JPMorgan's daily observation knock-out notes on Merck target bulls seeking unlimited upside

By Emma Trincal

New York, March 16 - JPMorgan Chase & Co.'s 0% daily observation knock-out notes due Sept. 24, 2012 linked to the common stock of Merck & Co. are for investors bullish on the stock who are looking for unlimited upside at the cost of a contingent buffer, sources said.

If the price of Merck stock falls by more than 25% from its initial price during the life of the notes, the payout at maturity will be par plus the stock return, which could be positive or negative, according to an FWP filing with the Securities and Exchange Commission.

Otherwise, the payout will be par plus the greater of the stock return and a contingent minimum return of at least 9.6% that will be set at pricing.

Modified reverse convertible

The prospectus called the 25% knock-out buffer amount a "contingent buffer" because the protection exists only if the stock price never declines by more than 25% during the term. If it does, the protection disappears and investors are fully exposed to the decline of the stock price on a one-for-one basis.

"It looks like a modified reverse convertible, although it's different because with a reverse convertible, you get the coupon no matter what," a distributor said.

"I guess this is more for investors looking for equity-like growth than income."

He said that unlike a reverse convertible, the appreciation potential of the notes is uncapped. But the trade-off is that investors are not receiving any income.

"Our clients wouldn't be interested because they are fixed-income investors who are looking for a coupon," he said.

"They would prefer a reverse convertible even if the coupon of a reverse convertible caps the return. We don't get a lot of complaints about missing up on the upside. What's going up these days anyway?"

Risky downside

The knock-out event could easily occur, especially with a health-care stock as the underlying, said a sellsider. As a result, the product is for aggressive investors only, he said.

"You have a very attractive contingent coupon with the possibility to get more if the stock performs better," he said.

"But this product has a risky profile because the buffer could go away if the stock drops by 25%. A stock like Merck could easily lose 25% in 18 months.

"You really have to be bullish on the stock to be willing to take that risk for the unlimited upside."

A market participant noted that investing in this product required not only a good knowledge of the underlying stock but also of the pharmaceutical sector.

"Before investing in a note tied to a drug stock, investors should really check the drug pipeline and understand the story of the company and the sector," he said. "These products require stock-picking skills."

Good sector outlook

But some said that a 25% decrease in the stock price is unlikely unless the economic picture turns negative.

For Joel Ray, health-care equity analyst at Davenport & Co., the odds of the knock-out event happening are limited given the overall sector outlook.

"Wall Street is looking for modest growth and earnings in the pharmaceutical sector for the next 18 to 24 months," Ray said.

"Merck pays a $1.52 dividend. It gives the stock a yield of 4.87%, which tends to support share prices.

"As long as people continue to buy drugs and that the industry continues to generate consistent earnings, the dividend will help support the stock. Unless the economy turns much worse, it's highly unlikely that the dividend will dry up.

"In those conditions, a 25% decline for Merck seems like a lot. Wall Street is not anticipating that type of pullback for the stock."

The notes (Cusip: 48125XJW7) are expected to price Friday and settle Wednesday.

J.P. Morgan Securities LLC is the agent.

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