JPMorgan analysts recommend Four Seasons convertibles for variety of strategies

By Ronda Fears

Nashville, Tenn., Jan. 9 - The Four Seasons Hotels Inc. zero-coupon convertible subordinated notes appeal to investors with a variety of strategies, said JPMorgan convertible analysts Alexander Robinson and John Levin in a report Wednesday. For yield-oriented investors, the analysts suggest selling credit default protection. Current Four Seasons Hotels Inc. shareholders should swap out of limited voting shares into the convertible. Convertible arbitrage investors would need to set up the convertible as a synthetic put instrument on a selective basis, as stock borrow availability allows.

"The convertibles are virtually the only debt in the company's capital structure; we expect Four Seasons will generate significant free cash flow upon a return to a normalized operating environment, while in the meantime the company should be approximately cash flow breakeven or better," the analysts said in the report.

"We see apparent absolute equity overvaluation, but modest relative historical equity valuation of Four Seasons limited voting shares," the analysts added, noting: "We would be inclined to revisit our view on the credit quality of Four Seasons in the event of dramatic negative events such as additional terrorist attacks or an extremely severe U.S. recession."

For yield-oriented investors, the analysts recommend selling credit default protection, which currently is believed trading rich and does not adequately recognize the company's strong long-term credit fundamentals.

Current Four Seasons shareholders should swap out of the limited voting shares into the convertible, the analysts said, because they view the limited voting shares as overpriced and as an equity alternative, the convertible offers the possibility of upside participation with increases in the shares price while at the same time offering solid downside protection in the event the shares price declines.

For convertible arbitrage investors, Robinson and Levin recommend setting up the convertible as a synthetic put instrument on a selective basis, as the stock borrow availability allows.

"Because the convertible does not pay a cash coupon, we hesitate to call it a paid-to-wait security, although the yield to maturity is 4.17%. At the current price of 31 the convertible is above the accreted value and trades on a yield to maturity basis. However, should the price of the shares decline, there is a Sept. 23, 2004, put at 32.873, payable at the option of Four Seasons in any combination of cash or shares," the analysts said.

"We recognize that the low float and limited borrow of the stock represents a challenge to the easy execution of our convertible arbitrage recommendation, and we suggest that investors be patient."

The analysts said that for convertible arbitrage investors, the appropriate strategy is infrequent, as opposed to daily, delta hedging. In addition, short rebate differences between brokers are likely to be exaggerated and the best locate will clearly be unusually valuable, they added. Currently, the analysts believe short rebate ranges from negative 5% to positive 1%. Both the Toronto and New York exchanges limited voting shares pay modest Canadian dollar dividends, currently C$0.055 per share payable semiannually.

In the analysts' view, the appropriate assumption for the Four Seasons convertible credit spread to U.S. Treasury Securities is about 450 basis points - modestly less than the credit default protection bid spread after adjusting for the about 75 basis point difference between the swap rate and U.S. Treasury yields. In addition, the analysts use a 90-day volatility assumption of 35% compared with the actual volatility of the NYSE-traded limited voting shares of almost 72% and the implied volatility of July 2002 calls at $50 of 40%.

At those assumptions, the convertible appears to be priced about 0.2% cheap, with attractive equity participation and a 4.17% yield to maturity. The analysts said at the current price of 31, the convertible offers less than 25% downside participation and more than 50% upside participation in limited voting share movements using 20% intervals. The convertible trades on an actual market delta of 65%, compared with the theoretical delta using the assumptions of 55% to 60%.

"Although we generally are confident that the risks to Four Seasons credit are modest, our view is guarded," the analysts noted in the report. "Worse than expected RevPAR deterioration could continue to cut into base management fees, and weakness in property-level operating profit could affect incentive management fees or achievement of milestone thresholds. In addition, although Four Seasons already anticipates some losses from hotel ownership operations, severe losses would affect the company's ability to generate cash from operations and could restrict the company's ability to generate liquidity through assets sales if the need arises. We would be inclined to revisit our view on the credit quality of Four Seasons in the event of dramatic negative events such as additional terrorist attacks or an extremely severe U.S. recession."

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