JPMorgan's 13.5% reverse convertibles tied to Netflix offer short-term play with high risk

By Emma Trincal

New York, Dec. 24 - JPMorgan Chase & Co.'s 13.5% reverse convertible notes due March 28, 2013 linked to Netflix, Inc. shares are worth the risk given the short tenor and the coupon acting like an extra buffer, a stock analyst said. But a market participant argued that the risk reward was not sufficient given the volatility of the underlying shares but also the strong upside potential of the share price.

The payout at maturity will be par in cash unless Netflix shares fall below 65% of the initial price during the life of the notes and finish below the initial price, in which case the payout will be a number of Netflix shares equal to $1,000 divided by the initial price, according to an FWP filing with the Securities and Exchange Commission.

Marc Gerstein, research consultant at Portfolio123, said that despite the volatility of the stock, he felt comfortable with the trade due to its short tenor of three months.

"It is at $90.00 now. It would have to go down to $60.00 in three months," he said.

"For one year, I wouldn't do it. But for three months, it's probably worth taking the gamble. Three months is a very short time."

In addition, the stock is not at its peak, having gone through negative headlines. The share price hit its 52-week high in February at $130.00 and dropped to its lowest point in September at $54.00.

Sell-off priced in

"It is a very volatile stock, that's for sure. The whole world hates it. Everybody has had something negative to say about Netflix. We know that. It's priced in. Could it go down by 35% or more? Not impossible. A bad market move certainly would be a factor. Then the entire market would go down. You always have the risk of earnings. But you have the extra kicker from the interest here. That's an extra protection. And if it goes down beyond that, you own the stock, it' not the worst thing in the world if you like the name," he said.

Despite a roller coaster year, shares are still up 30% for the year through Dec. 24.

Gerstein said that the sell-off this year was more the result of negative headlines and investors' sentiment and may not have fully reflected the stock's fundamentals. At some point, investors began to believe that the business model of the company was broken, he said.

"The stock went out of favor when they announced that they were planning to split and divide their DVD business and internet service. People went screaming. So they decided not to split the company," he said.

"They also had some price increases, but that happens. They operate in a competitive environment. They have competition from Hulu and Amazon."

For Gerstein, the sell-off may have been overdone.

"It seems to me the product has an audience. I don't think the studios are going to turn their back on Netflix.

"The stock has dropped a lot. It was at nearly $300 at one time. Knowing that the stock has already gone down that much, I think I could do this trade. First, it's only three month and second, I get a good cushion. If it was a one-year, I'd be more leery," he said.

Not enough coupon

A market participant agreed that the share price had upside potential. It was precisely its biggest concern. The high reward potential went along with a great level of risk, he noted, which he said was not reflected in the 13.5% annualized coupon, or 3.375% over the three-month term of the notes.

From Sept. 25 through Dec. 19, the stock rose to $96.6 from $53.8, a 79.55% increase in 85 days, he noted.

"We know the stock can move a lot. In less than three months, it can jump 80%.

"I'd buy a security that gives me a quarter of 13.5% for three month. It seems to me with a stock that can move like this one, a 3.7% return is really not compensating me enough for that risk," he said.

And the risk is not negligible, he said, pointing to a 60% drop in the share price in six months from Feb. 6 to Aug. 3.

"So could it breach this 35% level in three months? Absolutely. A 35% protection is not much when you know that the stock can go down 60% in six months and up more than 80% in less than two.

"With this note, you hold the risk for the issuer.

"To me it's more of an upside risk because I see the stock biased toward the upside, definitely. The 3.37% return is all I'm going to get. There's no participation. That's a real problem.

"You can't get more than the coupon but you can lose everything.

"Given these two things, I don't think 3.37% is enough compensation at all.

"I don't think it's a good risk reward," he said.

The notes are expected to price on Dec. 27 and settle on Dec. 31.

JPMorgan is the agent.

The Cusip number is 48126DQD4.

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