I was intrigued last month by the battle between Bill Ackman and Carl Icahn. You just never see stuff like this publicly, so to see it play out on CNBC was amazing. Then, when it was recently revealed that Carl Icahn had amassed a 12.98% stake in Herbalife (HLF), I was shocked that he would make such a big bet on what seemed on its face like it was based on a personal grudge. But when you look behind what he did, you see that it was way more than that. He is doing what smart money people do. Just deftly taking advantage of what the situation is giving him. The first hint of his approach appeared when he gave the interview the day following the filing of the 13D disclosing his large stake. Most people didn't take notice, but it is key in understanding how he intends to profit from this. He was being questioned as to the decision to use options as a way to build this stake. He stated he did this to avoid violating federal regulations on share accumulation and that he has already received or is about to receive permission to exercise the portion of the stake that was acquired through the call options. He stated that he intended to exercise all of them within the next 30 days.
This really intrigued me because the use of options means that he didn't necessarily actually go into the market yet to purchase all of his stake. Depending on the number of options/shares involved, there may be a built-in upward bias for the stock in the next 30 days as these options are exercised.
After reviewing the 13D filing it became clear what Icahn has been/is doing. It turns out that of the 14+ million shares that he "owns", over 11 million of those shares (over 75%), are currently in the form of deep in the money options that we now know will be exercised in the next 30 days. This represents over 10% of the outstanding shares of HLF that have yet to be "purchased" and because of the feud, likely will be "locked up" once received.
Since Icahn indicated he is exercising all of these options, the writers of these call options are either going to have to deliver the "covered" shares or, in the case of the naked writers, will have to go into the market and purchase the promised shares in order to effect delivery.
Both of these will provide upward pressure on the stock. First, those that have to go into the market to buy their shares will naturally provide an upside bias. Second, those that have the covered position likely have it with a broker. By itself this means little, however in this case it is important because the short position in Herbalife is somewhere north of 20%. This means that there is a high probability that a good chunk of those shares have been loaned out for short sale purposes. Early in my career, I worked in the stock-loan side of the business so I'm pretty familiar with it. The shares that have been loaned to the short seller can be recalled at any time. Once the owner sells or otherwise disposes of the shares, the short seller will have to either buy the shares back, or have them bought back (a "buy-in"), and they will have to pay the difference to maintain the short, thereby increasing their cost basis on the short sale. This obviously also will have a positive effect on the share price.
What makes this such a cunning move is that Icahn put in place a guaranteed buying spree affecting a large portion of the outstanding shares, in a short period of time, knowing that there is a gigantic short position.
But, this is Carl Icahn and that is only half the story. His true genius in this trade is that while amassing this huge call position, he was also selling puts. But they weren't just any puts. They were European style puts. The European distinction differed from the American option counterpart that Icahn used to build the long position in a couple of very important ways. First, the puts only settle in cash, which means he can never be stuck with a huge long position should the puts be exercised. Second, and most importantly, they are timed to expire at either the set expiration date or the exercising of the American call options. Whichever comes first. Do you remember Carl Icahn said he plans to fully exercise all of his call options in the next 30 days? Now we know why.
So what did Icahn do and what did he set himself up to do? He financed some of the buying of the call options by selling the puts. But selling those puts leaves him very exposed to the downside. His max downside of this trade is that if HLF drops down below the weighted average strike price of the calls ($25.30). The calculation follows:
All info below is from the 13D filing:
- Icahn purchased options on 3,230,606 shares with an expiration of May 10, 2013 and a strike price of $23.50
- Icahn purchased options on 8,311,738 shares with an expiration of January 28, 2015 and a strike price of $26.00
- Total number of option shares purchased = 11,542,344
- Total strike price paid to exercise the options = $292,024,429
- Weighted avg. price per share = $25.30
At this stock price level, he would then be out of his call premium, plus be on the hook financially on the short put side. He would likely have to exercise the calls to remove the short put, then either hold a large HLF stake or sell into a declining share price. That's the risk. But, if he can exercise the calls before that happens, he then gets the much bigger reward. The stock gets upward buying pressure from the quick, large exercise. At the same time, the put options automatically expire making the premium received become earned income effectively further lowering his cost basis on the appreciated long position of stock he now would hold.
The money earned on the put side was pure gravy as he knew that he planned to exercise these call options. Just the fact that he planned to exercise options on shares representing 10% of the outstanding amount guaranteed a floor for the stock price which would prevent it from getting anywhere near the mid $20 price that would have hurt him. As he stated, expect him to exercise these call options very quickly (in the next 30 days). There really isn't much that can stop this train at this point. Unfortunately, Bill Ackman messed with one of the few guys who has the ability and motivation to make his life miserable.