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
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.
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.
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Yellow Media Warrants
(n) If the Corporation, after the date hereof, shall take any action affecting any
Common Shares, other than action described in Section 4.1, which in the opinion
of the Board, acting reasonably, would materially affect the rights of
Warrantholders, the Common Share Rate shall be adjusted in such manner, if
any, and at such time, the Board, acting reasonably, may determine to be
equitable in the circumstances. Failure of the taking of action by the Board so as
to provide for an adjustment in the Common Share Rate prior to the effective
date of any action by the Corporation affecting the Common Shares shall be
conclusive evidence that the Board has determined that it is equitable to make no
adjustment in the circumstances.
(o)As a condition precedent to the taking of any action that would require an
adjustment pursuant to this Section 4.1, the Corporation shall take any action
which may be necessary, including obtaining regulatory, TSX or Shareholder
approvals or exemptions, in order that the Corporation may thereafter validly
and legally issue as fully paid and non6assessable all Common Shares that the
Warrantholder is entitled to receive upon exercise of a Warrant pursuant to this
Section 4.1.
(p) If and whenever at any time after the date hereof and prior to the Expiry Time,
any of the events set out in this Section 4.1 occur and the occurrence of such
event results in an adjustment of the Common Share Rate pursuant to the
provisions of this Article 4, then the Exercise Price will be adjusted
contemporaneously with the adjustment of the Common Share Rate by
multiplying the then applicable Exercise Price by a fraction, the numerator of
which will be the then applicable Common Share Rate in effect immediately
prior to the adjustment and the denominator of which will be the Common Share
Rate resulting from such adjustment.
yellow media warrants by my calcs are significantly better
http://www.ypg.com/en/newsroom/566-yellow-media-inc-announces-recapitalization-transaction
