Morgan Stanley's $23.18 million autocallables on Michael Kors seen as earnings play, one-off

By Emma Trincal

New York, Nov. 6 - Morgan Stanley priced $23.18 million of contingent income autocallable securities due Nov. 6, 2014 linked to the common stock of Michael Kors Holdings Ltd. two days ahead of the company's fiscal second-quarter earnings announcement in a deal said to have been designed for one investor.

The notes pay a contingent quarterly coupon at an annual rate of 14.05% if the stock closes at or above its 75% barrier level on the determination date for that quarter, according to a 424B2 filing with the Securities and Exchange Commission.

If on the observation date the stock closes at or above the initial share price, the notes will be called.

At maturity, the payout will be par plus the final contingent coupon unless the stock finishes below the 75% barrier level, in which case investors will receive a number of Michael Kors shares equal to par of $10 divided by the initial share price.

The autocallable reverse convertible product offers a potential 14.05% annual return, according to the prospectus, with no additional upside potential, but the trade-off is the 25% contingent downside protection, sources said.

The notes priced Friday, when the stock closed at $73.43.

In the next couple of days after pricing, investors in the stock would have gained more than half the contingent annual coupon yield.

After the company released its earnings before Tuesday's close, the share price soared 7.75% to close that day at $79.13. The stock closed at $79.49 on Wednesday, an 8.25% increase from Friday's price.

Risky business

"I don't know if you can analyze returns based on this short-term move," a market participant said.

"Just because it moved up 7% or 8% in a couple of days doesn't mean it's going to move 8% every day, especially when the move is entirely driven by earnings."

The share price of the luxury retailer surged 6% on the day of the earnings announcement from the day before due to a strong quarter. Earnings grew by 45% to 71 cents per share, beating analysts' expectations. Revenues increased 39%, surpassing the 23% increase in comparable-store sales.

"In general, it's a risky proposal to buy a reverse convertible just before the earnings announcement. It can go either way," the market participant said.

"Earnings were good. Maybe they were counting on it. It's very likely that Morgan Stanley believed that the earnings would be positive. For the investor, it's not the end of the game. The reverse convertible still lives on," he said.

The 100-day historical volatility of the stock is 27%, compared with 11.2% for the S&P 500 index, he noted.

"It's OK. It's more volatile and should give you more yield. But the key in this deal was timing," he said.

"Prior to earnings, they must have gotten a better premium. As you get close to the announcement, if there is uncertainty, there should be more volatility and the investor should be able to get better terms.

"If you're more conservative in general, you want to stick to more well-known names and not necessarily take on bets just before the earnings.

"On the other hand, if it's something Morgan Stanley had a good conviction on, 14% per annum isn't bad, and 25% protection is pretty good.

"It looks to me like a decent product."

Investor view

It's the investor rather than the issuer who is expressing a view on the price of the stock in these types of structured notes, a sellsider said.

"The goal of the issuer is to be completely risk-neutral. The issuer is not taking on any bet. They want to put together a product as marketable and profitable as possible for someone who has a view on the stock," this sellsider said.

"It's on their books, and they don't want the risk. If they wanted to take a bet, they wouldn't involve third-party distributors. They would trade it themselves. Those deals are meant for funding; it's to bring some money in."

Comparing a direct investment in the underlying equity to this type of reverse convertible investment is not very straightforward, he said.

Unlike investing in the stock, buyers of the notes do not participate in the appreciation of the share price and their return will be limited to the 14.05% annualized contingent coupon, according to the risk section of the prospectus. However, they are protected up to a 25% decline in the final share price.

"If you had bought the stock, you would have had a different risk return profile," the sellsider said.

"With the note, you get the downside protection, which you wouldn't have had with the stock.

"The product provides a different type of income and different risk factors."

One-off

The $23 million deal was the third largest to price last week, according to data compiled by Prospect News. It followed a $51.55 million commodities deal brought to market by JPMorgan and a $25.41 million UBS trigger notes offering based on a global equity index.

"We were not involved in this Michael Kors offering, but it's likely to have been driven by a reverse inquiry from someone," the sellsider said.

"Maybe you also had some piggy back around it. Maybe a large portfolio manager took a $20 million position. They showed it to a few others who bought the other $5 million.

"Is it a great deal? It depends. It's similar to the Tesla deals in a way."

Tesla Motors, Inc. saw its share price plummet after the car manufacturer reported its third-quarter earnings late on Tuesday. It closed on that day at $176.81, down by more than 11% in after-hours trading.

"Those reverse convertibles are really designed for people who believe strongly on a specific stock. At the same time, people believed strongly in Apple before the stock went through a major pullback. So whether it's a good deal or not really depends on the investor's view on the name," he said.

The notes (Cusip: 61762W430) carried a 1.5% fee.

Morgan Stanley & Co. LLC was the agent.

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