AIG, BAC Warrants - Bruce Berkowitz's Thoughts

We have just read Bruce Berkowitz's semi annual letter and was more than glad to see him discussing about the long-dated warrants that we have mentioned in previous posts.

Here is the snapshot of the returns that he is projecting for the different warrants:

Source: http://www.fairholmefunds.com

Both AIG and BAC warrants are high up on the list, offering returns of 752% and 592% respectively.

We have used even more conservative growth rate than his suggested 10% growth in book value through the years. What is interesting here is that Hartford warrants have almost the similar returns as AIG warrants. We will probably do some work on it.

On investing in the warrants, we always have people asking us how come then with such returns, well known value managers are not putting their money in the warrants but instead in the common stocks?

The reason is they can't. There is simply not enough volume of warrants out there in the market for them to buy. Bruce himself already holds close to 25mil of the 75 mil outstanding AIG warrants. That is almost 1/3 of the entire float!

But for retail investors, that is a different case altogether. We can instead buy in to these warrants and hold on till expiry and chances are, you will be getting a huge paycheck at the end!

BAC Warrants - Dividend Adjusted Strike Price

A reader of our blog posted the following:

“…I think you missed an important feature of the BAC warrants - they lower the exercise price for quarterly dividends in excess of a penny. This is huge…”

In our article, we have left out this portion as the prospective returns are already so high. But since it is mentioned, we shall explore this further.

A little background on the BAC Warrants A:
Unlike normal warrants, there is a clause in them that allows for any dividends paid that are above $0.01 to be subtracted from the strike price.

The table below shows the potential enhanced yield using conservative estimations on BAC’s PTPP and dividend payouts in the future.

	Payout ratio	PTPP	Dividend	Adj Strike Price	Enhanced Yield
2011	2.04%	27000	$0.04	$13.30	0%
2012	1.84%	30000	$0.04	$13.30	0%
2013	10%	35000	$0.25	$13.09	5%
2014	15%	40000	$0.44	$12.69	14%
2015	20%	50000	$0.73	$12.00	29%
2016	26%	53000	$1.02	$11.02	51%
2017	26%	56180	$1.08	$9.98	74%
2018	26%	59551	$1.15	$8.88	99%

 

We have decided to use adjusted PTPP instead of net income as in recent years, provisions have gone up quite significantly. As discussed in the previous article, the normalized PTPP would be in the range of $50B. Historical dividend payout has been about 26.5% of PTPP.

As shown in the table, the dividend payout of $0.04 in 2011 is only about 2.04% of BAC’s adjusted PTPP of 27000. In our calculations, we have assumed BAC’s historical dividend payout of 26.5% would only be restored in year 2016. And for their normalized PTPP of $50B, it would only be reached in year 2015 with subsequent years of CAGR 6%.

Using these estimations, the strike price would be adjusted lower from $13.30 to $8.88 by the end of 2018. This would provide an enhance yield of almost 100%!

The best part of these warrants is that they are long-dated compared to many other warrants out in the market. This would give BAC plenty of time to start paying out higher dividends.

Enjoy playing with the numbers and you will be amazed by how much more the enhanced yield could be!