SM-SAAM is a company with a relatively stable set of businesses, a high degree of recurring revenue and excellent long-term expansion prospects. At a price below CLP 53, the shares are recommended for purchase.

If the company does not make significant changes to its capital structure, an appropriate base-level valuation range for the stock is roughly CLP 49.45 to CLP 70.86. Due to the conservative nature of its chosen business segments within the shipping industry and the company’s low leverage, a further decline in price would appear to be less likely. On the other hand, should SM-SAAM’s management decide to expand its operating asset portfolio and aggressively expand by issuing debt – and recent joint venture activity is suggestive of this strategic direction – returns could be even higher. Our target price for 2016, under such a scenario, ranges from CLP 79.83 to CLP 89.06. Combined with dividends, which are expected to represent 30% of the company’s net income, annualized returns could surpass 17.5% over the four-year period. Lastly, there is additional optionality. SM-SAAM is a good strategic fit for Royal Boskalis Westminster, the company that has completed two similar acquisitions since 2009. With a potential acquisition price of CLP 67.04 to CLP 96.07, such an option could be the fastest way to monetize an investment in SM-SAAM.

On May 23, 2013, Dean Foods distributed the majority of its interest in WhiteWave Foods to shareholders. This ongoing separation was first initiated through a carve-out of a 13.3% interest in WhiteWave in October 2012. This latest transaction involved Dean Foods distributing 115.6 million shares of WhiteWave, which will leave the company with 34.4 million shares of WhiteWave, or just under 20% of the total shares outstanding.
 
The motive of the separation was twofold. WhiteWave is a manufacturer of organic milk products, and its premium brands are both growing at a higher rate than the core Dean Foods dairy business and generate noticeably higher profit margins. WhiteWave was worth more to Dean Foods shareholders as a standalone entity than remaining to exist within the lower margin non-organic dairy business.
 
Secondly, after years of debt-financed acquisitions, and a leveraged recapitalization that was used to repurchase shares, Dean Foods was left a highly leveraged company. By placing debt with WhiteWave, in addition to selling its wholesale food products company known as Morningstar, Dean Foods now has a far more reasonably arranged balance sheet. Thus, the separation of WhiteWave served two important purposes.
 
At the time of original publication in December 2012, the Dean Foods stub was trading at $4.50 per share. This seemed egregiously low, relative to possible earnings under a normal margin scenario of at least $1 per share. Dean Foods now trades at $10.52 per share, including the $3.39 per share value of its remaining interest in WhiteWave. The stub therefore is currently priced at $7.13, representing an increase on this basis of 58%. More traditionally, or assuming one purchased Dean Foods and subsequently received the WhiteWave shares, the return would have been as follows:
 
Table 1: Theoretical Dean Foods Return Since December 2012
 
DF Price, 12/14/12 $16.44

DF Price, 5/28/13 10.52
Plus: 0.255 WWAV shares @ $18.49 4.72
Plus: 0.364 WWAV-B shares @ $17.81 6.48
Spin-Off Adj. DF Price $21.72

Cumulative Return 32.1%
S&P 500 Return, including dividends 18.2%
 

Of course, equity prices have also risen substantially during this time, so one’s good fortune cannot be attributed exclusively to the market’s recognition of value in Dean Foods. Nevertheless, despite an increase in the company’s share price, it still appears quite undervalued. At a stub price of $7.13, Dean Foods trades at under 5x normalized earnings. Currently, the company estimates that its 2013 earnings per share, excluding WhiteWave, will be $0.50. Therefore, investors have placed a 14x multiple on these earnings, which is not inconsistent with the valuations of other low margin, food commodity-based companies. However, this earnings estimate is based on the company’s current operating margin of only 3.2%, far below historic levels of 6%-8%. There has been a sustained increase in raw milk prices over the last few years, which has dramatically compressed the Dean Foods margin, as it has been unable to pass this increase onto its customers.
 
If this ultimately is a permanent departure from historical industry pricing dynamics, then Dean Foods is more fairly valued. However, if raw milk commodity prices were to decline to normal historical levels, and Dean Foods regains its historical pricing power, its earnings per share could be two or three times the current $0.50. Yet, since most cannot forecast when or if this will occur, the company trades at more visible, nearer-term profit measures.
 
Aside from this margin-based optionality, Dean Foods has indicated that the final separation of WhiteWave could include a debt-for-equity exchange. This possibility is explored later in this report, and it seems that the removal of debt, on a dollar-for-dollar basis, would be accretive by some 34% to the company’s per share earnings. For instance, even at the current 3.2% operating margin, if Dean Foods exchanges its WhiteWave shares (currently worth $636 million) for a like amount of its debt to be placed at WhiteWave, it might generate $0.67 per share of net profit. This is 34% higher than the current company estimate, which excludes any impact of a possible debt-for-equity exchange, of $0.50 per share.
 
Given these outcomes, which provide, as estimated later in this report, as high as an 80% return, Dean Foods still seems attractively priced. Therefore, it is again considered for purchase.

On January 23, 2013, Siemens AG held its Annual Shareholders’ Meeting, at which time 98 percent of shareholders approved the proposed spin-off of the company’s lighting unit as OSRAM Licht AG. OSRAM is one of the world’s top lighting manufacturers, Royal Philips Electronics NV being the company’s primary competitor. The company’s portfolio includes the most basic lighting components such as light bulbs, as well as more technologically advanced products, including light-emitting diodes, light management systems and high-efficiency lighting solutions.
 
The decision to spin off OSRAM is a departure from the company’s original plan to dispose of the division through an initial public offering, a plan that was originally proposed in March 2011. In light of the turbulent market conditions and deterioration in the company’s results, the IPO was repeatedly delayed until June 2011, when the company decided to pursue the planned listing of OSRAM by means of a spin-off rather than an IPO. The spin-off is expected to take place during the second quarter.
 
The recent deterioration in results and need for restructuring is largely driven by the fact that technologies that require regular replacement of incandescent light bulbs are being displaced by longer-lived, more energy efficient light-emitting diodes. As a result, the lighting business is no longer simply a replacement business. Fortunately, the company acknowledges this trend and is taking steps to increase revenues derived from providing integrated, high-efficiency lighting solutions as well as ongoing servicing. As well, the company has stated that as part of the spin-off plan aggressive cost cutting measures are expected, including a 20 percent reduction in the workforce.
 
Indeed, the importance of such fundamental change is supported by the company’s recent financial performance. With respect to the company’s recent headline results, during fiscal 2011 and 2012, OSRAM generated revenue of €5,032 million and €5,400 million, respectively, a year-over-year increase of 7.3 percent; however, during fiscal 2012, the company reported a rather striking net loss of €378 million and an operating loss of €260 million. This compares to 2011 net income and operating income of €246 million and €417 million, respectively.
 
Notably, however, the result experienced during fiscal 2012 includes a variety of impairment charges and expenses associated with both the spin-off and the restructuring amounting to approximately €425 million. After accounting for such impairment charges and spin-off expenses, adjusted operating income (EBIT) and adjusted operating income before depreciation and amortization (EBITDA) amount to €162 million and €395 million, respectively. And though the adjusted operating results for fiscal 2012 are suggestive of a much less dire operating condition, investors are likely to heavily weight the more obvious headline figures when determining whether to hold or to discard the distributed shares. This could prove beneficial to the longer-term oriented investor.
 
Though the recent result and ongoing restructuring suggest that the next couple of years could prove rather difficult, this may also be suggestive of an opportunity for the patient investor. Should the restructuring ultimately succeed, the intervening vagaries in operating results-of which there are likely to be many-are bound to provide one with a number of attractive entry points. As well, one would be wise to recall that OSRAM is one the industry’s leading lighting manufacturers with global manufacturing, sales and distribution capabilities, not merely a marginal participant.
 
Therefore, in light of the conservative capital structure and market leading competitive position, the odds of successfully navigating the current restructuring are likely to be in the company’s favor. More importantly, perhaps, the potential realization of an artificially and abnormally low purchase price due to certain technical factors associated with the distribution may very well compensate one for any risks associated with an overly prolonged restructuring process.
 
Specifically, the frequency and magnitude of attractive entry points is likely to be compounded by the fact that OSRAM will be significantly smaller than the parent company, which is likely to result in substantial index selling following the spin-off due to OSRAM’s absence from widely followed indexes (e.g., DAX, EURO STOXX 50, MSCI World). As well, unlike the parent company, it is not currently expected that OSRAM will have a listing via an American depositary receipts program. This, too, is likely to result in shorter-term opportunities.
 
Notably, after the spin-off, Siemens intends to hold a 17 percent stake in OSRAM, with the Siemens Pension Trust receiving a 2.5 percent stake in the new company, further reducing the available float and, thereby, potentially magnifying the impact of the aforementioned technical factors associated with the distribution.
 
With respect to the potential valuation of Siemens, given the company’s normalized margin experience, we recommend that readers consider an allocation of capital were the share price to trade in the low €60 range, which may very well materialize should we experience a recurrence of increased European equity risk aversion. As to the potential equity valuation on the high side, one should allow for the fact that investors are increasingly allocating capital on the basis of yield.
 
As an acknowledgement of the cost of capital impact of an increased dividend, the company has nearly doubled its payout since the period between 2007 and 2009. One might argue that in an environment more positively biased towards European equities, the yield of Siemens should converge to a figure approximating that of, say, General Electric, or 3.5 percent. With a €3.00 per share dividend at yield of 3.5 percent, Siemens’ equity valuation would be nearly €86 per share, which would represent a potential return of more than 40 percent relative to our recommended purchase price.
 
With respect to OSRAM, our low valuation of €20 per share is established on the basis of the company’s current book value and comparable enterprise value-to-EBITDA multiples of German industrials. While we would view such a valuation as short-sighted, the technical and fundamental factors mentioned previously suggest that such an outcome is quite likely. In our opinion, such a valuation would undoubtedly be suggestive of an attractive opportunity. If one takes a longer-term perspective and frames the company’s full valuation potential in the context of the normalized EBIDTA margin, the approach suggests longer-term fair values ranging from a low of approximately €30 per share to a high of approximately €50 per share.
 
In summary, though we expect certain technical and fundamental factors described herein to result in a temporarily low valuation immediately subsequent to the distribution, we view the long-term potential of the lighting business as worthy of due consideration, especially if one is able to purchase such shares at a price that fails to account for the successful restructuring and the future earnings potential of the business. We posit that at a valuation approximating book value, or €20 per share, one is likely to have established a rather attractive risk reward opportunity with the associated free optionality related to the longer-term margin expansion potential.

Brookfield Asset Management (NYSE: BAM, BAM CN) intends to spin off Brookfield Property Partners (“BPY”), which will comprise the company’s commercial property operations. Brookfield Asset Management (“BAM”) expects to distribute 10% of the shares of BPY to existing shareholders while retaining the remaining 90% interest. BAM will also act as the manager of BPY and will earn a modest management and incentive fee. The date for the distribution has not yet been scheduled and the terms have not been finalized, but it is believed that the transaction could occur within the month. It should be noted that the distribution is expected to be taxable to shareholders, with non-Canadian residents subject to a 25% withholding tax on the value of the distribution.
 
BPY is expected to pay a distribution of approximately $1.00 per share, which is equal to 4% of the book value attributable to the parent company. This distribution will also represent approximately 80% of funds from operations, which, based on a valuation of 1x book value, would represent a multiple of 20x FFO. These valuation metrics – 4% dividend yield, 20x FFO multiple and 1x P/BV – are all reasonable relative to comparable companies and return a fair value estimate for BPY of $25 per share.

Gold Fields Limited is the world’s fourth largest gold company based on gold equivalent production during 2011 of 3.7 million ounces from eight operating mines in Australia (St Ives and Agnew), Ghana (Tarkwa and Damang), Peru (Cerro Corona) and South Africa (KDC, Beatrix and South Deep). As well, the company is the largest producer in South Africa with domestic output of 1.7 million ounces during 2011. South Africa’s second and third largest producers based on domestic output are AngloGold Ashanti (1.6 million ounces) and Harmony Gold (1.1 million ounces). AngloGold Ashanti is the third largest producer globally based on 2011 total production of 4.3 million ounces.
 
Recently, investment firms such as Paulson & Co. have become actively involved in highlighting a potential catalyst associated with South Africa’s gold mining companies. And though Paulson & Co. has placed a particular emphasis on AngloGold Ashanti, the potential catalyst undoubtedly applies to Gold Fields as well. That is, given the relatively high cost nature of South African gold mining operations, a rather obvious catalyst is to simply separate the higher cost, more mature South African assets from their lower cost, less mature-and, therefore, more capital intensive-international counterparts.
 
Though, historically, we have tended to harbor an aversion towards natural resources companies owing to the inherent complexities associated with predicting with confidence a variety of factors, such as capital expenditure budgets, production costs, ultimate output, and, of course, the vagaries in commodity prices, the unbundling of Gold Fields’ mature South African assets as Sibanye Gold strikes us as potentially quite interesting, especially from a shorter-term, more opportunistic perspective. Why? Given that the decision to unbundle Sibanye Gold appears to be largely driven by negative investor sentiment toward South African mining assets (e.g., Paulson & Co.), it strikes us as quite likely that a broad based sell-off by foreign shareholders may ensue following the listing of Sibanye Gold shares on Monday, February 11th. This could prove attractive despite what one might think about the risks associated with Sibanye Gold’s longer term restructuring potential.
 
Not only does South Africa support the highest costs in the gold mining industry, but the series of recent mine worker strikes suggests that such costs are at risk of further increases for those mature, more labor intensive mines operated by Sibanye Gold. And though management has made it clear that a primary motivation for the demerger is to moderate such costs by redirecting capital towards improving efficiencies at Sibanye Gold’s mature mines rather than having to fund capital intensive projects such as the mining operation at South Deep, our opinion is that investor sentiment following the unbundling is likely to reflect a rather negative impression of Sibanye Gold’s restructuring prospects.
 
One might argue, however, that this negative impression is likely to be countered by the company’s planned dividend policy. After all, management of Sibanye Gold has stated that once the company’s higher cost, more mature South African assets are separated from their lower cost, less mature, more capital intensive international counterparts, the company will be in a position to return a greater portion of this excess cash flow to shareholders-that is, provide a dividend policy of greater appeal to the yield starved masses. The proposed payout ratio of between 25 percent and 35 percent of normalized earnings would be equivalent to approximately ZAR 0.88 per share at the 25 percent level, or a yield of approximately 7.0 percent at our low fair value price (see Valuation section for details).
 
Though such a yield would likely prove alluring, one should note the oft cited risk that capital expenditures associated with improving efficiencies at the company’s mature mines may very well be higher than what management has allowed for, and, therefore, ultimately inconsistent with the proposed dividend policy. For example, as one investor noted on the unbundling announcement call held on November 29, 2012:
 
“You’re saying the new company is going to be a high-yield company. And you also implied, if I understood you correctly, that you would be investing for a longer [mine] life. Isn’t there some sort of contradiction there?”
 
Indeed, an overly optimist capital expenditure budget would not be an unusual occurrence for a gold mining company-especially in light of the proposed dividend policy-and, under normal circumstances, is precisely why we tend to harbor an aversion towards such companies. However, owing to the confluence of a wide variety of factors, the environment surrounding a spin-off is decidedly abnormal and, therefore, has a tendency to provide one with opportune entry points that can dramatically reduce the import of such risks as they relate to one’s ultimate return.
 
Our conjecture, then, is that the predominate and overly negative view towards South African mining assets owing to the recent involvement of several high-profile investors, as well as our own reservations regarding the company’s ability to both support a high dividend and the required level of capital expenditures needed for increased efficiencies suggests that there is a high likelihood of an exceedingly depressed valuation following the unbundling. And despite the doubts one might harbor regarding the longer term viability of the company’s restructuring proposal, the magnitude of the drawdown following the unbundling may very well result in an abnormally depressed valuation that substantially limits one’s longer-term downside risk. As such, we view the unbundling of Sibanye Gold as a transaction worthy of note and suggest that reader’s follow it closely.
 
With respect to valuation and as outlined in greater detail in the Valuation section of this report, we propose that one view the ultimate trading prices of Gold Fields and Sibanye Gold as attractive were Gold Fields to trade below ZAR 87 per share. For the more interesting Sibanye Gold, our low, mid, and high fair value targets are ZAR 12.57, 17.59, and 22.62, respectively. We would view Sibanye Gold as worthy of consideration were it to trade at-and, of course, below-the low end of our range.” – The Global Spin-Off Report

In just a few months time, Dean Foods has completed the carve-out of its higher growth, organic milk and beverage business, and sold its private label, extended shelf life dairy assets. Following the eventual spin-off of its remaining interest in WhiteWave Foods, Dean Foods will have shed a substantial portion of its current debt load, and will be a more narrowly focused dairy products company. Currently, the market has placed an earnings multiple of under 7x on this remaining business, as the company’s margins are at near decade lows due to high raw milk commodity prices. As the risk of capital loss seems well contained by the low valuation on the Dean Foods stub company, only slight improvements in the company’s operating performance or valuation are required for one’s return to reach suitable levels. A combination of both could produce a return in excess of 40%. Therefore, the shares are recommended for purchase.

On May 17, 2012, the Board of Directors of Cookson Group announced that it was initiating a strategic review to consider a number of options for the company, including a potential demerger of its main divisions. On Thursday, November 1, 2012-following an extensive review of restructuring options-Cookson Group announced that its Board of Directors had decided to demerge the company’s Performance Materials division from the Engineered Ceramics and Precious Metals Processing divisions.
 
Cookson Group’s Performance Materials division will accordingly be demerged to form a new London Stock Exchange-listed specialty chemicals company, called Alent plc. Cookson Group-consisting of the Engineered Ceramics and Precious Metals Processing divisions-will be renamed Vesuvius plc. On November 26, 2012, the company held the Court Meeting and General Meeting, during which time the proposed demerger was approved. The demerger is expected to become effective on Wednesday, December 19th, at which time shareholders will receive one Alent share and one Vesuvius share for every one Cookson Group share held as of the last trading date on Friday, December 14th. Vesuvius shares are expected to begin trading on Monday, December 17th, with trading in Alent shares expected to begin on Wednesday, December 19th.
 
The engineered ceramics business comprising Vesuvius is highly dependent on global steel production volumes-primarily European production, but with an increasing focus on the Chinese market-whereas the performance materials business comprising Alent depends primarily on production volumes in the global electronics market (e.g., smart phones and flat screen displays, etc. from providers such as Alcatel-Lucent, Apple, Hewlett-Packard, LG, and Samsung). With such disparate target markets and in light of the current slowdown in global steel production volumes, it comes as no surprise that such businesses trade at widely dissimilar multiples: engineered ceramics companies trading at enterprise values of between 5.5x and 6.0x trailing twelve months EBITDA and performance materials companies trading at multiples of closer to 10.0x, with recent transactions in the performance materials industry suggestive of multiples as high as 12.5x.
 
Relative to Cookson Group’s trailing twelve months EBITDA of £342 million, the company currently trades at an enterprise value multiple of 6.3x. As described in greater detail in the Valuation section of this report, a more refined valuation exercise that properly accounts for the disparate character of the two businesses results in a fair value estimate for the pre-demerger Cookson Group of approximately GBp 677 per share-Vesuvius: GBp 341 and Alent: GBp 336-or a 10.4 percent premium to the current price of GBp 613. Notably, however, the weakness in global steel production volumes is expected to continue and is likely to negatively impact Vesuvius’ 2012 results. In contradistinction, it appears that the markets served by Alent continue to be imbued with attractive growth prospects. Accounting for such factors results in a fair value of GBp 648 per share-Vesuvius: GBp 286 and Alent: GBp 362-or a 5.7 percent premium to the current price.
 
Importantly, however, with respect to Vesuvius’ longer-term prospects, it is essential to note that a large part of steel production in China is not yet based on the enclosed continuous casting technology that uses Vesuvius’ steel flow control products. The use of enclosed continuous casting is expected to increase over time as the Chinese steel industry continues to modernize and demand for higher grade flat steel product increases. This is also the case with Vesuvius’ advanced refractories product line, as there is of yet only modest revenue arising in China with the market having only recently been addressed.
 
China currently accounts for only around 12 percent of the Engineered Ceramics division’s steel-related revenue. As part of the Chinese government’s new five year plan (2011 to 2015) announced in November 2011, the country is targeting higher production levels of better quality, more value-added steel products. Should such events ultimately transpire, it would appear that Vesuvius products may very well be in much greater demand.
 
That said, the high correlation between global economic growth and steel production and the consequent decline in steel production volumes during 2012 is likely to result in a discounted share price once Vesuvius begins trading. In contrast, the demerger of Alent is likely to attract a premium valuation given the more attractively positioned markets served by the company as well as continued speculation that the company is well positioned as a takeover candidate. Notably, in April 2008, Dow Chemical completed the purchase of Rohm & Haas, an Alent competitor in the surface chemistries marketplace.
 
Our recommendation, then, is that given the modest rate of return suggested by our sum of the parts fair value estimates-GBp 677 (10.4 percent) and GBp 648 (5.7 percent)-one should await the completion of the demerger. As it is our opinion that Alent is likely to trade at a fair-to-premium valuation, the more compelling proposition could well be found through the shares of Vesuvius. Given the likelihood of increasing longer-term demand for steel flow control products, the cyclically depressed state of the steel industry, and the potential for share price volatility as a consequence of the demerger, one should be prepared to consider purchasing shares should the Vesuvius share price fall in range of our low case estimate of GBp 286.

Petrobank Energy and Resources Ltd. (PBG CN), based in Alberta, Canada, is a holding company focused on the exploration and production of oil and natural gas, as well as the development of patented production technologies. The company’s earnings are derived entirely from its 57% ownership in PetroBakken (PBN CN), a publicly-traded company that is consolidated on Petrobank’s financial statements. Petrobank has announced that it intends to spin off this equity stake to shareholders by the end of 2013, which is interesting because the value of this stake, adjusted for an expected 15% dividend tax to US shareholders, is equal to Petrobank’s current enterprise value. It is reasonable to believe, therefore, that the spin-off will serve as the catalyst that unlocks the value of the company’s Heavy Oil Business Unit (“HBU”), which presently provides some intrinsic value based on its exploitable oil in place, as well as additional potential upside should it develop these assets and/or successfully develop and license its THAI (Toe to Heel Air Injection) production technology. Because of this, shares of Petrobank are recommended for purchase.

Universally acknowledged as a period of intellectual revolution heralding the beginning of the modern age not only in art and religion but in natural philosophy and mathematics, the European Renaissance is less well known as a period during which intellectual advances towards greater precision and understanding evolved in an environment beset by an influential and beguiling belief in mysticism and magic.[1] And so it proves true today that in our inexorable drive to limit uncertainty and enhance our confidence in the range of conceivable outcomes, we rely on tools and techniques for which our knowledge of the potentially untoward effects can prove dangerously, perhaps contemptibly, inadequate.
 
For those investors too well acquainted with the near demise of American International Group owing to its misuse of credit default swaps during the fall of 2008, this parallel is apt. Having felt much less like owners of a tangible interest in the world’s largest insurance company and more like spectators at a performance of Eisenheim the Illusionist’s The Vanishing Lady, undoubtedly ticket holders are still recovering from the disorienting and disconcerting effects of such a deceit.[2] And though the professional investor may hesitate to acknowledge the validity of such a playful analog, woe is the one who forgets that in the short-term prices are determined by those masses of investors frequenting the ticket booth. The proverbial weighing machine always comes much later. The psychological impact of such a deceit on the large class of potential investors has undoubtedly been profound and likely explains, at least in part, the lack of coverage highlighting opportunities to be found in both American International Group’s common stock and the recently issued common stock warrants.
 
Of course, since today’s investing audience appears more inclined to buy tickets for the latest offering of exchange-traded funds-common stocks having been relegated to an inferior place on the marquee-one would do well to consider the significance of AIG’s weighting in widely followed indexes such as the S&P 500 and its various financial sector counterparts. Following the completion of company’s recapitalization on January 14, 2011, the U.S. Treasury established a 92 percent position in the common equity; this position now stands at 61 percent. As the U.S. Treasury continues to dispose of its interest-ultimately resulting in a larger public float-the potential valuation impact of weighting changes to the various float adjusted indexes may very well be significant. More tangible catalysts associated with the company’s ongoing restructuring include continued share repurchases at significant discounts to book value, the pending initial public offering of International Lease Finance Corporation and the sale of the company’s interest in Hong Kong listed AIA Group. Before proceeding to a discussion of such catalysts and their potential valuations, however, a few words regarding the recent restructuring are in order.
 
As part of American International Group’s recapitalization completed on January 14, 2011, the company consummated a series of transactions designed to terminate the AIG Credit Facility and to fully repay the New York Federal Reserve for its preferred interests in the AIA and ALICO special purpose vehicles. As a result of this comprehensive restructuring, American International Group is now in a position to dispose of its remaining shares of AIA Group and proceed with the proposed initial public offering of ILFC.[3]
 
American International Group holds 2,121,620,951 shares of AIA Group. At the current price of HK$27.25, the partial interest is valued at approximately HK$57.8 billion, or US$7.5 billion-that is, approximately 14 percent of AIG’s current market capitalization of US$54.0 billion. With respect to the valuation of ILFC, the company reported total shareholders’ equity as of the first quarter 2012 of US$7,631 million. And though the company reported a net loss of US$724 million in 2011, after adjusting for impairment changes, debt extinguishment expense, and assuming a 35 percent tax rate, adjusted net income amounts to US$497 million.
 
At an earnings multiple of 12 times and a book value multiple of 0.80 times, one arrives at a fair value estimate of approximately US$6 billion; however, over time, we think this will likely prove to be too conservative. Not only is ILFC the market leader, but historically the company has operated at significantly higher levels of profitability. In 2007, for example, the company reported net income of approximately US$600 million. In the fullness of time, one would expect a certain degree of reversion to higher levels of profitability as well as multiple expansion. Under the reasonable assumption that the company is capable of generating net income of US$600 million and ultimately warrants a higher earnings multiple of 15 times, a fair value market capitalization of US$9 billon appears reasonable.
 
Using the more conservative ILFC fair value estimate, the combined equity value of ILFC and the remaining interest in AIA amounts to roughly US$13 billion, or over 24 percent of AIG’s current market value. In consideration of the US$4,457 million in revenues generated by ILFC during 2011, AIG’s insurance company “stub”-albeit a rather large stub-generated revenues of US$59,780 million. Under the assumptions that insurance revenues and the US$13 billion in potential proceeds from the sale of AIA and ILFC grow modestly at 3 percent per annum through June 2015-that is, a three year investment horizon-net margins recover to their historical average of 9.5 percent, and if earnings are ultimately capitalized at a multiple of 15 times, the fair value of the common stock would be US$63.00 per share, or a rate of return of 26.3 percent per annum.
 
Notably, a similar fair value estimate is arrived at if one assumes that the company ultimately trades closer to book value (US$59.85 per share), as is the case with many of its competitors. Not only does the company trade at approximately 0.52 times book value but it is in the process of repurchasing shares as the U.S. Treasury disposes of its common equity interest. Should share repurchases continue to clear at such significant discounts to book value, obviously this will ultimately prove accretive to the company’s per share results. For example, with revenues of US$59.8 billion, were insurance operations to revert to net margins of 9.5 percent, net income would be approximately US$5.7 billion. At the current price, one year’s income could repurchase 182 million shares, or approximately 10.5 percent of shares outstanding, resulting in an increase in earnings per share and book value per share of 11.7 percent, ceteris paribus. Despite the uncertainty associated with the timing, price and manner of such repurchases-that is, whether such repurchases are financed through operating income, rights offering, etc.-the impact on the per share results is a potentially significant catalyst and, therefore, worthy of consideration.
 
Despite the presence of such significant catalysts, however, the potential investor must acknowledge that he is beset with a wide variety of uncertainties associated with the insurance industry generally (e.g., lower net investment income, municipal bond defaults, etc.) and with American International Group in particular (e.g., regulatory changes, negative loss reserve development, etc.). And while we acknowledge the risks associated with an investment in AIG common stock-both industry wide and company specific-at the right price, of course, the risk/reward dynamic can become quite appealing.
 
As it so happens, in the case of AIG, one is able to significantly de-risk such an investment-that is, establish the “right price”-through the pairing of the company’s common stock with the recently issued warrants. By entering into a one share for one share long common, short warrant position, one is able to take advantage of the appreciation potential of the common-owing to an improvement in the insurance operations and the various catalysts highlighted previously-while limiting the potential drawdown by shorting what is a rather high implied volatility option.
 
Though the proposed transaction is explained in greater detail in the Valuation section of this report, the scenarios below are most worthy of note. In the positive scenario (left), the common stock appreciates to a fair value of US$63.00 per share for the reasons outlined previously. Importantly, were the company’s fundamentals to improve over the proposed three-year period of time, one would expect a moderation in the variability of the company’s share price. Due to a presumed decline in the implied volatility of the warrant-from the current 41 percent to an assumed 20 percent-the negative impact of the short warrant position is limited, resulting in a long/short rate of return of 27.0 percent per annum, superior to the long-only rate of return of 26.3 percent per annum.
 
In the negative scenario (right), the common stock experiences a return of negative 30 percent. While the short warrant position may very well experience a material, short-term increase in implied volatility, over the longer-term, the implied volatility is likely to settle at a lower, though still elevated level, which in this case is assumed to be the current 41 percent. As a result, the common stock could experience a 30.0 percent cumulative drawdown, with the long/short position realizing a cumulative drawdown of only 10.2 percent. Therefore, if one is desirous of establishing exposure to the potential recovery of American International Group and the various catalysts expected to transpire and wishes to materially de-risk such exposure, a one share for one share hedged position using the common stock and warrant is recommended.