AIG Warrants (AIG/WS)

Shares:  75mm

Price: $19

Market cap: $1,425mm

Net debt: 0

TEV: 0

 Warrant background:

As part of the recapitalization of AIG, 10 year warrants to purchase 75mm shares of AIG common stock at an exercise price of $45 were distributed to holders of the common stock in January 2011.  The expiration date of the warrants is January 19, 2021, so there is still nearly 8 years of remaining life.   

These are highly attractive instruments because the underlying common stock is cheap and nearly 8 years is more than enough time for operations to improve enough for the business to trade at book value or more.  AIG common currently has a book value of $67.41, so at a price of $44.50, it is trading at only .66x book.  Book value over the next 8 years will grow substantially driven by retained earnings and share buybacks, which will lead to significant upward revision of the valuation multiple.  At expiration, the warrants should have returned many multiples of your investment. 

Why this opportunity exists:

There’s not a great methodology for valuing long term warrants. For example, almost all the TARP warrants, like these AIG warrants, trade at double the implied vols of short term warrants on their underlying stocks. Instead of being very overvalued they are actually quite cheap. The Black Scholes model is known for dramatically underpricing LEAPS, but there’s nothing great to use in its place. While AIG common looks like a good value investment, it’s just not clear, over a 1-3 year period, whether the ROE will return to a level where it would justify trading at book value. In this case, conversion to book value (plus?) is, however, very,very likely to occur over a 8 year period. Thus we can anchor the value of the warrants to where book value will be in 8 years. This is the key insight here… we have a valuation framework. 

Multi-bagger even under modest assumptions (Case 1):

Using a consensus type case of earnings for the remainder of 2013-2015, with a dividend starting in Q3 2013 and share buybacks of $12bn over 2014-2015, book value will grow to $80.77 by the end of 2015. 

This case has AIG earning a 6.7% ROE on total common equity in 2015.  If we assume it takes 2 years from that point for it to return to a more reasonable ROE level for this business of 10% and then maintain that level of profitability from 2018-2021, book value will end 2021 at $135.91.

If we assume the common trades at this level at the start of 2021 when the warrants expire, net of the $45 strike the warrants would be worth $90.91, nearly a 5 bagger from here.  If we discount this value 7 years (to the start of 2014) by 10%, they are worth $46.65, up 145% from the current price.  Note that dividends in this forecast are capped at $0.675 per share, since any amount in excess of that amount would lead to an adjustment in the strike price of the warrant. 

Upside cases (Cases 2-4):

The upside could be significantly higher if AIG earns more in the projection period and/or buys back more stock, therefore achieving a greater ROE and deserving a higher multiple.  We think that the consensus case above understates the likely amount of share buybacks, which are very accretive when done below book value.  AIG has and will generate even more excess capital that will be deployed into buybacks once regulatory certainty from the Fed has been attained.  And there are certainly outcomes in which the business achieves better operating performance.

We use the same basic framework for these cases as in case 1, but have an additional $10bn of buybacks and better operating performance after 2015.  We use higher multiples to value the stock in 2021 which flows through to significantly greater upside for the warrants.

Risks:

1.  Warrants could expire worthless if the common stock is not trading above $45 in January 2021 if turnaround at AIG fails miserably.
2. The warrants are somewhat illiquid with concentrated ownership, 32% owned by Fairholme Capital.
3. Our valuation methodology is long term oriented, unlike Black-Scholes where implied volatility is a significant driver.

Catalysts:

1.  Continued improvement of core insurance operations of AIG
2. Resumption of share buybacks
3. Multiple re-rating as ROE of the business expands

Disclosure:

We and our affiliates are long AIG warrants (AIG/WS) and may buy additional shares or sell some or all of our securities, at any time. We have no obligation to inform anybody of any changes in our views of AIG/WS. This is not a recommendation to buy or sell securities. Our research should not be taken for certainty. Please conduct your own research and reach your own conclusion.

Catalysts:

1.  Continued improvement of core insurance operations of AIG
2. Resumption of share buybacks
3. Multiple re-rating as ROE of the business expands