Morgan Stanley’s $4 million contingent income autocalls on Alibaba set good model for value

By Emma Trincal

New York, Sept. 3 – Morgan Stanley Finance LLC’s $4 million of contingent income autocallable securities due Aug. 30, 2024 linked to the American Depositary Shares of Alibaba Group Holding Ltd. present some of the positive characteristics of a contrarian, value play, which should set an example for structuring desks, said contrarian portfolio manager Steven Jon Kaplan, founder of True Contrarian Investments.

The notes will pay a contingent quarterly coupon at an annual rate of 10% if the underlying stock closes at or above its 55% coupon threshold on any quarterly observation date, according to a 424B2 filing with the Securities and Exchange Commission.

If the underlying stock closes at or above its initial price on any quarterly determination date after six months, the securities will be redeemed at par plus the contingent payment.

If the underlying stock finishes at or above the 55% downside threshold level, the payout at maturity will be par plus the contingent quarterly payment.

Otherwise, investors will be fully exposed to any losses.

“This is a stock that’s now undervalued,” said Kaplan.

The share price hit a 52-week low of $152.80 a share on Aug. 23. It rose to a $319.32 high on Oct. 27.

“That’s more than a 50% drop,” he said.

“It has gone back up a little bit from its recent low of August, but it’s still depressed from about a year ago,” he said.

The stock closed at $170.30 on Friday.

Beijing’s control

Kaplan compared buying the shares outright with the purchase of the structured note. The two strategies differ. But the note, based on its price on the trade date and its barrier level, was relatively attractive, he said.

The initial price was $159.47. The notes priced on Aug. 27.

The stock has been falling strongly since October in response to headlines about the Chinese government tightening its control over Chinese “big tech,” including not only Alibaba but also internet conglomerate Tencent, e-commerce company Pinduoduo and ride-hailing Didi among others.

“Beijing’s regulatory clampdown has been the focus of an intense media coverage,” he said.

“As always, they have exaggerated the risk, giving investors a great buying opportunity because it’s a fake risk. There’s no risk of further crackdown in my opinion. The Chinese government is heavily dependent upon its capital markets. They’re very committed to making investments in China as appealing as possible,” he said.

“If anything, the Chinese government will loosen up regulation.”

Donation

Another headline pushed down the price of the ADRs on Friday, but this time, the catalyst was a company’s initiative.

In pre-market trading on Friday, the share price of the ADR dropped more than 1% after Alibaba announced a $15.5 billion donation to support social and economic programs, in line with president Xi Jinping’s push for reforms.

“We’re probably going to see pressures from the government,” said Kaplan, who dismissed the importance of the news.

“The price didn’t move much during the day,” he said.

The stock opened at $169.52 and closed nearly a point higher. It finished less than 1% off its previous close.

Another risk

Kaplan downplayed the regulatory headwinds faced by Chinese internet companies. But he said he anticipates a sell-off looking forward.

“People are over-anticipating a crackdown, and now it’s fully built into the price. I’m not saying the share price is not due to a pullback. But a regulatory crackdown is not going to be the main driver.”

“However, if I was to buy the stock, I would buy small, laddered positions. I would be cautious,” he said.

The risk lies in the U.S., not so much China, he added.

“U.S. stocks are so overpriced... we’re heading to multiple pullbacks which is the hallmark of bear markets.

“Obviously, a bear market in the U.S. would have an impact on the whole world, including China.

“So, I would wait for pullbacks in the U.S. market to add shares of stocks like Alibaba,” he said.

In the meantime, he said, the notes provide a good short-term strategy. He explained why.

Good start

The first appealing factor was the initial price of the underlying just below $160.

In his own portfolio, Kaplan said that he has already placed small limit orders to buy below $160.

“It’s a very good starting point, not far from the bottom of the past year,” he said.

“That’s my initial entry and I can buy more all the way down.

“It’s not so often that you see an underlying pricing 50% off its previous high. If you buy a note, it’s a very good thing.”

Short duration

The three-year term was not ideal. But the likelihood of a call offset some of the risk, he said.

“Usually, I don’t like three-year. There’s plenty of time for the stock to pull back but not much time for a recovery during a three-year period. In this case, it’s not that important because the chances of getting called are high given the low entry point.

“So, the fact that it’s a three-year is not a significant negative factor,” he said.

Deep barrier

One of the most attractive terms was the 55% barrier applied to both the coupon and the principal repayment at maturity.

“Not only you’re buying the stock at a bargain, but you also have a 45% margin for error. That’s an extra protection,” he said.

The barrier price would be $87.70.

“It hasn’t gone down that low since the beginning of 2017.”

The low barrier also facilitated the payment of the 10% contingent coupon, he noted.

“The risk-reward is very good.”

Not a bond

Kaplan however was hesitant to categorize the notes as a true income substitute.

“It’s not a guaranteed coupon. Your principal is still at risk. You have the credit risk exposure like any bond. But you also have equity risk exposure.

“The note has some of the characteristics of a bond. But if you’re looking for income, you’re looking in the wrong place,” he said.

Kaplan said he would rather call the 10% payout a “bonus.”

Good example

The portfolio manager said issuers should price more deals like this one, adding that the timing of the trade and the terms of the notes were unusually advantageous.

“You’re buying at a deep discount,” he said.

“It’s structured in a conservative fashion, which I like. You have a huge amount of downside protection and getting paid doesn’t require the stock to go up. That’s one of the main differences with a long position.

“Frankly, other issuers should follow this model. I see too many underlying that are extremely overvalued. The S&P 500, the Nasdaq are incredibly overbought.

“When an asset goes down in price, you don’t see many notes on it. It’s when it goes back up again that they reappear. I’ve noticed that with gold miners for instance.

“That’s because, too often, the deals are based on trendy stocks with very high P/Es – look at Tesla for instance – not on value.

“So, if the example of this note could be imitated by others, that would be a good thing for investors.”

The securities are guaranteed by Morgan Stanley.

The agent is Morgan Stanley & Co. LLC.

The notes (Cusip: 61773FTZ6) settled on Aug. 31.

The fee is 2.5%.

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