The document evaluates Best Buy's 2.25% convertible bonds due 2022 with call overwrites as a risk-adjusted trade on Best Buy stock. It analyzes the trade over 3 time horizons (3 months, 5 months, 15 months) with varying degrees of call option overwrites. Selling calls at higher implied volatilities allows investors to monetize rich option premium. The trade provides upside potential if the stock rises while limiting downside through the call premium collected and bond floor. Tables show estimated returns for the convertible bond under different stock price scenarios and call overwrite strategies.
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Best Buy 2.25% due 01/15/22 with Call Overwrites Risk-Adjusted Play
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 views
expressed 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 Overwrites
Figure 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 30.7
Source: 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
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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 Overwrites
Figure 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/Credit
Bond (mln) Prem % Prem % CY (bps) Put (yrs) Convert Px Stock Px Value (Cheap) Vol OAS Delta Assump
BBY 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+50
Source: Lehman Brothers
Figure 3: Short Term Horizon (1/21/06) - Long 1 BBY 2.25% Convert with Call Overwrites
Short term (1/21/06) - Long 1 BBY 2.25% with call overwrites
Horizon Stock Price $12 $30 $32 $34 $36 $38 $40 $42 $44 $46 $48 $50 $52 $54 $72
Stock 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 99.34 100.34 101.59 103.09 104.88 106.91 109.19 111.72 114.46 117.41 120.55 123.85 158.42
Px 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 50.67
Cpn 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 0.63
Without Overwrite
Total 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 51.30
Total 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 2.66
Call 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 4.96
Total 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 1.33
Call 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 28.13
Total 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 1.48
Call 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 8.78
Total 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 0.74
Call 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 30.04
Total 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
6. Best Buy 2.25% due 01/15/22 with Call Overwrites
Figure 5: Long Term Horizon (1/15/07) - Long 1 BBY 2.25% Convert with Call Overwrites
Horizon Stock Price $12 $30 $32 $34 $36 $38 $40 $42 $44 $46 $48 $50 $52 $54 $72
Stock 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 100.00 100.00 100.00 100.00 100.00 100.08 101.62 103.45 105.37 107.37 109.45 111.63 113.97 117.43 156.53
Px 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 48.78
Cpn 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 2.88
Without Overwrite
Total 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 51.65
Total 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 9.37
Call 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 10.28
Total 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 4.69
Call 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 30.97
Total 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 7.32
Call 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 14.97
Total 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 3.66
Call 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 33.31
Total 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 Overwrites
While we believe that the risk in our suggested trades is rather limited there are some risk
factors that investors should be aware of. We have assumed that the convertible bond can
be sold in the secondary market at its theoretical value. If the bonds cheapen returns could
be lower. If the volatility of BBY decreases and/or credit spreads widen and/or interest
rates rise and/or BBY raises its common dividend, investors are likely to realize a lower
return than what is presented in our analysis. However, the relatively short dated 1.3 year
put on the bonds limits the effect of these risk factors.
In conclusion, we believe Best Buy’s convertible bonds overlaid with an overwrite strategy
present several defensive yet attractive trade alternatives in the current uncertain
environment. We believe these will appeal especially to investors looking for potential
upside 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 FIRM'S DISCLOSURE WEBSITE AT www.lehman.com/disclosures
Important 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 can
have 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 the
convertible 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 Stocks
Best Buy (BBY - USD41.86) 1-Overweight / Positive J/K/M
Risks Which May Impede the Achievement of the Price Target: 1. If Circuit City is promotional, Best Buy's sales and earnings could be negatively impacted. 2. If problems arise with the integration of Future Shop,
Best Buy's earnings could be negatively impacted. 3. If prerecorded music sales decline, Best Buy's 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 multiple
of 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 past
five 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 team
of 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 to
www.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 Rating
1-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 an
advisory capacity on a merger or strategic transaction involving the company.
Sector View
1-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.
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