JPMorgan's 17.25% reverse convertibles tied to Netflix target contrarians seeking high return

By Emma Trincal

New York, Aug. 23 - JPMorgan Chase & Co.'s 17.25% reverse convertible notes due Nov. 30, 2012 linked to Netflix, Inc. shares offer an attractive return over a short time, sources said.

But whether the volatile stock represents a fair or excessive amount of risk for this type of coupon remained debatable among market participants.

The payout at maturity will be par in cash unless Netflix shares fall below 75% 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.

Out of favor

Netflix is an internet subscription service streaming television shows and movies and renting DVDs through the mail.

Netflix's stock price has generated headlines for its wide fluctuations and has become unpopular among investors.

Shares have lost 75% in the past 12 months and are down 20% over the past month.

From its July 12 high this year at $84.97 to its low on Aug. 2 at $53.87, the stock has fallen by 37%.

But with a 19% appreciation since then, some investors believe that the company may have turned the corner.

Analysts have lowered their estimates after the stock plunged by 25% in just one day on July 24, falling to $60 from $80 after the announcement of the company's second-quarter 2012 financial results. The stock since then has gained 6.5%, and some analysts have recently upgraded their ratings.

"We believe that consensus figure is simply too draconian and is the result of estimate revisions based on emotion rather than analysis," Caris & Co. analyst David Miller, who just upgraded the stock, wrote in a research report. He was commenting on the cut in the Street's consensus on earnings per share that resulted from the "awful FQ2 print four weeks ago."

"Netflix is a strong company as it targets two audiences," said Robert Castellano, president of the Information Network.

"You can get a DVD in your mailbox and watch a movie in a family setting or you can download a movie on your tablet and watch it at a Starbucks. That's the beauty of the Netflix model. However, the stock performance depends very much on what's out there in terms of competition."

For Doug Anmuth, JPMorgan analyst with a neutral outlook, competition from Amazon, Hulu and TV Everywhere continues to increase.

Because the stock has already dropped so much, it may not be a bad candidate for a reverse convertible, said Marc Gerstein, research consultant at Portfolio 123, who likes the upside and tenor of the product.

Not a CD

"It's really not bad. The stock has plunged since last year. There is already a lot of hatred reflected in the stock price," he said.

"They managed to [anger] everybody last year, customers and investors alike. They had the nerve to raise their price by a lot, and they had this idea of splitting the company between the CD business and streaming, which led investors to despise them in their heart and soul.

"But a 17% annualized is a pretty good return. You're not going to get this at the bank. If you want this kind of return you have to take some risk."

One type of risk is minimized by the short maturity, he said.

"The credit risk is pretty much eliminated. If JPMorgan goes broke in three months, chances are everything else you've invested in will tank as well. It's only a three-month, so that's reasonable. I don't know if I would want to do it for one year," he said.

"And if you get put the stock, there are worse things you could be sitting with."

Gerstein said that any company whose stock would drop from $300 in July 2011 to $64 today would inevitably be out of favor.

"But it's really not a bad service. I know there is competition and the stock has tanked. But it's also the Street having a love affair with the stock and now they hate it. You see that all the time. You'll see a huge short interest in Facebook when it's a screaming buy.

"I don't think there's anything wrong with Netflix's business model. The business is what it is. It's probably more emotions and culture than anything really rational.

"This note offers a very good return, as long as you understand the risk. I like it."

Shorting puts

Clemens Kownatzki, independent currency and option trader, said that he understands the risk but that he doesn't think he could easily manage it.

"This note may be attractive for someone who doesn't have experience with options or no access to an exchange," he said.

"It may also work if you're bullish on the stock and want to own it at the strike price, which is the 75% barrier level. You would buy that for the same reason you'd short a put: it's a cheaper limit order.

"But the problem is risk: while the upside is enticing, it's very difficult to manage the risk."

Kownatzki said that he could replicate the trade and decrease the risk with an option.

"This is the equivalent of selling a put option. You get put the stock and own the shares if you breach the barrier. I could replicate the same strategy and create my own barrier with an option. You could select what strike you're comfortable with and probably generate the same return with less risk," he said.

Kownatzki pointed to the volatility of a stock, which is now worth approximately a fifth of the one-year-ago price.

"It's a huge decline. It's probably not going to happen in the next three months especially at this level, but you could very easily lose 10% or 20% in the next three months. In fact, it could happen in a couple of days. Then I'm stuck with a deal I can't get out of and I end up with the stock substantially lower," he said.

"From the risk/reward point of view, I don't find it very appealing. I am taking a huge downside risk in order to get 4.31% in three months."

Using options instead of the note would give investors a better tool to manage the downside, he said.

"If instead I sold a put, I could buy it back. From a risk management point of view, I have much more flexibility with options than with this," he said.

"I actually sold some puts on Netflix but very short term. I know that this note is only three months, but I'm talking about options expiring in one or two weeks.

"I wouldn't have nearly the same concern if it was a note on the S&P or even a basket of commodities. But I always find single stocks far more risky. It's tougher to get yourself locked in, even for three months."

The notes are expected to price Aug. 29 and settle Aug. 31.

J.P. Morgan Securities LLC is the agent.

The Cusip number is 48125V4A5.

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