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Convertible Bonds and Call Overwrites - 2007

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Actionable trade ideas for stock market investors and traders seeking alpha by overlaying their portfolios with options, other derivatives, ETFs, and disciplined and applied Game Theory for hedge fund …

Actionable trade ideas for stock market investors and traders seeking alpha by overlaying their portfolios with options, other derivatives, ETFs, and disciplined and applied Game Theory for hedge fund managers and other active fund managers worldwide. Ryan Renicker, CFA

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  • 1. October 12, 2005 Best Buy 2.25% due 01/15/22 Venu Krishna, CFA with Call Overwrites 1.212.526.7328 venu.krishna@lehman.com An Attractive Risk-Adjusted Play on Best Buy Brendan Lynch 1.212.526.8432 Best Buy’s stock (BBY) has come under pressure in the past few weeks. The stock closed at blynch1@lehman.com $41.86 on 10/10/2005, 21% below its 52 week high of $53.17 on 07/28/2005. The S&P 500 was down 4.5% over the same period. Manoj Shivdasani 1.212.526.8428 mshivdas@lehman.com In this note we evaluate BBY’s 2.25% due 01/15/2022 convertible bonds with call overwrites as an attractive risk-adjusted play on Best Buy. We have analyzed the trade over three time horizons and with varying degrees of overwrites to help investors make a choice based on their individual preferences and outlook. 3-month implied volatilities for BBY are trading at the higher end of their historical range on both an absolute basis as well as in comparison to the market (S&P 500) and the S&P 500 Consumer Discretionary sector. By selling calls at a higher implied volatility against a long convert position (28.9 implied volatility), investors can monetize the higher volatility in the options market which appears rich at current levels. Given their attractive risk-reward profile, the fact that the returns are computed on a holding- period basis (not annualized) and the overall risk-averse, uncertain, low return expectation macro environment that we are currently in, we believe these trades are attractive and Analyst Certification should appeal especially to investors looking for potential upside in a highly risk controlled I, Venu Krishna, CFA hereby manner. certify (1) that the viewsexpressed in this research report . accurately reflect my personal views about any or all of the subject securities or issuers referred to in this report and (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report. Lehman Brothers does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Customers of Lehman Brothers in the United States can receive independent, third-party research on the company or companies covered in this report, at no cost to them, where such research is available. Customers can access this independent research at www.lehmanlive.com or can call 1-800-2LEHMAN to request a copy of this research. Investors should consider this report as only a single factor in making their investment decision. PLEASE REFER TO IMPORTANT DISCLOSURES BEGINNING ON PAGE 8
  • 2. Best Buy 2.25% due 01/15/22 with Call Overwrites Introduction Best Buy’s stock (BBY) has come under pressure in the past few weeks. The stock closed at $41.86 on 10/10/2005, 21% below its 52 week high of $53.17 on 07/28/2005. Lehman Brothers fundamental research analyst Alan M. Rifkin believes that after an impressive 1Q, 2Q results and management’s maintained full year guidance fell short of investor’s expectations, which is why the stock has been weak. In our opinion, high oil prices, an uncertain interest rate environment, lowered expectations on consumer spending and the after effects of the hurricanes have also likely led to the decline of BBY’s stock price. Lehman Brothers’ fundamental research stock and sector ratings remain positive at 1- Overweight/1-Positive with a 12-month price target of $57.00 based on a 22x multiple of 2006 earnings estimate of $2.58 (including $0.11 of options expense). In this note we evaluate BBY’s 2.25% due 01/15/2022 convertible bonds with call overwrites as an attractive risk-adjusted play on Best Buy. We have analyzed the trade over three time horizons and with varying degrees of overwrites to help investors make a choice based on their individual preferences and outlook. Also, we have chosen option contracts that are relatively liquid for ease of execution. ~3 month – short term to include near-term preliminary data on holiday season spending and to end coincidentally with the 01/21/06 options expiry date ~5 month – medium term to include actual reported results for the holiday season and to end coincidentally with the 03/18/06 options expiry date ~15 month – relatively longer term till the first put/call date (01/15/2007) on the bonds (options expire on 01/20/07) 1 According to our Equity Derivatives Strategy Team 3-month implied volatilities for BBY are trading at the higher end of their historical range on both an absolute basis as well as in comparison to the market (S&P 500) and the S&P 500 Consumer Discretionary sector. Since the Company is next scheduled to report earnings in December, the recent run up in risk expectations seems to be driven more by factors discussed earlier. By selling calls at a higher implied volatility against a long convert position (28.9 implied volatility), investors can monetize the higher volatility in the options market which appears rich at current levels. For example, the $47.5 strike 1/21/06 expiry calls have an implied volatility of 34.6% and the $50 strike calls with the same expiry have an implied volatility of 33.1% The $50 strike, longer dated calls expiring in January 2007 too have an implied volatility of 30.7% which is 1.8 points higher than the implied volatility of the convert. 1 Ryan Renicker and Devapriya Mallick.2 October 12, 2005
  • 3. Best Buy 2.25% due 01/15/22 with Call OverwritesFigure 1: Listed Call Options Table (versus $42.00 Current Stock Price) 01/21/2006 03/18/2006 01/20/2007 Strike Bid # Contracts Size Imp. Vol Bid # Contracts Size Imp. Vol Bid # Contracts Size Imp. Vol $46.25 - - - - - - - - $4.69 2754 150 30.6 $47.50 $1.33 1249 100 34.6 $1.89 490 100 32.8 - - - - $50.00 $0.74 3990 100 33.1 $1.31 1850 100 32.6 $3.66 4294 100 30.7 $50.00 $0.74 7264 150 33.1 $1.31 434 150 32.6 $3.66 190 150 30.7Source: Lehman Brothers Figure 3: BBY Implied Volatility Trend versus S&P 500 and S&P 500 Consumer Discretionary Sector 40% BBY 3m Imp Vol 35% 30% 25% Sector Avg Imp Vols 20% (Consumer Discretionary) 15% 10% SPX 3m Imp Vol 5% 0% 4 5 5 04 5 5 5 5 05 5 05 4 -0 -0 -0 -0 n-0 0 -0 0 c-0 ct- p- - b- g- ar r ov ay Jul Jun Ap De Ja Fe Se Au O M N M Source: Lehman Brothers Equity Derivatives Strategy We believe that the trades discussed below have a defensive yet attractive risk-reward profile and are likely to appeal to investors seeking to participate in BBY’s potential upside while significantly lowering downside risk. The rest of this report details out the potential payoffs for various trades. BBY 2.25% due 01/10/2022 Convertible The key terms of the BBY 2.25% convertible are below. Note the relatively low risk premium (high bond floor of 96.35). The converts have a conversion price of $46 and a conversion ratio of 21.7391. In this section we analyze the total return of the convertibles over the three horizon periods under different stock price scenarios and overwrite strategies. The tables detail out the potential payoffs for trades that are long 1 bond (@107.75 vs. $42.00) with varying degrees of overwrites and over different time horizons. All payoffs are calculated in bond points and the percentage returns are for the holding period. October 12, 2005 3
  • 4. Best Buy 2.25% due 01/15/22 with Call OverwritesFigure 2: Best Buy 2.25% Convertible due 10/01/2025 Issue Income Call Size Risk Pickup Yrs to Prot Theo % Rich/ Implied Libor Theo Vol/CreditBond (mln) Prem % Prem % CY (bps) Put (yrs) Convert Px Stock Px Value (Cheap) Vol OAS Delta AssumpBBY 2.25% 402.5 18.0 11.8 2.08% 133 1.3 1.3 107.750 $42.00 107.80 (0.05) 28.9 50 52 29 Vol / L+50Source: Lehman BrothersFigure 3: Short Term Horizon (1/21/06) - Long 1 BBY 2.25% Convert with Call OverwritesShort term (1/21/06) - Long 1 BBY 2.25% with call overwritesHorizon Stock Price $12 $30 $32 $34 $36 $38 $40 $42 $44 $46 $48 $50 $52 $54 $72Stock Price % Chg (71.4%) (28.6%) (23.8%) (19.0%) (14.3%) (9.5%) (4.8%) 0.0% 4.8% 9.5% 14.3% 19.0% 23.8% 28.6% 71.4%Estimated Cvt Px 97.05 98.57 99.34 100.34 101.59 103.09 104.88 106.91 109.19 111.72 114.46 117.41 120.55 123.85 158.42Px Return (10.70) (9.18) (8.41) (7.41) (6.16) (4.66) (2.87) (0.84) 1.44 3.97 6.71 9.66 12.80 16.10 50.67Cpn Return 0.63 0.63 0.63 0.63 0.63 0.63 0.63 0.63 0.63 0.63 0.63 0.63 0.63 0.63 0.63Without OverwriteTotal Return (10.07) (8.55) (7.78) (6.78) (5.53) (4.03) (2.24) (0.21) 2.07 4.60 7.34 10.29 13.43 16.73 51.30Total Return % (9.3%) (7.9%) (7.2%) (6.3%) (5.1%) (3.7%) (2.1%) (0.2%) 1.9% 4.3% 6.8% 9.6% 12.5% 15.5% 47.6%Overwrite: Sell 20 $47.5 strike calls expiring on 1/21/06 @ $1.33 per call (34.6% implied volatility)Call Premium 2.66 2.66 2.66 2.66 2.66 2.66 2.66 2.66 2.66 2.66 2.66 2.66 2.66 2.66 2.66Call Payoff 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 (1.00) (5.00) (9.00) (13.00) (49.00)Total Return (7.41) (5.89) (5.12) (4.12) (2.87) (1.37) 0.42 2.45 4.73 7.26 9.00 7.95 7.09 6.39 4.96Total Return % (6.9%) (5.5%) (4.7%) (3.8%) (2.7%) (1.3%) 0.4% 2.3% 4.4% 6.7% 8.4% 7.4% 6.6% 5.9% 4.6%Overwrite: Sell 10 $47.5 strike calls expiring on 1/21/06 @ $1.33 per call (34.6% implied volatility)Call Premium 1.33 1.33 1.33 1.33 1.33 1.33 1.33 1.33 1.33 1.33 1.33 1.33 1.33 1.33 1.33Call Payoff 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 (0.50) (2.50) (4.50) (6.50) (24.50)Total Return (8.74) (7.22) (6.45) (5.45) (4.20) (2.70) (0.91) 1.12 3.40 5.93 8.17 9.12 10.26 11.56 28.13Total Return % (8.1%) (6.7%) (6.0%) (5.1%) (3.9%) (2.5%) (0.8%) 1.0% 3.2% 5.5% 7.6% 8.5% 9.5% 10.7% 26.1%Overwrite: Sell 20 $50.0 strike calls expiring on 1/21/06 @ $0.74 per call (33.1% implied volatility)Call Premium 1.48 1.48 1.48 1.48 1.48 1.48 1.48 1.48 1.48 1.48 1.48 1.48 1.48 1.48 1.48Call Payoff 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 (4.00) (8.00) (44.00)Total Return (8.59) (7.07) (6.30) (5.30) (4.05) (2.55) (0.76) 1.27 3.55 6.08 8.82 11.77 10.91 10.21 8.78Total Return % (8.0%) (6.6%) (5.8%) (4.9%) (3.8%) (2.4%) (0.7%) 1.2% 3.3% 5.6% 8.2% 10.9% 10.1% 9.5% 8.2%Overwrite: Sell 10 $50.0 strike calls expiring on 1/21/06 @ $0.74 per call (33.1% implied volatility)Call Premium 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.74Call Payoff 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 (2.00) (4.00) (22.00)Total Return (9.33) (7.81) (7.04) (6.04) (4.79) (3.29) (1.50) 0.53 2.81 5.34 8.08 11.03 12.17 13.47 30.04Total Return % (8.7%) (7.2%) (6.5%) (5.6%) (4.4%) (3.0%) (1.4%) 0.5% 2.6% 5.0% 7.5% 10.2% 11.3% 12.5% 27.9%Source: Lehman Brothers The first overwrite trade presented above exemplifies the attractive risk-reward profile. Should stock increase from the current $42 to $46 (+9.5%), we estimate the total return on the trade to be 6.7%, an upside participation of 70%. And for a $4 decline in stock to $38 (-9.5%), the total return on the trade is -1.3%, a downside participation of just 14%. We find this 5:1 risk reward profile very attractive. Investors should note that the risk-reward for this particular trade becomes less attractive for larger price changes and can tailor their strategy according to their individual expectation on the stock and their risk-return preferences. One can see that trades with a fewer number of higher strike overwrites (last example) are likely to perform better should stock appreciate significantly. 4 October 12, 2005
  • 5. Best Buy 2.25% due 01/15/22 with Call OverwritesFigure 4: Medium Term Horizon (3/18/06) - Long 1 BBY 2.25% Convert with Call OverwritesHorizon Stock Price $12 $30 $32 $34 $36 $38 $40 $42 $44 $46 $48 $50 $52 $54 $72Stock Price % Chg (71.4%) (28.6%) (23.8%) (19.0%) (14.3%) (9.5%) (4.8%) 0.0% 4.8% 9.5% 14.3% 19.0% 23.8% 28.6% 71.4%Estimated Cvt Px 97.47 98.63 99.29 100.18 101.32 102.71 104.40 106.36 108.57 111.04 113.74 116.67 119.80 123.10 157.93Px Return (10.28) (9.12) (8.46) (7.57) (6.43) (5.04) (3.35) (1.40) 0.82 3.29 5.99 8.92 12.05 15.35 50.18Cpn Return 2.88 2.88 2.88 2.88 2.88 2.88 2.88 2.88 2.88 2.88 2.88 2.88 2.88 2.88 2.88Without OverwriteTotal Return (7.40) (6.24) (5.58) (4.69) (3.55) (2.16) (0.47) 1.48 3.70 6.17 8.87 11.80 14.93 18.23 53.06Total Return % (6.9%) (5.8%) (5.2%) (4.4%) (3.3%) (2.0%) (0.4%) 1.4% 3.4% 5.7% 8.2% 11.0% 13.9% 16.9% 49.2%Overwrite: Sell 20 $47.5 strike calls expiring on 3/18/06 @ $1.89 per call (32.8% implied volatility)Call Premium 3.78 3.78 3.78 3.78 3.78 3.78 3.78 3.78 3.78 3.78 3.78 3.78 3.78 3.78 3.78Call Payoff 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 (1.00) (5.00) (9.00) (13.00) (49.00)Total Return (5.52) (4.36) (3.70) (2.81) (1.67) (0.28) 1.41 3.37 5.58 8.05 9.75 8.68 7.81 7.11 5.94Total Return % (5.1%) (4.0%) (3.4%) (2.6%) (1.5%) (0.3%) 1.3% 3.1% 5.2% 7.5% 9.0% 8.1% 7.2% 6.6% 5.5%Overwrite: Sell 10 $47.5 strike calls expiring on 3/18/06 @ $1.89 per call (32.8% implied volatility)Call Premium 1.89 1.89 1.89 1.89 1.89 1.89 1.89 1.89 1.89 1.89 1.89 1.89 1.89 1.89 1.89Call Payoff 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 (0.50) (2.50) (4.50) (6.50) (24.50)Total Return (7.41) (6.25) (5.59) (4.70) (3.56) (2.17) (0.48) 1.48 3.69 6.16 8.36 9.29 10.42 11.72 28.55Total Return % (6.9%) (5.8%) (5.2%) (4.4%) (3.3%) (2.0%) (0.4%) 1.4% 3.4% 5.7% 7.8% 8.6% 9.7% 10.9% 26.5%Overwrite: Sell 20 $50.0 strike calls expiring on 3/18/06 @ $1.31 per call (32.6% implied volatility)Call Premium 2.62 2.62 2.62 2.62 2.62 2.62 2.62 2.62 2.62 2.62 2.62 2.62 2.62 2.62 2.62Call Payoff 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 (4.00) (8.00) (44.00)Total Return (6.68) (5.52) (4.86) (3.97) (2.83) (1.44) 0.25 2.21 4.42 6.89 9.59 12.52 11.65 10.95 9.78Total Return % (6.2%) (5.1%) (4.5%) (3.7%) (2.6%) (1.3%) 0.2% 2.0% 4.1% 6.4% 8.9% 11.6% 10.8% 10.2% 9.1%Overwrite: Sell 10 $50.0 strike calls expiring on 3/18/06 @ $1.31 per call (32.6% implied volatility)Call Premium 1.31 1.31 1.31 1.31 1.31 1.31 1.31 1.31 1.31 1.31 1.31 1.31 1.31 1.31 1.31Call Payoff 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 (2.00) (4.00) (22.00)Total Return (7.99) (6.83) (6.17) (5.28) (4.14) (2.75) (1.06) 0.90 3.11 5.58 8.28 11.21 12.34 13.64 30.47Total Return % (7.4%) (6.3%) (5.7%) (4.9%) (3.8%) (2.6%) (1.0%) 0.8% 2.9% 5.2% 7.7% 10.4% 11.5% 12.7% 28.3%Source: Lehman Brothers October 12, 2005 5
  • 6. Best Buy 2.25% due 01/15/22 with Call OverwritesFigure 5: Long Term Horizon (1/15/07) - Long 1 BBY 2.25% Convert with Call OverwritesHorizon Stock Price $12 $30 $32 $34 $36 $38 $40 $42 $44 $46 $48 $50 $52 $54 $72Stock Price % Chg (71.4%) (28.6%) (23.8%) (19.0%) (14.3%) (9.5%) (4.8%) 0.0% 4.8% 9.5% 14.3% 19.0% 23.8% 28.6% 71.4%Estimated Cvt Px 100.00 100.00 100.00 100.00 100.00 100.08 101.62 103.45 105.37 107.37 109.45 111.63 113.97 117.43 156.53Px Return (7.75) (7.75) (7.75) (7.75) (7.75) (7.67) (6.13) (4.30) (2.38) (0.38) 1.70 3.88 6.22 9.68 48.78Cpn Return 2.88 2.88 2.88 2.88 2.88 2.88 2.88 2.88 2.88 2.88 2.88 2.88 2.88 2.88 2.88Without OverwriteTotal Return (4.87) (4.87) (4.87) (4.87) (4.87) (4.79) (3.25) (1.42) 0.50 2.50 4.58 6.76 9.10 12.56 51.65Total Return % (4.5%) (4.5%) (4.5%) (4.5%) (4.5%) (4.4%) (3.0%) (1.3%) 0.5% 2.3% 4.2% 6.3% 8.4% 11.7% 47.9%Overwrite: Sell 20 $46.625 strike calls expiring on 1/20/07 @ $4.69 per call (30.6% implied volatility)Call Premium 9.37 9.37 9.37 9.37 9.37 9.37 9.37 9.37 9.37 9.37 9.37 9.37 9.37 9.37 9.37Call Payoff 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 (2.75) (6.75) (10.75) (14.75) (50.75)Total Return 4.50 4.50 4.50 4.50 4.50 4.58 6.12 7.95 9.87 11.87 11.20 9.38 7.72 7.18 10.28Total Return % 4.2% 4.2% 4.2% 4.2% 4.2% 4.3% 5.7% 7.4% 9.2% 11.0% 10.4% 8.7% 7.2% 6.7% 9.5%Overwrite: Sell 10 $46.625 strike calls expiring on 1/20/07 @ $4.69 per call (30.6% implied volatility)Call Premium 4.69 4.69 4.69 4.69 4.69 4.69 4.69 4.69 4.69 4.69 4.69 4.69 4.69 4.69 4.69Call Payoff 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 (1.38) (3.38) (5.38) (7.38) (25.38)Total Return (0.18) (0.18) (0.18) (0.18) (0.18) (0.10) 1.44 3.27 5.19 7.19 7.89 8.07 8.41 9.87 30.97Total Return % (0.2%) (0.2%) (0.2%) (0.2%) (0.2%) (0.1%) 1.3% 3.0% 4.8% 6.7% 7.3% 7.5% 7.8% 9.2% 28.7%Overwrite: Sell 20 $50.0 strike calls expiring on 1/20/07 @ $3.66 per call (30.7% implied volatility)Call Premium 7.32 7.32 7.32 7.32 7.32 7.32 7.32 7.32 7.32 7.32 7.32 7.32 7.32 7.32 7.32Call Payoff 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 (4.00) (8.00) (44.00)Total Return 2.45 2.45 2.45 2.45 2.45 2.53 4.07 5.90 7.82 9.82 11.90 14.08 12.42 11.88 14.97Total Return % 2.3% 2.3% 2.3% 2.3% 2.3% 2.3% 3.8% 5.5% 7.3% 9.1% 11.0% 13.1% 11.5% 11.0% 13.9%Overwrite: Sell 10 $50.0 strike calls expiring on 1/20/07 @ $3.66 per call (30.7% implied volatility)Call Premium 3.66 3.66 3.66 3.66 3.66 3.66 3.66 3.66 3.66 3.66 3.66 3.66 3.66 3.66 3.66Call Payoff 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 (2.00) (4.00) (22.00)Total Return (1.21) (1.21) (1.21) (1.21) (1.21) (1.13) 0.41 2.24 4.16 6.16 8.24 10.42 10.76 12.22 33.31Total Return % (1.1%) (1.1%) (1.1%) (1.1%) (1.1%) (1.0%) 0.4% 2.1% 3.9% 5.7% 7.6% 9.7% 10.0% 11.3% 30.9%ySource: Lehman Brothers Summary Given their attractive risk-reward profile, the fact that the returns are computed on a holding- period basis (not annualized) and the overall risk-averse, uncertain, low return expectation macro environment that we are currently in, we believe these trades are attractive. We suggest the following process to determine an optimal strategy: First define the time horizon i.e. short term, medium term or a slightly longer term. Second, arrive at a stock price estimate over the holding period. This will help in choosing the appropriate overwrite strategy. For instance if investors feel that the stock is not likely to rise above $47.50 over the holding period then they may consider writing calls with that strike. And third, determine the preference for income versus potential appreciation. If investors prefer greater income and don’t mind giving up the upside beyond the call overwrite threshold, they could potentially write more number of calls at lower strikes for each long convert position. 6 October 12, 2005
  • 7. Best Buy 2.25% due 01/15/22 with Call OverwritesWhile we believe that the risk in our suggested trades is rather limited there are some riskfactors that investors should be aware of. We have assumed that the convertible bond canbe sold in the secondary market at its theoretical value. If the bonds cheapen returns couldbe lower. If the volatility of BBY decreases and/or credit spreads widen and/or interestrates rise and/or BBY raises its common dividend, investors are likely to realize a lowerreturn than what is presented in our analysis. However, the relatively short dated 1.3 yearput on the bonds limits the effect of these risk factors.In conclusion, we believe Best Buy’s convertible bonds overlaid with an overwrite strategypresent several defensive yet attractive trade alternatives in the current uncertainenvironment. We believe these will appeal especially to investors looking for potentialupside in a highly risk controlled manner. October 12, 2005 7
  • 8. FOR CURRENT IMPORTANT DISCLOSURES REGARDING COMPANIES THAT ARE THE SUBJECT OF THIS RESEARCH REPORT, PLEASE SEND A WRITTEN REQUEST TO: LEHMAN BROTHERS CONTROL ROOM 745 SEVENTH AVENUE, 19TH FLOOR NEW YORK, NY 10019 OR REFER TO THE FIRMS DISCLOSURE WEBSITE AT www.lehman.com/disclosuresImportant Disclosures:The analysts responsible for preparing this report have received compensation based upon various factors including the Firm’s total revenues, a portion of which is generated by investment banking activities.Convertibles Risk Disclosure(s):The convertible valuations are based on Lehman’s proprietary convertible valuation model, under which key assumptions relate to credit spread and volatility metrics. Material changes in any of these variables canhave a significant impact on valuation. Upside/downside analysis takes into consideration likely future valuation and expected trading patterns, among others. It is based on a total return participation of theconvertible relative to a +/- 25% change in the common stock’s price over a one-year investment horizon. A material change in the company’s financial situation can significantly alter this assessment.Mentioned StocksBest Buy (BBY - USD41.86) 1-Overweight / Positive J/K/MRisks Which May Impede the Achievement of the Price Target: 1. If Circuit City is promotional, Best Buys sales and earnings could be negatively impacted. 2. If problems arise with the integration of Future Shop,Best Buys earnings could be negatively impacted. 3. If prerecorded music sales decline, Best Buys sales could be negatively affected.Disclosure Legend:J: Lehman Brothers Inc. or an affiliate trade(s) regularly in the shares of the subject company.K: Lehman Brothers Inc. has received non-investment banking related compensation from the subject company within the last 12 months.M: The subject company is or during the last 12 months has been a non-investment banking client (securities related services) of Lehman Brothers Inc.Valuation Methodology:BBY shares currently trade at 19.5x and 16.5x our 2005 and 2006 EPS estimates of $2.18 and $2.58 (including $0.11 of options expense), respectively. Our 12-month price target of $57 is based on a multipleof 22x our 2006 estimate. The shares currently trade at an 8% premium to the S&P 500, based on our 2006 estimate, having traded between a 34% discount and a 40% premium to the S&P 500 over the pastfive years. We maintain our 1-Overweight rating on the shares, as we believe the potential exists for BBY shares to outperform the unweighted expected total return of the retail industry over the next 12 months.Guide to Lehman Brothers Equity Research Rating System:Our coverage analysts use a relative rating system in which they rate stocks as 1-Overweight, 2- Equal weight or 3-Underweight (see definitions below) relative to other companies covered by the analyst or a teamof analysts that are deemed to be in the same industry sector (“the sector coverage universe”). To see a list of companies that comprise a particular sector coverage universe, please go towww.lehman.com/disclosures.In addition to the stock rating, we provide sector views which rate the outlook for the sector coverage universe as 1-Positive, 2-Neutral or 3-Negative (see definitions below). A rating system using terms such as buy,hold and sell is not the equivalent of our rating system. Investors should carefully read the entire research report including the definitions of all ratings and not infer its contents from ratings alone.Stock Rating1-Overweight - The stock is expected to outperform the unweighted expected total return of the sector coverage universe over a 12-month investment horizon.2-Equal weight - The stock is expected to perform in line with the unweighted expected total return of the sector coverage universe over a 12-month investment horizon.3-Underweight - The stock is expected to underperform the unweighted expected total return of the sector coverage universe over a 12-month investment horizon.RS-Rating Suspended - The rating and target price have been suspended temporarily to comply with applicable regulations and/or firm policies in certain circumstances including when Lehman Brothers is acting in anadvisory capacity on a merger or strategic transaction involving the company.Sector View1-Positive - sector coverage universe fundamentals are improving.2-Neutral - sector coverage universe fundamentals are steady, neither improving nor deteriorating.3-Negative - sector coverage universe fundamentals are deteriorating.Distribution of Ratings:Lehman Brothers Equity Research has 1758 companies under coverage.42% have been assigned a 1-Overweight rating which, for purposes of mandatory disclosures, is classified as a Buy rating, 35% of companies with this rating are investment banking clients of the Firm.41% have been assigned a 2-Equal weight rating which, for purposes of mandatory disclosures, is classified as a Hold rating, 7% of companies with this rating are investment banking clients of the Firm.17% have been assigned a 3-Underweight rating which, for purposes of mandatory disclosures, is classified as a Sell rating, 84% of companies with this rating are investment banking clients of the Firm.This material has been prepared and/or issued by Lehman Brothers Inc., member SIPC, and/or one of its affiliates (“Lehman Brothers”) and has been approved by Lehman Brothers International (Europe),authorised and regulated by the Financial Services Authority, in connection with its distribution in the European Economic Area. This material is distributed in Japan by Lehman Brothers Japan Inc., and in Hong Kongby Lehman Brothers Asia Limited. This material is distributed in Australia by Lehman Brothers Australia Pty Limited, and in Singapore by Lehman Brothers Inc., Singapore Branch (“LBIS”). Where this material isdistributed by LBIS, please note that it is intended for general circulation only and the recommendations contained herein does not take into account the specific investment objectives, financial situation or particularneeds of any particular person. An investor should consult his Lehman Brothers’ representative regarding the suitability of the product and take into account his specific investment objectives, financial situation orparticular needs before he makes a commitment to purchase the investment product. This material is distributed in Korea by Lehman Brothers International (Europe) Seoul Branch. This document is for informationpurposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy the securities or other instruments mentioned in it. No part of this document may be reproduced in any mannerwithout the written permission of Lehman Brothers. With the exception of disclosures relating to Lehman Brothers, this research report is based on current public information that Lehman Brothers considers reliable,but we make no representation that it is accurate or complete, and it should not be relied on as such. In the case of any disclosure to the effect that Lehman Brothers Inc. or its affiliates beneficially own 1% or moreof any class of common equity securities of the subject company, the computation of beneficial ownership of securities is based upon the methodology used to compute ownership under Section 13(d) of the UnitedStates Securities Exchange Act of 1934. In the case of any disclosure to the effect that Lehman Brothers Inc. and/or its affiliates hold a short position of at least 1% of the outstanding share capital of a particularcompany, such disclosure relates solely to the ordinary share capital of the company. Accordingly, while such calculation represents Lehman Brothers’ holdings net of any long position in the ordinary share capital ofthe company, such calculation excludes any rights or obligations that Lehman Brothers may otherwise have, or which may accrue in the future, with respect to such ordinary share capital. Similarly such calculation
  • 9. Best Buy 2.25% due 01/15/22 with Call Overwritesdoes not include any shares held or owned by Lehman Brothers where such shares are held under a wider agreement or arrangement (be it with a client or a counterparty) concerning the shares of such company(e.g. prime broking and/or stock lending activity). Any such disclosure represents the position of Lehman Brothers as of the last business day of the calendar month preceding the date of this report.This material is provided with the understanding that Lehman Brothers is not acting in a fiduciary capacity. Opinions expressed herein reflect the opinion of Lehman Brothers and are subject to change without notice.The products mentioned in this document may not be eligible for sale in some states or countries, and they may not be suitable for all types of investors. If an investor has any doubts about product suitability, heshould consult his Lehman Brothers representative. The value of and the income produced by products may fluctuate, so that an investor may get back less than he invested. Value and income may be adverselyaffected by exchange rates, interest rates, or other factors. Past performance is not necessarily indicative of future results. If a product is income producing, part of the capital invested may be used to pay thatincome. © 2005 Lehman Brothers. All rights reserved. Additional information is available on request. Please contact a Lehman Brothers entity in your home jurisdiction.Complete disclosure information on companies covered by Lehman Brothers Equity Research is available at www.lehman.com/disclosures. October 12, 2005 9

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