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Third Avenue Management Comments on PNC Warrants
Posted by: Holly LaFon (IP Logged)
Date: July 5, 2013 11:37AM

To illustrate, here is our base case for the PNC warrants (PNC): The Fund purchased the warrants for approximately $11 each. Each warrant provides the Fund with the right to purchase one share of PNC Common stock at $67.33 per share at any time through December 31, 2018. PNC's book value is currently $68 per share, which we conservatively estimate will increase by 8% per year (net of dividends paid). At April 30, 2013, PNC Common traded at $67.88 per share (1 times book value). Simply compounding book value at 8% per year would result in a book value of about $105 per share at the end of 2018. We assume that PNC Common will continue to trade at1timesbookvalue,or$105pershare at expiration, resulting in each warrant having an intrinsic value of approximately $38 ($105 minus $67.33). Our base case would result in a 25% IRR over the life of the investment, or a 3.5 times multiple on the original $11 invested.

We believe our base case assumptions are fairly conservative in that we do not project increasing ROE or the common stock trading in excess of 1 times book value. It seems likely that if banking profits improve (higher ROE), stock prices could trade at 1.5 to 2 times book value, which would result in an exceptional return on the warrants. For example, if book value per share is $125 and PNC Common trades at 1.5 times book value at the end of 2018, each warrant would have an intrinsic value of about $120, or nearly an 11 times multiple on the original $11 investment (41% IRR over 5+ years).

The potential returns on TARP Warrants appear very compelling, but we also bear in mind that they could ultimately prove worthless should the banks record significant impairments, the ROEs fall further or the price-to-book multiples decline. However, we view the prospects of a "zero" to be quite remote given (i) the starting point of depressed ROEs and low price-to-book multiples and (ii) our focus on Wells Fargo and PNC, both of which are well-capitalized and well-managed banks with strong franchises that should allow them to continue compounding book value per share over the life of the warrants. Nevertheless, we have decided to limit the Fund's investment in TARP Warrants to 2% of the Fund at cost. While small today, they have the potential to grow into much larger positions over the next few years. We are always happy when a 2% position appreciates to become a top-ten holding in the Fund.

From Third Avenue Management's semi-annual 2013 letter.

Guru Discussed: Third Avenue Management: Current Portfolio, Stock Picks
Stocks Discussed: PNC,
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