conclusion

Despite the current run-up in price, the AIG warrants are still a major asymmetric bet, and are trading at a steeper discount than the common shares are. For those of you willing to accept some volatility and illiquidity, the warrants offer plenty of upside. As long as AIG doesn't relive its past misdeeds.

Disclosure: I am long AIG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long the warrants, but hold no common shares.