Pitch:
We believe these are an outstanding risk/reward because the common stock continues to be
undervalued and there is plenty of time for AIG’s business performance to improve enough for the stock
to trade at least at book value before the warrants expire. If that happens, the warrants should be
multi-baggers.
Background:
10 year AIG warrants were issued in January 2011 as part of the government rescue of AIG. The
warrants expire in January 2021 and have a strike price of $45.
We think about the value of these warrants in relation to the intrinsic value of the common stock over
the long term. Many/most market participants probably rely on the typical Black – Scholes
methodology which systematically undervalues long term warrants.
AIG BVPS is $78 and it is currently trading at ~0.69x book. We believe that BVPS will continue to grow
steadily if the business continues to deliver solid and improving earnings and buys back stock. Should
the ROE of the business improve to peer levels, the valuation multiple of the common stock should
trade at least at 1x book. The S&P P&C Index trades at ~1.4x book today, similar to its long term
average.
Valuation:
Using modest assumptions of slowly improving performance and buybacks roughly equal to taxed net
income from 2015-2018 and none beyond that, we project BVPS to grow by a ~9% CAGR until the end of
2021. In this scenario, BVPS growth is slower than might be expected due to the utilization of the DTA.
2015 ROE (Net income / average total equity) should be around 6% and we think the business should
have improved and have enough capital returned to get to a ~10% ROE in 2021.
By the end of 2021, we project BVPS to reach $140.
If the common is trading at BVPS, that would mean the warrant is worth $95 ($140-$45) which is a 4
bagger, or a ~27% annualized return for 6 years.
If the business has improved even more and can trade at 1.2x BVPS, the warrant would be worth $123,
more than a 5 bagger, or a 32% annualized return for 6 years.
Alternatively, we can look at a more standard valuation approach to help us think about downside.
Current implied vol of the warrant is 45%. If we assume in 2 years, the stock trades to just the current
average analyst price target of $62 and vol compresses to 35%, the warrants should be break-even. If
vol remains constant, the warrants should appreciate by 15%.