American International Group Inc. (NYSE: AIG) is a U.S. based insurance company that serves commercial, institutional and individual clients in over 130 nations. The company offers general insurance, life and retirement insurance, and property-casualty insurance. AIG is the largest nonlife insurer worldwide based on market capitalization and is ranked #1 in commercial insurance in the United States.
TARP Warrants Issued January 2011, Expire January 2021
Before 2008, AIG’s Financial Products segment sold Credit Default Swaps – insurance against a collapse in value – on $441 billion of AAA-rated securities, including $57.8 billion in structured debt linked to subprime mortgages which went bust in the financial collapse that followed. Subsequently, a liquidity crisis pushed AIG to the verge of bankruptcy, and led to the Federal Reserve stepping in with an $85 billion bailout loan under the Treasury’s Troubled Asset Relief Program (TARP). The loan was backed by AIG stock in the form of warrants that represented a 79.9% stake in AIG and an agreement on the payment of dividends with anti-dilution provisions for warrant holders.
TARP Warrants: Needed when the Great Recession Started in Motion
In January 2011, to recapitalize the company, AIG gave existing non-governmental shareholders a conditional dividend in the form of a 10-year warrant (CUSIP 026874156, NYSE: AIGWS). This warrant gave eligible shareholders 0.533933 warrants for each AIG share held as of January 13, 2011. With each warrant, shareholders can buy one AIG share at a strike price of $45, any time before January 19, 2021 – up to a total of 75 million shares through cumulative warrant exercises.
Warrant Strike Price Decreases if Quarterly Dividends Exceed $0.16875
The warrant was structured to prevent dilution. So if AIG pays dividends on common and preferred shares above a quarterly threshold of $0.16875, the warrant’s strike price will be reduced. Under this scenario:
New Strike Price = Old Strike Price x [Market Price on Record Date – Excess Dividend Paid] / Market Price on Record Date, where Excess Dividend Paid = Quarterly Dividend Paid on Common – $0.16875.
So since [Market Price on Record Date – Excess Dividend Paid] / Market Price on Record Date is mathematically less than 1.0, the New Strike Price is less than the Old Strike Price.
However, the drop in Strike Price depends on two factors, the Market Price on Record Date and the Excess Dividend Paid. So a lower Market Price on Record Date will result in a lower New Strike Price. And a higher Excess Dividend Paid will also result in a lower New Strike Price. So for the same level of excess dividends, AIG warrant holders stand to gain more if AIG’s share price is low than when AIG’s share price is high.
Consider the following two examples:
Scenario A: Old Strike Price = $45
AIG Market Price on Record Date = $60 per share
Excess Dividend Paid = $0.28 (AIG quarterly dividend) – $0.16875 = $0.11125
New Strike Price = $45 x [$60 – $0.11125]/$60 = $44.9165625
Adjustments are rounded to the nearest hundredth of a cent ($0.0001), so the New Strike Price will be $44.9166, a drop of $0.0834 from the Old Strike Price.
But here’s another clause: if the decrease in the exercise price is less than 10 cents, the strike price will not change but the decrease “will be carried forward and applied in any subsequent adjustment of the exercise price.”
Scenario B: Old Strike Price = $45
AIG Market Price on Record Date = $30 per share
Excess Dividend Paid = $0.28 (AIG quarterly dividend) – $0.16875 = $0.11125
New Strike Price = $45 x [$30 – $0.11125]/$30 = $44.833125
Adjustments are rounded to the nearest hundredth of a cent ($0.0001), so the New Strike Price will be $44.8331, a drop of $0.1669 from the Old Strike Price, which is greater than 10 cents and will result in a lower New Strike Price.
Drop in Exercise Price Triggers Increase in Number of Shares per Warrant
To further prevent warrant dilution, any decrease in strike price also triggers an increase in the number of shares each warrant can buy.
New Shares per Warrant = Old Shares per Warrant x Old Strike Price / New Strike Price
Since the Old Strike Price will always be higher than the New Strike Price, their quotient is always greater than 1.0, so New Shares per Warrant will increase on adjustment.
Warrant Offers Better Value than Call Option on AIG Shares
On 11/2/2015, AIG declared a quarterly dividend of $0.28 per common share (record date of 12/7/2015, payable 12/21/2015), which exceeded the $0.16875 threshold and triggered an adjustment with a New Strike Price of $44.9036 and an increase in Number of Shares per Warrant from 1.000 to 1.002, effective 12/7/2015.
As of 12/11/2015, AIG shares traded at $59.48 while AIG warrants traded at $22.70 – so investors can establish larger positions with warrants than by buying shares outright. So with the New Strike Price of $44.9036, the warrants have an intrinsic value of $14.5764 [$59.48 – $44.9036] and time value of $8.1236. The January 2021 $22.70 warrant price offers three more years of expiry and significantly more value than AIG’s January 2018 $45 call option which trade at $17.70. In addition, warrants offer valuable anti-dilution provisions that are not included in options.
One of the downsides with AIG warrants is that they have wider bid-ask spreads and are less liquid than options because their low total quantity makes them unattractive to institutional buyers and their long-term upside make them attractive to private investors who have accumulated large positions which they plan to hold to maturity.
However, this is still a good time to buy warrants because there will pretty surely be greater demand as AIG shares rise and the warrants move in the money.
Why AIG Shares Should Move Up Between Now and January 2021
At $59.48, AIG shares trade at 0.75x Book Value of $79.40 per share, and will likely catch up to and exceed Book Value over the long run.
Activist investor Carl Icahn has purchased 42 million AIG shares and in late-October 2015, urged AIG’s management to shrink the company and accelerate cost cuts. Icahn argues that breaking AIG up into three public companies would allow each to compete more effectively. While AIG CEO Peter Hancock has met with Icahn several times, AIG does not see value in the breakup. But if AIG agrees to a breakup at some point over the next five years, shares could run up significantly in value.
In addition, AIG is actively divesting non-core or underperforming assets to streamline operations and reduce costs. For example, on 12/7/2015, AIG sold 361 million shares in Chinese insurer PICC Property & Casualty, and received $751.8 million from the sale. This is the second time AIG lowered its stake in PICC P&C, previously selling 256 million shares for $500 million in March 2015. AIG has also exited other investments, and plans to use proceeds to buy back shares.
And on 12/10/2015, AIG announced a significant cutback in its global management team – from 15 to 11 – to simplify operations and cut expenses – seen as a response to shareholder demands to trim expenses amid falling revenues, and to tighten his management team with old loyals. The new team will place an emphasis on profitable growth, optimization of data assets and returning value to shareholders. AIG will also cut between 300 to 400 senior management jobs, roughly 20% of the senior work force.
In 2015, AIG management has strongly focused on strengthening the company’s balance sheet by lowering expenses, improving reserves, shedding non-core assets and lowering its equity investments.
3Q15 Financials Disappoint yet Stock Holds
For its third quarter ended September 30, 2015, AIG reported total revenues of $12.82 billion, down 23% from $16.70 billion in 3Q14. Premium revenue fell about 7% on a 10% drop in total commercial insurance revenue and an 8% drop in consumer insurance revenue, which management attributed to market volatility. AIG reported 3Q15 after-tax operating income of $691 million, or $0.52 per share, down from $1.7 billion, or $1.19 per share, in 3Q14. Despite a 6% reduction in total benefits, claims and expenses, AIG reported a loss from continuing operations of $115 million, down 104% year-over-year. AIG also reported a 111% decrease in net income to a net loss of $231 million, or $0.18 per share. The company missed analysts’ estimates on revenue by about 10% and on adjusted-earnings by about 98%.
Dividend More Than Doubled, New $5 Billion Buyback Program
AIG declared a fourth quarter dividend of $0.28 per share (up 124% annually), payable on December 21, 2015, for shareholders of record December 7, 2015. This marks the second dividend increase since 2013 when the company resumed paying a dividend after the recession in 2008. At $59.48, AIG shares offer a dividend yield of 1.88%.
In August 2015, flush with proceeds from asset sales, AIG added $5 billion to its existing share repurchase program, bringing the total to $6.4 billion. From July to October 2015, AIG repurchased $4.3 billion worth of shares.
Analysts Bullish on Share Price Growth, Warrant Upside
Despite disappointing 3Q15 financial results, analysts see significant upside potential given the company’s global leadership. AIG has a median analyst target price of $68.50 per share (15% upside) and a high price target of $77 per share (29% upside). With a lower cost basis, warrant holders stand to reap higher gains as the stock moves up – with gains of 53% at $68.50 and 71% at $77.
Valuel Line estimates a recovery to positive earnings in FY2015 and earnings growth of about 26% in FY2016. ValuLine.com believes shares could climb to $95 by the 2018-2020 timeframe, giving warrant holders’ potential upside of 112%.
Management is strongly focused on squeezing efficiencies, cutting costs and streamlining operations, and AIG’s share price should improve as restructuring efforts steadily flow to the bottom line quarter after quarter, all the way to January 2021 and beyond.
I believe $AIG-WTA, $AIG warrants, could be the best name we own for future capital gains.
I believe in selling $AIG common stock and buying $AIG-WTA. The warrants have a higher return on invested capital. I use options to position the warrants in an ideal setup.