Wells Fargo TARP warrants analysis – a compelling investment?

By | 23/07/2011

During the last 3 days Wells Fargo TARP warrants exploded with 16.6% return, along with the stock, from a price of 8.4$ per warrant to 9.8$.

WFC Warrants present an interesting opportunity since their expiration date is very far from now – October 28th 2018, or over 7 years. Their strike price is 34.01$ – each warrant can be replaced by one stock for 34.01$.

Currently, these warrants cost almost 10$ but their true value, if they should expire today, is zero since the stock is well below the strike price. The current buyer is paying for what is known as the "time value" of the warrant, or in other words he is paying for the chance that the warrant will be worth something at the time of expiration.

I will not get into complex calculations like Black & Scholes or other Warrant / Options valuation models but try to see what does the market believe by pricing the warrants as it does. I will also ignore dividends that could add adjustment to the warrant's strike price if cross a threshold of 34c per quarter.

Let's start from the investor's point of view: Is it better to buy the stock or the warrant?

The answer of course depends on the stock price at the time of expiration. Let's examine the relation between the warrant price and the stock price by some back of the envelope calculations (that I did on the bus today):

S_{current} = Stock current price

S_{expiration} = Stock price at expiration date

W_{current} = warrant current price

W_{expiration} = warrant's price at expiration

Y_{stock} = Stock's yield at expiration date

Y_{warrant} = Warrant's yield at expiration date

Now it is clear that:

Y_{stock}= \frac{S_{expiration}}{S_{current}}

And that the warrant's yield will be the warrant's price at expiration divided by the current warrant's price:

Y_{warrant}= \frac{W_{expiration}}{W_{current}} = \frac{S_{expiration}-34.01}{W_{current}}

Because Warrant's price at the time of expiration will be the stock's price deducted by the strike price.

For an investor to invest at the warrant, his minimum requirement is for the warrant's yield to equal the yield of the stock at expiration. So lets see what should be Wells stock price at expiration as a function of all other values:

Demand yields from warrant and stock to be equal:

\frac{S_{expiration}}{S_{current}} = \frac{S_{expiration} - 34.01}{W_{current}}

We get:

S_{expiration} = \frac{34.01 \cdot S_{current}}{S_{current}-W_{current}}

If we use: W_{current} = 9.78\$ and S_{current}=29.14\$ we get that the stock price at expiration should be 51.19$ for the investor to be indifferent between the stock and the warrant.

Now what does it tell us?

It means that if the stock will yield 75.7% in the next 7 years, investing in the warrant will equal to investing in the stock.

There are a little over 7 years for the stock to reach 51.19$, so the market expects Wells Fargo to yield 8% per year.

Considering that Wells equity is worth about 136 B$ and current market valuation is 13% above this number, and that wells achieves 10.6% yield on equity and distributes about 1.8% of that as dividends, we get that warrants are priced as if wells will earn this kind of yield on equity for the next 7 years and keep current valuation of 13% above book.

But what will happen if Wells will earn more money as it will loan more money? or if it will earn more than 10% on equity? or if the dividend will grow sufficiently to "fix" the warrant exercise price downwards? or if the current buyback program will be expanded significantly?

Some points to consider:

Consider 2005 for example, Wells was worth 103 B$, equity was 40.66B$, a multiple of 2.5 on books, more than double the valuation today. P/E at 2005 was 13.4 (no adjustments). This means almost 20% yield on equity.

From the end of 2000 till the end of 2005 profit rose by 90%, a 5 year only stretch that included a big recession.

Today's P/E is only 10 times 2011's first half extrapolated profits (no adjustments). But today's profits also include many other temporary charges like the Wachovia merger charges and above average loan writedowns, so the actual P/E is much lower. It also does not include the fact that Wells can dramatically enlarge its loan portfolio.

Considering these simple points, it seems very likely that in the next 7 years Wells' stock will achieve much more than 75.7% yield, which makes the warrants an attractive investment.

In case Wells' stock will rise a little more, for example, by 90% (will reach 55.4$), the yield on warrants will be 119% or an average of 11.3% per year.

For the warrants to yield 15% per year as Buffett likes to demand – we get a total of 177% yield for a 7.3 year stretch or a price for warrants at expiration of 27.1$. This implies stock price of 61.1$, which in turn implies that the stock will yield 109% in the next 7.3 years (10.6% per year), and as we saw in the past, it is more than possible.

You can see all of this graphically here.

12 thoughts on “Wells Fargo TARP warrants analysis – a compelling investment?

  1. shlomi ardan

    Hey Assaf, great post.
    Can you elaborate on how dividends affect the warrant?
    Is a 1$ divident equivilant to a 1$ increase in the strike price without a dividend?
    Is a more aggressive dividend policy a risk for warrant holder?

    1. Assaf Nathan Post author

      Actually a more aggressive policy is of help to the warrants investor, IF the dividend is above 34c per quarter.
      In that case the strike price is adjusted downwards at the same amount as the stock. I.e if wells stock is 30$ and the div is 1$, it represents 3.33% yield, so the strike price will be adjusted 3.33% downward, to 32.88$.
      The risk is that the div will rise but not cross 34c per quarter, so only stock holders will enjoy the div and warrant holders will not get anything, not price adjustment or equity or anything else for that matter.
      As long as they keep buying back stock, warrant holders still profit, but the current div is lost for them.

  2. Roy

    Hello Assaf,

    Great blog, just found out about it, very well written, educational and inspiring, thank you.

    Regarding the warrant risk, right off the top of my head, there's also some risk that if there's a company split/break up, it might reduce its market cap while the warrant strike price will not be adjusted.


    1. Assaf Nathan Post author

      Hi Roy,

      Actually there is no such risk at all, see the warrants prospectus:

      In the case of stock splits, subdivisions, reclassifications or combinations of common stock. If we declare and pay a dividend or make a distribution on our common stock in shares of our common stock, subdivide or reclassify the outstanding shares of our common stock into a greater number of shares, or combine or subdivide or reclassify the outstanding shares of our common stock into a smaller number of shares, the number of warrant shares at the time of the record date for such dividend or distribution or the effective date of such subdivision, combination or reclassification will be proportionately adjusted so that the holder of a warrant after such date will be entitled to purchase the number of shares of our common stock that it would have owned or been entitled to receive in respect of the number of warrant shares had such warrant been exercised immediately prior to such date. The exercise price in effect immediately prior to the record date for such dividend or distribution or the effective date of such subdivision, combination or reclassification will be adjusted by multiplying such exercise price by the quotient of (x) the number of warrant shares immediately prior to such adjustment divided by (y) the new number of warrant shares as determined in accordance with the immediately preceding sentence.

      Effectively, warrants are protected against ANY kind of spin off, dividend (above 34c), buyback, split or reverse split, demerger or merger, etc… Those are warrants originally given to the US treasury and the US treasury is nothing but a sucker.

  3. Roy

    (Roy, not Eldad 🙂 )

    "The exercise price will not be adjusted, however, for other events, such as a third-party tender or exchange offer, a merger or reorganization in which our common stock is acquired for cash or an issuance of common stock for cash, that may adversely affect the trading price of the warrants or our common stock. Other events that adversely affect the value of the warrants may occur that do not result in an adjustment to such exercise price. "

    1. Assaf Nathan Post author

      Fixed 🙂
      I disagree, those risks are nonexistent.
      Who can acquire Wells for cash?
      3rd party tender offers are nothing but a big buyer that wants a chunk of the company in a fixed price, it is not different than any other large buyer for that matter and won't influence on the underlying intrinsic value of the stock.
      Merger? Such an acquisition or merger will be publicly known so the stock price will "adjust" your profit by itself. Besides, in such merger warrant holders also have convertible rights, just as shareholders:
      In the case of a merger, consolidation, statutory share exchange or similar transaction that requires the approval of our stockholders (any such transaction, a “business combination”) or a reclassification of our common stock. In the event of any business combination or a reclassification of our common stock (other than a reclassification referenced in the first bullet point above), a warrantholder’s right to receive shares of our common stock upon exercise of a warrant will be converted into the right to exercise that warrant to acquire the number of shares of stock or other securities or property (including cash) which our common stock issuable (at the time of such business combination or reclassification) upon exercise of such warrant immediately prior to such business combination or reclassification would have been entitled to receive upon consummation of such business combination or reclassification...

      Risk of issuing more shares for cash (dilution if to be inaccurate) exists, but it exists also in the share itself. It is slightly higher for a warrant holder, but this is because it is a warrant.

      I feel that the prospectus covered all the things that are possible and I am afraid of.

  4. איתי

    Aasaf, if the stock will be higher than 34.01$, all the warrants will dilute the stock, right? If "yes", how many warrants are public?

    1. Assaf Nathan Post author

      yes they will "dilute" shareholders, i use double quotes because it depends on how you define dilute. On each warrant that is converted to a share WFC will get 34.01$, so it really depends on the BV of WFC on the time of the conversion.

      You can see how many warrants are floating in the latest 10K or 10q, but it is a very small amount – WFC bought many of these warrants back and cancelled them, I think over 80% of them.

  5. דניאל

    " On each warrant that is converted to a share WFC will get 34.01$, so it really depends on the BV of WFC on the time of the conversion."

    לא, הם לא יקבלו 34.01, מספר מתואם של וורנטס יוחלף במספר מתואם של מניות.

    מה אתה חושב על הסקיורטי הזה בזמננו?

    1. Assaf Nathan Post author

      היי דניאל, אני לא ממש מבין במה אתה מתכוון "מספר מתואם של וורנטס יוחלף במספר מתואם של מניות", אבל אני מציע לך לקרוא את זה.

      בכלל, כאשר משקיע מממש אופציה / וורנט, החברה מקבלת את התשלום של ה strike ומנפיקה לך מניה בתמורה. המניה שאתה מקבל לא "מוחלפת" היא מונפקת. אתה אולי מתבלבל בין וורנט/אופציה לחוזה אופציה, שזה באמת מכריח מישהו לקנות / למכור לך מניה במחיר (strike) מראש והוא לא מערב את החברה כלל. לצערי בעברית לכל אלו קוראים אופציה למרות שמדובר בשלושה מכשירים פיננסיים שונים לגמרי (warrant, stock option, option). במקרה דנן מדובר בנייר שהנפיקה החברה ולכן את הכסף שתשלם כדי להמיר אותו למניה החברה תקבל, ולכן האם הוא בעל אופי דילולי או לא תלוי בערך הספרים למניה באותה עת. לטעמי יהיה לו אופי דילולי היות וקשה לי לראות מצב שבו המניה לא תהיה מעל ע"ס למניה של $34.01 כאשר הוורנט ימומש.

      לשאלתך השניה – דעתי חיובית.

  6. דניאל


    " The exercise price of the warrants cannot be paid in cash and is payable only by netting out a number of shares of our common stock issuable upon exercise of the warrants equal to the value of the aggregate exercise price of the warrants.

    In addition, other than the strike price adjustment following a certain dividend which you wrote about, there will be an adjustment for the number of common stocks.

    Sorry, no Hebrew.

    1. Assaf Nathan Post author

      Yes you are correct. I was wrong. To pay the exercise price they will deduct the a number of shares from your exercise batch equal to the exercise price, according to the value of the stock at the time of closing.
      So this actually has a dilutive effect on the shares.

      Nevertheless, there are very few warrants outstanding, about 39 million. To assume a dilution of 39 million shares, we need to assume they will all be exercised at $68.02 per share, which is very optimistic. In any case, the dilution is very small. For instance, in any certain day, 30 million shares change hands. I will be surprised if it will cause a dilution of over 1%.


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