I’ve had this article written for about a week but didn’t publish it because I am far from certain on legalese of the warrants prospectus. I have written my best understanding of it and could be wrong. I would love to hear other investors’ opinions on the warrant adjustments. The reason I am publishing this article now is I just read Francis Chou’s 2012 letter which specifically discusses ‘the secret’. By the way, there are a number of other companies with TARP warrants, I also hold some Bank of America warrants, I just chose AIG for this post.
“Bank TARP warrants are complex, with terms and conditions that are unique to each bank. Thus we encourage you to research them for yourself and draw your own conclusions. The legalese is quite intimidating but there is some help on the way. Some banks have started to pay dividends that exceed a set price, and we are starting to see how anti-dilution clauses that were added to protect TARP warrant holders apply with regard to:
a) the adjustment of the strike price.
b) the adjustment to the number of shares you can purchase for each warrant you hold.”
By now, most investors are familiar with the TARP warrants on some major US financials. Famed investor Francis Chou discussed these warrants in his 2010 semi-annual letter. I’m not usually very interested in derivative securities like options due the short time horizon. Even with LEAPs the duration is only up to a max of 39 months. (If stocks were to move into a long term bear market you run the risk of losing your investment). However, the Tarp Warrants have expirations in 2019 and with American International Group Inc (NYSE:AIG) 2021. So the ‘timing’ risk isn’t really too concerning, even for a conservative investor like myself.
By Hardcore Value
It is also well understood that the Warrants have an added benefit of adjusting for dividend payments beyond a threshold. In American International Group Inc (NYSE:AIG)’s case this is 67.5 cents per year. So if there is a $2 dividend payment the exercise price will be lowered by $1.325 (From $45 to $43.675).
However, what is less understood and has often been referred to as the ‘secret’ is the number of shares each warrant will be entitled to purchase. Plan Maestro of Variant Perceptions has discussed the secret both on his website and on the corner of berkshire message board. But other than that, there is little discussion possibly due the inability for many institutional investors to purchase TARP warrants because of liquidity concerns or fund mandates.
The AIG Tarp ‘secret’ revolves around one paragraph of the AIG prospectus:
Upon any adjustment in the exercise price, each Warrant will evidence the right to purchase the number of shares of Common Stock obtained by multiplying the number of shares of Common Stock purchasable immediately prior to the adjustment by the exercise price in effect immediately prior to the adjustment and dividing that product by the exercise price in effect after the adjustment.
Lets try and break it out to its simplest form and assume a $2.33 dividend is paid.
the right to purchase the number of shares of Common Stock obtained by multiplying the number of shares of Common Stock purchasable immediately prior to the adjustment
No adjustment has taken place yet because AIG is not paying dividends yet. So the number of common stock purchasable is 1 for 1 (1 warrant for 1 share).
the exercise price in effect immediately prior to the adjustment
Again, no adjustment has taken place so we still have a $45 exercise price.
dividing that product by the exercise price in effect after the adjustment.
After the adjustment $1.655 ($2.33-.675) the exercise price falls to $43.345
So we have:
1*45/43.345 = 1.038
Obviously a 3.8% increase in the number of common available to the warrant is not a huge different but remember these warrants don’t expire until 2021 and the prior years adjustment factor becomes the base rate for the next year.
So, Let’s assume American International Group Inc (NYSE:AIG) pays no dividends until 2015 by which point book value has only increased to $70 (It’s already at $66 but lets stay conservative). Of course, AIG could chose to focus on buybacks and at this price that makes sense but I’m pretty sure most institutional investors will be pushing for a dividend by then. Assuming a 10% ROE, EPS will be $7. Assuming a 1/3rd payout ratio, Dividends will be $2.33 per share or $1.655 over the dividend threshold. Let’s assume that dividends grow at 6.6% per year thereafter. Here’s what we get:
Dividends Excess Exercise Adjustment
2015 $2.33 $1.66 $43.35 1.04
2016 $2.48 $1.81 $41.54 1.08
2017 $2.65 $1.97 $39.56 1.14
2018 $2.82 $2.15 $37.42 1.20
2019 $3.01 $2.33 $35.08 1.28
2020 $3.21 $2.53 $32.55 1.38
2021 $3.42 $2.74 $29.81 1.51
So not only do we have the exercise price dropping from the original $45 to $29.81 but the warrant to common adjustment factor increases to a massive 1.51:1 ratio.
Putting it all together:
Under the above assumptions* (which of course will be wrong, by how much I don’t know!)with the common we get a very attractive 13% per year growth rate, the warrants would obviously get higher at 19% per year, however adding in the ‘secret’ which allows each warrant to purchase 1.51x common (under the above assumptions) pushes the the growth rate to a massive 25% for 8 years.
Anyways, that’s my best understanding of it, please comment if you think I am misreading the prospectus.
Disclosure: Long AIG and BAC ‘A’ Tarp Warrants.
$70 of book value by 2015.
6.6% growth in book value thereafter.
price to book of 1x.
no dividends reinvested (for simplicity, I’m lazy and it wouldn’t be a huge difference)
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