RBC’s 7.3%-9.3% autocallables tied to Micron show good fundamentals but not so good technicals

By Emma Trincal

New York, Nov. 14 – Royal Bank of Canada’s 7.3% to 9.3% airbag autocallable yield notes due Nov. 21, 2017 linked to Micron Technology, Inc. shares offer guaranteed income for investors who are not overly bullish on the stock. But while the reverse convertible play is supported by the fundamentals of the stock, according to an equity analyst, a read of the chart suggests some risks associated with the instrument, a financial adviser said.

Interest will be payable monthly, with the exact rate to be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

The notes will be called at par if Micron shares close at or above the initial share price on any quarterly observation date.

The payout at maturity will be par unless the final share price is less than the conversion price, in which case the payout will be a number of Micron shares equal to $1,000 divided by the conversion price. The conversion price will be 75% of the initial share price.

Fundamentals

“We are bullish on Micron short-term,” said Abhinav Davuluri, an equity analyst at Morningstar who covers the stock.

Micron’s fourth-quarter results released last months were disappointing. But Davuluri said that the stock is on track for a significant recovery in 2017.

“Memory stocks are in a very cyclical space, and sometimes oversupply can push down margins and stock prices,” he said.

Micron Technology is a manufacturer and marketer of semiconductor components. Samsung Electronics Co. Ltd. is one of its most important competitors.

“Samsung has been flooding the market with their own products. It hurts the industry as a whole,” he said.

The company faced other difficulties this year: demand for PCs was weak as was growth for smartphones.

“These headwinds have put a lot of pressure on the stock, but we expect these headwinds will subside in 2017 with a newer generation of products,” he said.

“Another improvement is that the number of key competitors has declined. Micron is facing four or five key competitors right now. There used to be many more.”

Bullish

The analyst recently raised his fair value for the stock to $23 a share. This is the equivalent at Morningstar of a one-year price target.

If the prediction is correct, the stock could rise 30% from its current price of $17.60 a year from now.

“Obviously, this product would not meet the needs of a bullish investor,” he said, comparing the 9.3% cap with his predicted upside potential.

The stock dropped at the end of last year and has been trading range bound from January through May. But since then, it has nearly doubled.

Terms

Commenting on the autocall feature, Davuluri said the odds of an early redemption are high.

“There is a good probability that it would stay at its initial price or higher three months from now,” he said.

“I think the company will have more solid margins, so the risk/reward is well balanced.”

Asked about the possibility of losing principal at maturity based on a 25% decline, he said he does not see the downside scenario as very likely.

“This is a stock that was trading at $35-$36 on its recent high two years ago,” he said.

“I believe it won’t hit that 25% barrier.

“At this point in time, we continue to believe the stock is in the upswing.”

Timing

Kirk Chisholm, wealth manager and principal at Innovative Advisory Group, said he would not do the trade at this point given technical factors.

“But if I wanted to ... extract some income, I would do it selling a put option, not through this note.”

Noting that the stock price is near its 52-week high of $18.33, he said that he has doubts about the timing of the trade.

“From a technical perspective it looks that it is trading at a resistance level in a range between $18.20 and $16.50,” he said.

“It’s not all that attractive to me on an absolute basis, as a strategy.”

But if he had to do the trade, he would use options instead and get income via a put sale.

A 25% price decline from the current level would represent a short sale of a put at a $13.00 strike price.

This means that the put seller bets that the stock price when the contract expires will not fall below the $13.00 strike price. For making that bet, he gets to keep a premium paid at the start. If he is wrong and the price falls below $13.00, he will be “put” the stock or forced to buy it at the strike price.

Put sale

Chisholm picked the closest expiration date for January 2018, or two months after the notes mature.

A bet that the stock by then would not drop more than 25% (not below $13.00) pays a $1.25 premium per contract.

The return on this investment would be measured as the $1.25 premium divided by the $13.00 strike price, or 9.6%. Since the contract has a 14-month length, the return per annum would be 8.25%, which is approximately at the mid-point of the range announced in the prospectus.

Chisholm said this type of cash-covered put sale would offer several benefits over the reverse convertible.

“I don’t have exposure to the credit risk of the issuer when I deal with a publicly traded option,” he said.

“And I don’t have liquidity risk. I can trade the put any time and buy it back. I don’t have to wait for the contract to expire.”

He offered an example: After three months, the stock price rallies and the cost of the same put drops to $0.50. The short-seller would buy it back at that price, and his net would be the difference between the $1.25 premium he pocketed and the cost of buying back the put, which is $0.50. As a result, the investor would collect a $0.75 net premium, which based on the strike price would represent an immediate 5.75% gain in three months, or 23% per year.

Chisholm said this scenario would be much better than having to be called.

“If you’re called after three months, you’re not getting the 8% or 9% change. You’re only getting it for a quarter,” he said.

“Options are liquid. If you’re right and the stock is up, you can always close out the position. You don’t have to wait for months. The liquidity is a huge benefit.”

UBS Financial Services Inc. and RBC Capital Markets, LLC are the agents.

The notes are expected to settle on Wednesday.

The Cusip number is 78014C814.

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