Loving The Leverage: American International Group

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 |  About: American International Group Inc (AIG)
by: Wall Street Hippie

Summary

First we'll explore the features that AIG warrants offer investors, including the exercise price, expiration date, and adjustment formulas.

Since the warrants are obviously dependent upon the underlying security, we'll walk through a valuation of AIG common stock and its effect on the warrants.

Lastly, we'll weigh the potential risks associated with the warrants so that you can make a sound investment decision based upon your risk tolerance.

This is the first article in my "Loving The Leverage" series in which I explore the potential gains of stock warrants, which offer great long term leverage for those who are bullish financial services. (Prosepectus linked here.)

AIG Warrant Features

On January 19th, 2011, American International Group, Inc. (NYSE:AIG) issued a .533933 warrant per share dividend to stockholders. The warrants can be exercised anytime before January 19th, 2021 at an initial strike price of $45.00 per share, though the strike price is subject to certain adjustments (as discussed below). They trade under the symbol (AIG WS), though this may vary from broker to broker.

As previously mentioned, the strike price is subject to anti-dilution adjustments. This is somewhat of an arcane point that seems to be widely misunderstood in the investment community. Many believe that any dividend amount in excess of the dividend threshold set forth in the prospectus, which is $0.675 within any twelve-month period, proportionately adjusts the exercise price downward. So, for example, if AIG were to pay out $1.00 in dividends within a twelve-month period, then the strike price would be adjusted downward by $0.325 ($1.00-$0.675) to $44.675. I wish this were the case, but in reality the true adjustment formula is not so generous. But what it lacks in generosity, it makes up for in complexity. Below is the formula used to calculate cash dividend adjustments:

(click to enlarge)Click to enlarge

Under this dividend adjustment formula, if we assume that AIG pays out $1.00 in dividends within a twelve-month period, and we assume that the stock closes at $56 on the record date, then the true downward adjustment could be calculated as follows:

SR1 = 45 * (56 - (1.00-0.675))/ 56

SR1 = 44.74

Initially, it seems like the difference is somewhat negligible - I mean 6.5 cents, what's the big deal? Well, over 6+ years the difference will surely add up. The point of all of this is to say that the dividend adjustment threshold does not impact the strike price as dramatically as a some have claimed, though the adjustment could still prove to be significant over the coming years.

AIG Stock Valuation & Warrant Returns

The whole point of owning warrants is to gain leveraged exposure to the underlying security. In this case, that would be AIG common stock. The company is still on the road to recovery, but the firm has sure come a long way from near collapse. The company is reaching pre-recession profitability levels, with 2013 normalized annual income topping $14 billion, which the company hit back in 2006. Here's the kicker though - AIG's market cap at the end of 2006 was around $160 billion. Today AIG's market cap stands at $80 billion. There's no question that the stock, even after appreciating 60% over the past two years, is still steeply discounted. How much upside is left? That's what we're going to try to figure out.

First off I'd like to take a quick look at AIG's most recent quarterly report. Regarding the company's insurance business, the company is showing strong progress in improving combined ratios, with each division booking lower ratios year over year. Property & Casualty decreased 3.8% from 102.6% to 98.8%, Commercial Insurance decreased 6.3% from 101.7% to 95.4%, and Consumer Insurance decreased 2.1% from 100.1% to 98%.

Additionally, the company has shown strong book value growth, with second quarter book value coming in at $75.71 per share, a 15% year over year increase. Over the past 3 years, book value has grown at an average compound rate of 19%.

(click to enlarge)Click to enlarge

Currently, AIG is trading at 0.74x book value, and even when using the much more conservative book value excluding accumulated other comprehensive income, AIG still trades at only 0.82x.

AIG has also been increasingly aggressive in its share repurchase program, having bought back $2.46 billion worth of stock over the past year, with an additional $1.5 billion remaining under the current repurchase authorization.

It's obvious that AIG has some very attractive value prospects; and with a little over 6 years remaining between now and the warrant expiration date, there's a lot of time for AIG to recover and potentially surpass pre-recession valuation levels. That would be wonderful, but for the below projection, I think it would be better to remain conservative in growth estimates.

For these calculations I'll be making a few reasonable assumptions: 1) AIG per share book value grows 7.5% annually. 2) AIG trades at a price to book value multiple of 0.85x by year end 2014, which then increases .05 points annually through 2020. 3) Book value will be $75 by year end 2014. 4) Dividends will grow 15% through 2020, starting at $0.50 through year end 2014.

It should also be noted that the adjusted strike price is based off of the previously explained formula, though I calculated the adjustments as if dividends are paid annually rather than quarterly in order to simplify the math. Also, please note that the returns are based on a $56 entry point for AIG stock and a $26 entry point for AIG warrants.

Year End P/B Mult. BV Dividends Adj. Strike

Stock Return (inc. div.)

Overall % Return Warrant Intrinsic Value Overall % Return
2014 0.85 75.00 0.50 45.00 64.25 14.73 18.75 (27.88)
2015 0.90 80.63 0.58 45.00 73.14 30.60 27.56 6.01
2016 0.95 86.67 0.66 45.00 83.00 48.21 37.34 43.61
2017 1.00 93.17 0.76 44.96 93.93 67.74 48.21 85.44
2018 1.05 100.16 0.87 44.87 106.04 89.36 60.29 131.90
2019 1.10 107.67 1.01 44.75 119.45 113.29 73.69 183.43
2020 1.15 115.75 1.16 44.59 134.27 139.76 88.52 240.47
Click to enlarge

If the above scenario were to play out, one could expect a CAGR of nearly 16% for the common stock over the next 6 years. Those are certainly excellent returns, but for those who go with warrants, the CAGR will be closer to 23%. Of course there's no guarantee that AIG will make it north of 1x book value, but 6 years seems to be plenty of time for investor confidence to be restored. If we're really lucky, AIG could get back to its early 2010 P/B of ~1.4x - but let's not get ahead of ourselves here.

Bottom Line

Warrants aren't for everyone. If AIG should run into trouble between now and expiry, these warrants offer no protection. AIG common stock is, in theory, good forever. These warrants, on the other hand, will rest in peace on January 19, 2021. If the timing is bad, the warrants will be worthless. If the stock pricing is bad, the warrants will be worthless. Personally, I don't see AIG taking a dive for the foreseeable future, so I highly doubt the warrants will fall and expire out of the money. However, the possibility is always there, and so if you have an extremely conservative approach to investing, these warrants may not be right for you. But if you're like me, and you have a high risk tolerance and/or are bullish AIG, then I don't see how you could pass up cheap leverage on an extremely undervalued stock.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I may initiate a long position in AIG through AIG stock warrants (AIG WS) over the next 72 hours.