AIG Warrants Offer More Attractive ROI than Common Shares and Offer Anti-Dilution Provisions
On January 6, 2011, American International Group (NYSE: AIG) issued warrants (NYSE: AIG-WT) to AIG shareholders (of record January 13, 2011) in lieu of cash dividends. Each AIG common share received 0.533933 warrants. The warrants have a 10-year term and expire at 5 p.m. Eastern Standard Time on January 19, 2021 (the warrant’s expiry date). Each warrant gives its holder the right to buy one AIG common share for $45 (the exercise price), anytime through the expiry date and time. Think of this warrant as a long-term call option on AIG shares with a strike price of $45 and a January 2021 expiry date.
With warrants trading at about $26 each (as of August 21, 2014), AIG shares will have to rise to $71 by January 2021 for warrant holders to breakeven. However, bullish projections on AIG share price could make these warrants deliver a 300% return through their expiry date, well above the projected 170% return you’d get from just buying AIG common stock at about $55.
Warrants do not carry the same rights as common shares and warrant holders will not receive dividends.
Warrants can be traded on the open market through regular stock brokers but carry a significant bid-ask spread because of relatively low trading volumes. Most warrant holders see tremendous upside and are unwilling to part with their warrants just yet, with most holding on for the long run. For example, AIG warrants had a bid of $25.87 and ask of $27.08 at market close on August 21, 2014, with a spread of $1.21 or 4.7% over the bid price.
Immediately after their issuance, warrants fell substantially in value from about $16.29 to less than $6 near the end of 2011. Warrants have, since, soared over 4x in value to about $26 as of August 21, 2014. This gain in warrant price reflects the performance and upside offered by AIG common shares which increased from about $20 near the end of 2011 to $55 as of August 21, 2014. Even so, AIG shares still trade at about 73% of book value.
Warrants Offer More Upside than Shares
With AIG shares at about $55 per share, warrants offer intrinsic value of $10 based on the $45 exercise price, well below the warrant’s market price of about $26 and are currently underwater. The additional $16 in warrant fair value comes from their time-value through January 2021 expiration.
FastGraphs projects that AIG shares could rise to about $148 by January 2021, when warrants are due to expire, so warrants could have an intrinsic value of $103 at expiry, 300% above their current value of about $26 per share and higher than the 170% gain in AIG shares.
If projections bear out, AIG warrants could offer better ROI than AIG common shares.
Why AIG Shares Could Rise to $148 or More by 2021
AIG is a global insurance company that provides a range of products for property casualty insurance, life insurance, mortgage insurance, retirement and financial services to customers in over 130 countries. Its diverse offerings help businesses and individuals manage risk, protect their assets and get dependable retirement income. AIG earns its revenue primarily from insurance premiums, policy fees and income from investments. In May 2014, AIG fully divested International Lease Finance Corporation to focus on growing its core insurance and retirements’ business.
26 Wall Street analysts have a Strong Buy / Buy / Hold rating on shares and expect 11.8% long-term earnings growth. Further, AIG’s business fundamentals are well above industry peers (net margin of 19% vs. 7% peer average) while its valuation lags the industry average significantly. For example, AIG has a price-to-earnings ratio of 9.3 vs. 20.3 average and double-digit P/E for its peers.
AIG has demonstrated strong gains in its consumer business and annual improvements in its loss ratio driven by U.S. warranty and Japan auto insurance segments, with more conservative accident reserves and recent losses below-trend, which is a positive sign. AIG is still in the process of restructuring its operations and worries about the success of its current restructuring have kept investors at bay and shares significantly below tangible book value of about $68 per share, making this a great time to buy the warrants before prices catch up with fundamentals.
Let’s put things in perspective. AIG shares touched an all-time high of $1,971.25 in December 2000, well before the 2008 crisis and had a floor of about $1,000 through most of the decade leading up to the crash in 2008. Shares now trade at about $55, well below where they were pre-2008.
Though AIG’s business suffered dramatic losses due to its heavy use of leverage, its fundamental business value is now back on the rise and shares could, potentially, handily surpass current projections of $148 by 2021… so warrant upside could be even more significant.
And while AIG’s insurance business is volatile and can get severely impacted by one-off loss making periods, the company is tightening its focus on core operations and has divested non-core businesses such as aircraft leasing. AIG has also aggressively bought back shares because management believes they are significantly undervalued relative to AIG’s long-term potential.
Anti-Dilution Adjustment Offers Protection to Warrant Holders
Warrants are protected against dilution and will be adjusted to compensate for:
i) stock dividends (the distribution of common shares in lieu of cash dividends) and stock splits;
ii) the issuance of other warrants, rights or stock options that allow exercise below the prevailing market price of AIG common shares;
iii) the issuance of other (non common) classes of shares or rights;
iv) the distribution of more than $0.675 in cash dividends per common share in any 12-month period; and
v) offers (such as acquisition bids) to purchase more than 30% of AIG common shares at above-market price.
With anti-dilution adjustments in place, warrants offer compelling value.
AIG currently pays $0.125 in quarterly cash dividends per common share, with the next payment due September 25, 2014, to holders of record September 11, 2014.
From the time warrants were issued in January 2011, AIG dividends have not exceeded $0.675 in any 12-month period.
However, if AIG pays more than $0.675 in dividends
in any 12-month period (more than $0.16875 per share quarterly), the strike price adjusts downwards and warrant holders receive the right to purchase additional shares for each warrant held, at no additional cost (see tables below).
If dividends exceed the threshold, the new strike price = initial strike price of $45 x (stock price on record date – excess dividend over threshold) / stock price on record date, and the new number of shares per warrant = $45 / (new lower strike price). The table below present sample scenarios assuming a quarterly dividend payout of $0.50 that exceeds the quarterly dividend threshold of $0.16875 (one-fourth the $0.675 12-month threshold). The lower the stock price on the record date, the lower the new strike price. For example, with shares at $30, the new strike price is $44.5031, about $0.32 below the strike price of $44.8246 if shares were at $85.
So investors will get more upside if AIG’s share price stays low in the coming years and climbs sharply as January 2021 expiry approaches because a lower price delivers marginally more new shares per warrant.
Warrants Exercisable through Wells Fargo
Warrants can be exercised by completing an exercise notice and providing payment through check to Wells Fargo, which serves as the warrant agent. Upon exercise, warrant holders will receive AIG shares equal to the whole number of warrants exercised and cash in lieu of fractional warrants. Shares obtained from the exercise of warrants may be sold immediately, without any waiting period.
Taxes Due On Warrants
When issued in January 2011, the warrants were classified as a non-dividend distribution with a fair market cost basis of $16.29 for tax purposes based on the average of the highest ($16.93) and lowest ($15.65) price at which warrants were traded on the NYSE on January 20, 2011. To adjust for this $16.29 fair market value and 0.533933 warrants per share, holders’ should reduce their cost basis (for common shares) by $16.29 x 0.533933 or $8.70 per share to get the adjusted tax basis of common shares on which warrants were issued. Here’s the math:
AIG warrants have an attractive long-term expiry date which gives the company significant room for its restructuring to play out and for the global economy to stabilize from continued weakness and global strife. Warrant investors will also sizably benefit from leverage effects – buying a security that trades at $26, at less than half its underlying equity’s market value of $55 with all the upside and a minor sacrifice of the 0.9% annual dividend yield. The warrant comes with strong anti-dilution provisions that ensure warrants are not de-valued. If shares rise to $150 by expiry, which seems wholly possible given AIG’s strong execution focus, warrant holders could reap rich returns relative to AIG shares.