UBS introduces the first Facebook-linked structured note in a 13%-14.35% reverse convertible

By Emma Trincal

New York, May 24 - The first Facebook, Inc.-linked note is underway just a week after the company's botched initial public offering. The note will be brought by UBS AG, London Branch, which recently made the news with the pricing of a record-size deal of nearly $1 billion in a separate transaction.

UBS plans to price 13% to 14.35% annualized reverse convertible securities due Nov. 29, 2012 linked to the common stock of Facebook. The notes are set to price Friday, according to a 424B2 filing with the Securities and Exchange Commission.

Interest is payable monthly.

The payout at maturity will be par unless Facebook shares fall below the trigger price - 75% of the initial share price - during the life of the notes and finish below the initial share price, in which case the payout will be a number of Facebook shares equal to $1,000 divided by the initial price.

"Please don't tell me they're doing a Facebook deal! They didn't wait long on that one, did they?" said Marc Gerstein, research analyst at Portfolio 123.

"I bet it's Morgan Stanley," he quipped.

He was referring to the stock's painful market debut marked by computer glitches at the Nasdaq and a massive sell-off. Morgan Stanley was the lead underwriter. The stock priced at $38.00 in the IPO on Friday and fell by 18.5% through the next two trading sessions. Shares have moved up a little since then, closing at $33.03 (Nasdaq: FB) on Thursday, but the stock is still 13% less than its IPO price.

Shareholders have sued Facebook and Morgan Stanley as well as Goldman Sachs and JPMorgan, also underwriters in the deal, accusing them of withholding material information.

Not the worst thing

Despite its turbulent beginning, Facebook continues to fascinate the public, said Gerstein, but he added that he is not a "fan" of the company.

"Anybody who even thinks of buying Facebook is crazy in my opinion," he said.

"But if it's what you really have in mind, I think this note is not worse than going the IPO. It might be even better. At least you're getting 7% even if it goes down.

"Say it prices at $33.00. It would have to go down to $24.75 before you're exposed to the downside. That's not bad. At least you have the protection, and if things turn bad, you own the stock. Because this is really what this deal is for. This deal is for people who want a piece of Facebook," he said.

For Gerstein, there are poorer choices to make than buying a reverse convertible linked to Facebook shares. One is to be long the stock; the other, which he said is even worse, is to buy the shares on the IPO as so many investors tried to do last week.

The stock, which has a trailing-12-month PE of 75, is "grossly overpriced," he said.

"The stock priced at a huge PE, and there is no reason to think it's going to grow out of advertising. People like Facebook because they have Facebook pages and Facebook friends. But Facebook itself has no clue on how to monetize advertising. General Motors knows that."

He was referring to news reports last week, prior to the IPO, suggesting that General Motors had decided to pull its advertising out of Facebook because of too little impact on sales.

"Again, a note like that is going to be better than buying on the IPO," he said. "If you think you have to get the IPO, you need a psychoanalyst, not an analyst.

"But if I was a registered adviser and if a client had an interest in the stock, I'd take the reverse convertible into consideration."

Ideal timing

For a New York structurer, there may not be any better timing than now for a structured note linked to Facebook.

"Of course, you have to have a view on the stock. If you're comfortable with the company, if you find valuation attractive, if you have your own opinion, then it makes sense.

"The timing is ideal for a reverse convertible on Facebook. You had a sell-off, and volatility is high. That makes it very attractive," he said.

This structurer explained that investors in a reverse convertible are selling a down-and-in put. When the 75% barrier is hit, it triggers the put. The higher the volatility, the more expensive the option and the higher the coupon because the put premium is high, he said.

Hedging the volatility

One of the problems with pricing a fresh Facebook deal, however, is the lack of historical data on volatility.

"I would guess the implied is around 40%, well above the S&P. But I don't know," the structurer said.

You can extrapolate that with the realized volatility and the prices of at-the-money options, he said.

"With a brand new stock, there is almost no volatility data. It will take some time, probably up until the end of the month, to see volatility quoted on the stock. For the issuer, it may be harder to hedge because they're not going to find out-of-the-money puts to hedge volatility properly. They'll find at-the-money puts and calls, but not out-of-the money options. It will evolve pretty quickly, but in the meantime, they may have had to lower the coupon a little bit because of that," he said.

"However, if it's a few basis points less, I don't know, it may not be a big deal given the timing. You're probably getting an attractive coupon just because of the high vol."

Headlines

Still, this structurer said that investing in this underlying at this time presents some risks. And even if the timing makes sense from the standpoint of pricing a reverse convertible, the product may not represent the best deal given the headline risk.

"They probably have a lot of demand for Facebook notes from retail clients, and from their perspective, it makes sense to put it on the shelf now. But I think it's a little bit weird," he said.

"Sure, given how the stock plunged after the IPO, the potential litigation, you're getting a higher coupon.

"But I would have been more interested in an absolute return play. The stock had too much hard time after the IPO. With an absolute value deal, you can benefit from a recovery of the stock or a new decrease. It's a little bit more efficient.

"But just betting on the stock not falling by more than 25%, that's strange."

Absolute return notes give investors the absolute value of a stock decline above a downside threshold. The upside is usually capped.

The notes (Cusip: 902674HV5) will price Friday and settle May 31.

UBS Securities LLC and UBS Investment Bank are the underwriters.

The fees are 2.25%.

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