Is AIG a Buy Following the Government Bailout?

| About: American International (AIG)

Based on CNBC, the stock is worthless when AIG (NYSE:AIG) issues warrants to the government in exchange for the bridge-loan. Based on my simple Finance 101 calculations, AIG stock is not worthless and should be a buy as a long-term investment.

When I first read the deal, it does not make much sense – $85 billion loan for 80 % stake. How can you provide a loan for equity? The government gets the best deal because the loan needs to be repaid. So, the government will own 80% of the company without any investment in the company. I think any private equity firms would jump into this kind of deal. But will it be similar to convertible debt? If so, why don't they just call it convertible debt then?

First of all, the government is only providing a loan, not equity investment. The loan is for 24 months and should be repaid from the proceeds from assets sales. According to the Fed statement, "The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries, and of its primary non-regulated subsidiaries." This is what AIG intends to do anyway. But the government wants some insurance that AIG will perform according to the agreement. So, the government requires AIG issuing warrants as a condition to obtain the loan. The warrants can be converted to 80% ownership.

As I understand, warrants are basically options issued by the company. Warrants are not stocks until they are exercised. So, we can only say there is a potential dilution of ownership if exercised by the government. The government is not in investment business looking for profits. The government is providing the loan to avoid a financial meltdown. So, if AIG performs as promised, the government should not exercise those warrants, and the current ownership will not be diluted. I expect the warrants in the hands of the government are used to ensure AIG will perform accordingly. If AIG's performance is not satisfactory, then the government can exercise the warrants and take control of the company. At that time, the government can actually replace the AIG's board and the executives.

Since the government funding is a loan, the warrants should be canceled once the loan has been fully repaid. Furthermore, if AIG's financial condition is stable and secure, AIG can buy back the warrants from the government.

Let's deal with AIG valuation. Since the government provides $85 billion for potential 80% ownership, the remaining 20% should be worth $21.25 billion. Yahoo finance shows the total number of shares outstanding is 2.69 billion. Therefore, the current 2.69 billion shares should worth about $7.90 per share. This valuation method is a simple comparable sales technique, nothing fancy at all. If this makes sense, then you should buy AIG for long-term investment.

A few points that I want to emphasize:

1. AIG is a solvent company, but it just needs time to sell some assets for raising capital. AIG has a lot of viable business units.

2. The government assistance is not a bailout because the company is solvent. This is why AIG wants a bridge-loan to buy some time in order to facilitate the necessary sales. Instead of fire sales getting low prices, now AIG can sell the assets at more reasonable prices.

3. The loan package is for warrants, not convertible preferred. This indicates the government is not interested in owning the company long-term.

4. It makes no sense to me that the government wants to wipe out the current shareholders of a solvent company.

One side note: if the government was willing to provide the bridge-loan on last Sunday when it was first requested, the loan amount was only $20 billion. AIG needs more funding now because of the downgrades by rating agencies on late Monday. Because of the downgrades, AIG needs to post an additional $14.5 billion as required by its trading partners. Also, AIG could pay additional $5.4 billion payments for early termination of contracts. Therefore, because of the time delayed, AIG needs more funding.

I am not sure then why all the media claim the current stocks are worthless. Your thoughts.