Bank of Montreal's 13.13%-16.13% Valero-linked reverse convertible seen as attractively priced

By Emma Trincal

New York, July 26 - Bank of Montreal's 13.13% to 16.13% annualized reverse exchangeable notes due Feb. 16, 2011 linked to Valero Energy Corp. shares offer attractive terms for investors mildly bullish on the stock, a financial adviser said.

The payout at maturity will be par unless Valero stock closes below the trigger price - 75% of the initial share price - during the life of the notes and the final share price is less than the initial share price, in which case the payout will be a number of shares of Valero stock equal to $1,000 divided by the initial share price or, at the issuer's option, the cash equivalent, according to a 424B2 filing with the Securities and Exchange Commission.

Interest will be payable monthly.

"If you're mildly bullish on Valero, if you don't see the stock going down or see it even going up a little, then this is an excellent alternative to buying the stock," said Lee Kramer, president of Capital Management Analytics.

"It's a 14% annualized return, and if the stock price drops, it still gives you some protection."

Low P/E

Using technical analysis, Kramer said that he is comfortable with the downside risk based on the 25% level of protection.

"Sure, the share price could drop as there is a risk for the refiners if the economy pulls back. That said, the stock is very cheap. It's trading seven times this year's earnings estimates," he said.

The stock closed Tuesday at $26.48 (NYSE: VLO), and 2011 earnings estimates are around $3.57 per share, he explained. This implies a price-to-earnings ratio of 7.4.

In comparison, the current P/E ratio for the S&P 500 is 16.55.

The P/E ratio is the most common measure of a stock valuation. It is a company's share price divided by its earnings per share.

While the stock price has already been rising a lot - the price is up 14.5% year to date and 50% for the past 12 months - Kramer said that the outlook continues to be positive, which offers support on the downside against a severe price decline.

Consensus estimates

One of those positive signals, he said, is that fact that earnings revisions have been positive.

"Over the past few months, consensus estimates have been rising steadily. Three months ago, it was $3.00 a share for the year 2011. Now it's $3.60 for the year," he said.

"I like that. Every time earnings revisions trend upwards, it's favorable. You don't want a stock with earnings estimates that are being cut."

$20.00 support

Kramer said that the 25% knock-in level, which would translate into a stock price of about $20.00 per share, gives him confidence.

"Twenty dollars a share: that's where the stock started its big run at the end of 2010. I think there is a lot of technical support at or above $20.00, and it would provide protection if the stock dropped significantly," he said.

Support is the price level at which the stock is not believed to trade lower.

"They'll price in August. I would wait until the day the notes get priced to see what the actual knock-in price would be. I'd be comfortable with a knock-in at or below $20.00. If the knock-in was above $20.00, I may be a little bit more hesitant," he said.

Kramer said that a typical protection for a six-month reverse convertible would tend to be 20%.

"A 25% cushion is often for slightly more volatile names," he said, adding that Valero belongs to that category with an implied volatility of 40%.

Looking at a fairly modest beta of 1.15, Kramer concluded that the implied volatility is higher for this stock than its actual volatility.

"That means that the market is anticipating greater volatility going forward and you can expect better pricing because the issuer can make more money from the options they're selling," he said.

The better terms can be offered via a higher coupon, a more protective downside protection or both.

In this case, the greater-than-usual protection level of 25% derives from the high implied volatility, he said.

Fairly priced coupon

But the coupon offered to investors is also attractively priced, he said.

Kramer explained that in a reverse convertible, the underwriter sells a put option at a strike level equivalent to the knock-in level. The difference between the initial price and the strike is where the put is out of the money and the investor remains protected. If the strike price is hit, the investor will be forced to take delivery on the stock.

"The underwriter is selling a put to bring in some premium and pass it on as a coupon. And if the stock hits the strike price, instead of being put with the stock, the underwriter passes the stock off to the investor," Kramer said.

One way to evaluate if the coupon adequately compensates investors against the risk of being knocked in is to look at option pricing models, Kramer said.

"You basically compare the coupon with the premium you would get for selling a put on the equivalent period," he said.

"You can use an options model and figure out the probability of getting knocked in."

Looking at a January options contract on Valero, Kramer said that the probability of the stock dropping by 25% is about 30%.

Based on the current stock price, a 25% decline would represent a $6.50 loss.

"So you have a 30% probability of losing $6.50. That's $1.95. It means that $1.95 should be your expected return for the risk of that particular outcome to occur. The $1.95 is the price of that negative value for the risk you're taking," he said.

A put seller would receive this amount as a premium to be compensated for that risk, he added.

Kramer then compared this estimated premium on a put option with the actual coupon paid to the noteholders assuming a coupon priced at mid-range between 13.13% and 16.13%.

"If your annual coupon is 14.63% at mid-point, your coupon for the six-month term is 7.31%. That gives you a $1.94 return based on the current stock price of $26.50. That's very much in par with the options premium," Kramer said.

"I would say this deal is decently priced. You're fairly compensated for that risk of a negative event happening, which would be a drop of 25%.

"Then of course, it comes down to your view on the stock. If you're very bullish, you should definitely own the stock."

Processing discounted crudes

Philip Weiss, energy analyst at Argus Research, said that he is bullish on Valero.

"I think the stock is very well positioned. Given the market conditions, there's still room for appreciation of the shares," said Weiss, who has a buy rating on the stock with a $35.00 price target.

One of the main advantages the U.S. refiner has over its competitors is its ability to produce oil from less-expensive sour crude, Weiss noted.

"The company has made the capital investments necessary to be able to process cheaper crude, which lowers its costs especially when the price of high-quality crude, such as Oklahoma crude, crude from the North Sea or Louisiana Sweet crude, remains high," he said.

"Not every refiner can do it. If you can buy more of this cheap crude in this market and process it, you'll make more money," he said.

BMO Capital Markets Corp. is the agent.

The notes will price on Aug. 11 and settle on Aug. 16.

The Cusip number is 06366QSM0.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.