Citi’s contingent income autocalls on Tesla seen as short-term, speculative play

By Emma Trincal

New York, Sept. 9 – Investors in Citigroup Global Markets Holdings Inc.’s contingent income autocallable securities due September 2025 linked to the common stock of Tesla, Inc. could incur deep principal losses at maturity due to the volatility of the underlying stock. But the high likelihood of an early redemption offsets some of the risk, making the notes appropriate for a speculative, small-size position, said Clemens Kownatzki, finance professor at Pepperdine University.

The notes will pay a contingent quarterly coupon at the rate of 20.75% per year if the stock closes at or above its coupon barrier level, 50% of its initial level, on the corresponding determination date, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be automatically called at par plus the coupon if the stock closes at or above its initial level on any quarterly determination date.

The payout at maturity will be par plus the final coupon unless the stock finishes below its downside threshold, 50% of its initial level, in which case investors will lose 1% for every 1% that the stock declines from its initial level.

High volatility

“My first impression is that I like the note. You have a pretty good chance of being called and called early, which is not bad given the size of the coupon and the volatility of the stock,” said Kownatzki.

He looked at the call option contract expiring Dec. 16, which is the date of the first call date. If the notes were to be priced at Friday’s closing level of $300 a share, the chances for the call to expire “in the money,” or above the 300-strike price, would be approximately 45%.

“The current implied risk metrics from the market tells us that traders are pricing a 45% probability for the stock in December to be greater than it is today,” he said.

“That gives you almost a 50% chance of being called on the first call date.”

Those probabilities vary with the implied volatility of the stock, he said.

Charismatic CEO

The implied volatility of the at-the-money call option for the same option contract is 54%, he noted, which is 2.5 times the implied volatility of the S&P 500 index of 22%.

“The stock has had a very bumpy road. It offers a massive growth but at a very high risk,” he said.

What is driving a lot of the volatility is the company’s chief executive officer, Elon Musk, he noted.

“The market assumes there is a risk associated with the company founder’s personality. It’s understandable.

“Musk is a risk-loving, risk-seeking person. If I was an insurance company, I wouldn’t write a life policy on him,” he said.

Historically though, the “personality” of Tesla’ CEO has worked to the advantage of what debuted as a start-up in 2008 and became the sixth largest company in the world by market capitalization.

“A few years ago, Tesla was on the brink of bankruptcy. Several times, Musk convinced bankers and bondholders to help him out. If you’re a typical banker, you’re not going to lend money to an organization that’s so risky. But they all saw growth potential. They all believed that he could pull it off. And he did,” he said.

A barrier, not a floor

A drop of more than 50% in the stock price during the life of the notes has limited consequences on the income, he said. Investors miss the call and the call premium for that quarter. But the snowball structure allows them to catch the cumulative payout at a later date if the coupon barrier condition is met.

But a barrier breach at maturity would be devastating, he noted, creating a loss of at least half of the initial investment.

“At any point in time, within a six- to 12-month period, there is a good chance the stock could drop more than 50%. That probability rises if we extrapolate over a three-year period,” he said.

Advisers buying structured notes tend to feel more comfortable extending maturities as they are under the impression that risk decreases with time.

Kownatzki put this assumption into perspective.

“People sometimes see more risk over a short period of time, and that’s true if you’re looking at an index. Over a five-year period, the S&P has a greater chance to mean revert compared to a single stock.

“But it’s not true with a single stock because a variety of factors can impact the share price at all times,” he said.

Legal distraction

Kownatzki cited some of the challenges Tesla is facing as an automaker.

Last spring, for instance, Tesla reduced vehicle production at its Shanghai factory due to part shortages. The supply disruption has now been resolved, he noted.

The big headline risk is Musk’s proposed acquisition of Twitter, Inc. for $43 billion five months ago and his decision in July to pull out of the deal, which led to lawsuits between Tesla and Twitter. During that time span, the share price dropped nearly 40%.

“This lawsuit with Twitter is an ongoing distraction for Musk. It distracts him from his actual business of building the best electric cars,” said Kownatzki.

“Another factor of enormous distraction is Musk’s involvement in his other ventures, like SpaceX.”

Kownatzki however downplayed the risk of the highly publicized lawsuits on the share price of Tesla.

“If forced to buy, he will have to sell shares of Tesla. It’s obviously a risk. But knowing the history of this company and its owner’s past behavior, he will find a way out of this deal,” he said.

“The risk may be overblown but it’s part of the unknown. It’s one of the reasons Tesla is more than twice as volatile as the S&P.”

Not a bargain

The valuation of the stock at least for value players is a red flag.

On a split-adjusted basis, the price-per-earnings ratio is 104.16.

“A P/E ratio of 104 is high, for sure. Other valuation metrics confirm that Tesla is an expensive stock. But the P/E is lower than Amazon, which is 116. In addition to that, Tesla’s P/E is also lower than what it was in the past three years,” he said.

Tesla implemented a 3:1 stock split on Aug. 25.

The split, as it is usually the case, had no effect on the share price, he said.

“The impact of a stock split is usually just psychological. When you split a stock 3:1 you just triple the shares and divide the price by three, but the market cap remains the same.”

More players in the field

For Kownatzki what could really negatively impact the price of the stock was the evolution of the electric vehicle marketplace in general.

“Right now, Tesla is still the leader in the space. But most automakers are now building high-quality electric vehicles too,” he said.

He cited Toyota, BMW, Ford, General Motors, Mercedes, among others.

“That’s perhaps the biggest headwind.

“Tesla’s success is its brand and Musk’s massive following. But more car makers competing in the space and building better or perhaps more reliable cars at a lower price is a major threat for Tesla,” he said.

Speculative bet

With all the headwinds faced by the company, any investment in the stock even with a 50% barrier should be considered “speculative,” he said.

“The stock already dropped 50% from its high to its low. It’s a tremendous drop in just six months. But it happened and it can happen again,” he said.

He was referring to the 50.09% price decline from a 52-week high in Nov. 4, 2021 to a 52-week low on May 24.

“Some people believe that once a stock falls by 50%, it can’t drop much further,” he said.

“It’s absurd. There are no mathematic stats that say: once down 50%, the stock has to go back up from 50%.”

Despite the risks, Kownatzki had a favorable opinion about the note.

“I sort of like it just because there is such a high probability of getting called. Nothing wrong with getting called in December with a 5.2% return,” he said.

“But the stock is tremendously volatile, and the risk reward situation is not great. I wouldn’t load up on the notes. A small allocation is OK.”

The notes are guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the underwriter with Morgan Stanley Wealth Management as a selected dealer.

The notes are expected to price on Sept. 16 and to settle on Sept. 21.

The exact maturity date is expected to be Sept. 19, 2025.

The Cusip number is 17330U298.

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