Morgan Stanley’s contingent income autocalls on stock basket positioned for economic recovery

By Emma Trincal

New York., Aug. 13 – Morgan Stanley Finance LLC’s 0% of contingent income autocallable securities due May 29, 2024 linked to an equally weighted basket of four travel stocks is a bet on the resilience of the global economy as a new wave of the Covid-19 pandemic is compromising the reopening momentum, said Clemens Kownatzki, finance professor at Pepperdine University.

The basket consists of the stocks of American Airlines Group Inc., United Airlines Holdings, Inc., Norwegian Cruise Line Holdings Ltd. and Carnival Corp., according to a 424B2 filed with the Securities and Exchange Commission.

The notes will pay a contingent monthly coupon at an annual rate of 10.25% if the basket closes at or above its 70% coupon barrier on the relevant observation date.

The notes will be called at par plus the coupon if the basket closes at or above its initial level on any monthly review date after six months.

The payout at maturity will be par plus the final coupon unless the basket finishes below its 60% downside threshold, in which case investors will be fully exposed to the basket decline from its initial level.

Variant

“It’s a play on economic growth. It’s a bet on whether the recovery trade is still working or whether it’s on hold for a while due to the Delta variant,” said Kownatzki.

The basket consists of travel and leisure stocks with two major airlines and two large cruise lines.

Revenue improvements for those four companies are directly tied to a strong pickup in demand for travel, he said.

Any worsening of the Covid-19 pandemic due to the current variants or the emergence of new ones would adversely impact those businesses.

New restrictions

“You could see a decline in bookings or an increase in cancellations if things get worse. The future is uncertain due to the variants,” he said.

“Our lives had almost returned to normal and then the Delta variant emerged. There are going to be changes in policies depending on where you live. Restrictions are greater in California than they are in Florida.

Some states have indoor masking mandates; others don’t.”

He said that his school – Pepperdine’s Graziadio Business School in Malibu – has just mandated students and teachers to get a weekly Covid-19 test or a vaccine beginning next month.

He gave this example to show how people’s daily lives can be affected by the spread of the virus and the policies in place, which makes a bet on travel and leisure stocks risky.

“The variant or the advent of new variants has modified how we live and how we travel,” he said.

Fundamentals

Free cash flow, a metric that measures a company’s financial performance, has been negative last year for the four companies, he said. Free cash flow has improved this year but has remained negative for all four as well.

The situation is more severe for the cruise lines than for the airlines, he noted. But overall, the travel and leisure industries have not yet recovered from last year’s blow.

“From a fundamental perspective, last year has been devastating,” he said.

Anecdotally, some statistics reveal that the chances of contracting the virus are higher during a cruise trip than on an airplane despite the greater space between passengers in a ship because cruise trips last longer than flights, he said.

“The big picture remains clear from the fundamental analysis of the stocks. Those companies have all been severely damaged by last year’s pandemic and continue to struggle,” he said.

Technical perspective

On the year-to-date chart, all four stocks showed a similar pattern: growth early in the year until March, when three of them hit their respective 52-week highs (Carnival peaked in June) followed by a choppy stretch leading to a down trend beginning in June.

The four stocks started to recover in late October, prior to the emergence of the Delta variant, he noted.

“And yet, none of those stocks have been anywhere near their pre-pandemic highs of last year.”

Norwegian Cruise Lines for instance trades 58% lower than its pre-Covid high of January 2020.

Carnival’s shares are 56% off their January 2020 high.

United Airlines dropped more than half from its pre-pandemic peak of November 2019, and American Airlines dropped more than a third from its February 2020 high.

“Current valuations offer an attractive entry point if you’re confident in the recovery of those industries,” he said.

Late last year, investors were upbeat about the reopening of the global economy as vaccination was about to become available. Investors began to bid on value and cyclical stocks, which included pummeled travel stocks.

But concerns began to emerge with the spread of the Delta variant, which originated in India, a country hit in February by a second devastating wave of the pandemic. Before that, in January, a new lockdown in China stoked fears about a potential global recession.

“The potential for new lockdowns and travel restrictions is raising concerns, making those stocks more volatile. You’re buying them at a bargain with a good premium. The risk is well priced in the notes. That’s why I like this structure,” he said.

Volatility

The call feature was one of the attractive terms of the product, he added.

“I think the most likely scenario is an early redemption in six months. If it’s not called, you can still pick up a double-digit coupon. It’s priced to pay you 10.25% in the event of a 30% downside or less. That’s valuable. You can still make money if the basket is down 30% and these stocks are already heavily discounted.”

The 10.25%-digit coupon was “appropriate,” he added.

“This double-digit return reflects the risk involved with the current uncertainty around this virus. If we can’t control the spread of Delta, if new variants pop up or if more people refuse to be vaccinated, then we’ll see a deterioration of all areas of the industry, not just travel and leisure, except for the technology sector.

“This is why you have highly volatile stocks in this basket. If the components were less volatile, your coupon would be a single-digit coupon,” he said.

Fair pricing

There may be uncertainty around the spread of Covid around the world, but investors get compensated for the risk, Kownatzki.

“Things can get worse of course. The risk exists. But the risk is appropriately priced.

The nature of the underlying asset offered an additional benefit.

“It’s not linked to a single stock. A basket is more diverse. A basket is less risky than a single stock and less risky than a worst-of.”

The possibility to see the note called every month after six months if the basket price is not negative was a risk mitigating factor.

“Finally, a 60% barrier at maturity almost three years from now...that’s pretty solid considering that you’re buying those stocks at such deep discounts,” he said.

In comparison, investing in the S&P 500 index presented its own sets of risks.

“The S&P is extremely overvalued. It’s trading at all-time highs while those stocks have yet to reach their pre-Covid levels.

“As long as you are confident in the recovery, the terms of this note are pretty decent in my view,” he said.

The securities are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes will price on Aug. 23 and settle on Aug. 26.

The Cusip number is 61773FNX7.

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