Citigroup ELKS Based on Nucor: Lock in 11.5% Yield

Citigroup ELKS linked to Nucor (AMEX: ENQ) ($9.79) are a stock/bond hybrid issued by Citigroup (NYSE: C) that tracks steel maker Nucor (NYSE: NUE).

ENQ first started trading on October 24, 2007 at $10 a share and will mature on November 6, 2008. Over the life of the security, ENQ will pay total distributions of $1.1306, for a yield of 11.5% ($1.1306/$9.79). This payout consists of $0.4798 in interest income and $0.6598 in option premium. Payments will be doled out in May 2008, as well as when ENQ matures in November 2008.

If shares of NUE stay above the "trigger price" of $44.91 during the life of the note, then ENQ investors will receive $10 in cash at maturity. But what happens if underlying shares of Nucor fall sharply? The exact terms of these equity-linked securities can be tricky to understand, and ENQ is no exception. There are two key concepts: the "trigger price" and the "exchange ratio."

The trigger price represents the dollar value the underlying shares must stay above in order for ENQ investors to receive the full $10 issue price at maturity. For Nucor, this amount is $44.91 and is calculated by taking 72.5% of the $61.94 price of NUE shares when the ELK was issued ($61.94 x .725).

But what if NUE falls below that price? That's where the exchange ratio comes into play.

The exchange ratio for Nucor is 0.16145. That ratio is determined by dividing the $10 face value of ENQ by the issue price ($61.94) of NUE. This exchange ratio represents the amount of common shares the holder will receive at maturity if NUE's stock falls below $44.91 at any time between now and November 6, 2008. For example, if NUE dipped to $40 per share tomorrow and stayed at that price until ENQ matures, then come next November ENQ investors would receive NUE stock worth $6.46 ($40 x 0.16145), generating a substantial capital loss, at least on paper.

What the investor needs to weigh is the juicy yield offered by ENQ against the risk that shares of NUE will drop below the $44.91 trigger price. With NUE currently trading in the $59-range, there is close to a 30% margin of safety "insurance policy" against this kind of decline.

Further, Nucor's stock would have to become very cheap on a price/earnings basis in order for it to fall below the $44.91 threshold. As the third-largest U.S. steel producer, Nucor manufactures products such as rebar, beams, joists and girders. Currently, 15 analysts follow the stock (a substantial number). Over the last 90 days, these analysts have hiked their consensus earnings estimates for 2008 from $5.43 to $5.62 per share.

For NUE to fall below $44.91, the stock would have to trade below eight times projected earnings ($44.91/$5.62 = 7.99). This low multiple is unlikely, since the company is projected to grow at a healthy +15% pace next year

In a volatile market, however, anything can happen. We suspect if NUE did trade below $44.91, then it would bounce back very quickly. In August, for example, the stock bottomed near $43 per share, only to bounce back to near $65 by October.

ENQ's juicy 11.5% yield must be weighed against the possibility of having to take shares of NUE at a reduced price at maturity. For those willing to shoulder that risk, this unique security might be worth a closer look.

Disclosure: none

Comments

[rdial54]

Think I will take a look. Sounds interesting. I like NUE too.