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First off, let me say that I have no opinion on the business model of Herbalife (HLF). My research has solely focused on the interplay between Carl Icahn (IEP) and William Ackman.

As everyone knows by now, they have both taken diametrically opposed views of the company Herbalife and where the stock is heading. As an added bonus, they really don't like each other either. So, not only is it great theatre, but because they have both laid out their positions and intentions so publicly, it is possible to handicap the battle and profit from the strategy most likely to succeed in the short term.

I feel there is a great opportunity coming in the next few weeks. I also think most observers have really missed the Icahn angle up to this point which means that the opportunity still remains. Most think that what Icahn did (buying that huge position right after the public confrontation with Ackman), was pure spite. Spite, I'm sure is part of it, but it is more than that. It is backed by sound investing concepts and principles. It is truly amazing how much misunderstanding is out there related to how Icahn is playing this.

A little background:

Icahn first began buying shares of Herbalife in December of 2012. During that time he purchased 1,672,807 shares for a cost of $53,822,938 with a weighted avg. share cost of $32.175:

His December purchases from the 13d filing were as follows:

  • 12/20/12 Buy 748,308 shares with a price of $33.41 and a cost of $25,000,970
  • 12/21/12 Buy 751,692 shares with a price of $32.43 and a cost of $24,377,372
  • 12/24/12 Buy 172,807 shares with a price of $25.72 and a cost of $4,444,596

First, note that these purchases were made over a month before the legendary battle of titans played out over the airwaves of CNBC. This clearly shows that, at least up to that point, he was doing this because he clearly thought there would be money to be made at those stock price levels. Second, note the total value of these purchases (approx. $54 million). This is important because, at that point, he was starting to bump up against federal laws that would require him to report his holdings and to get approval for more accumulation. Specifically, he would have to adhere to the Hart-Scott-Rodino (HSR) section of the Clayton Antitrust Act. This section requires FTC approval before an acquiring entity passes certain thresholds of share accumulation. The threshold in effect when Icahn was purchasing in December was $68.2 million. So for him to continue to purchase in these quantities, he would have to get regulatory approval. Since a filing did not come at that time, it appears that he was just going be content in his position (coincidentally, when he bought shares on 12/24/2012, the shares traded that day at their 52 week low). Then came the verbal fistfight played out on CNBC on January 25th. And, because this happened on a Friday, he had all weekend to think about the interview and how he would respond. And respond he did. What he devised was a plan that when fully implemented, would put extreme pressure on anyone shorting the stock (not coincidentally, William Ackman is a major short seller of the stock).

He knew he couldn't purchase anymore physical shares without running afoul of the HSR act. So he immediately sought approval from the FTC to buy more (he acknowledged seeking this approval in an interview on February 15th, transcript here). The only problem is that this typically takes 30 days for clearance to continue buying. So, rather than waiting, instead he decided he would synthetically purchase the stock, then when he received his FTC approval, convert that synthetic position to physical shares.

Beginning on January 28th, (the next trading day after the CNBC battle with Ackman), he put his plan into motion.

Per his 13d filing, he made the following purchases/sales:

Option

HLF

HLF

HLF

Icahn

Date

Quantity

Price

Open

high

low

Price*

1/28/2013

987,297

Options-Jan 2015 $26 Strike

13.92

43.44

44.54

38.71

39.92

1/28/2013

600,000

Physical Shares

N/A

43.44

44.54

38.71

39.96

1/29/2013

1,800,000

Options-Jan 2015 $26 Strike

13.60

40.25

40.58

38.02

39.60

1/29/2013

200,000

Physical Shares

N/A

40.25

40.58

38.02

39.94

1/30/2013

30,000

Options-Jan 2015 $26 Strike

9.52

38.85

38.98

34.70

35.52

2/1/2013

50,000

Options-Jan 2015 $26 Strike

9.02

36.39

36.43

34.80

35.02

2/4/2013

2,434,240

Options-Jan 2015 $26 Strike

6.93

31.59

35.90

30.84

32.93

2/5/2013

470,198

Options-Jan 2015 $26 Strike

9.60

35.25

36.95

34.83

35.60

2/6/2013

924,112

Options-Jan 2015 $26 Strike

9.57

35.92

36.62

35.32

35.57

2/7/2013

16,600

Options-Jan 2015 $26 Strike

9.72

35.80

37.50

35.57

35.72

2/8/2013

499,291

Options-Jan 2015 $26 Strike

9.67

36.01

36.41

35.36

35.67

2/11/2013

1,100,000

Options-Jan 2015 $26 Strike

10.17

35.83

36.64

35.74

36.17

2/12/2013

1,167,241

Options-May 2013 $23.50 Strike

12.51

36.10

36.42

35.42

36.01

2/13/2013

508,311

Options-May 2013 $23.50 Strike

12.78

35.82

36.49

35.82

36.28

2/14/2013

1,555,054

Options-May 2013 $23.50 Strike

14.05

36.17

38.28

36.17

37.55

* The Icahn price for the option purchases represents a fully diluted price (meaning the amount he will have paid per share if fully exercised). The price of the option plus the exercise price, in other words, his cost basis in the underlying shares.

Total purchases:

Calls $26.00 strike expiry 1/28/2015

8,311,738

Calls $23.50 strike expiry 5/10/2013

3,230,606

At the same time, he sold corresponding European puts (with the same expiration and strike prices as the calls). These however were structured to only settle in cash and will expire either at the set expiration date of the corresponding call option or the exercise of the calls (see 13d filing). As we now know from the Form 4 filing with the SEC, these puts were sold for $.01 per share.

Sales:

1/28/2015 Puts $26.00 strike

8,311,738

5/10/2013 Puts $23.50 strike

3,230,606

So the income received from the puts was a paltry ($115,423,44): 11,542,344 put option shares at $.01 each

Now the questions we have to ask are:

  • Why would a counterparty sell deep in the money options going out at least several months (if not years), and place no volatility or time premium into the price?
  • Additionally, why would Icahn sell puts for a nominal amount (only $.01 per share), and not include any premium to account for volatility in the security?
  • Why would the put option be structured to automatically expire with the corresponding calls?

When looked at in it's entirety it becomes clear what the strategy is. Icahn has intentionally entered this trade with the intent to exercise these options and to take physical possession of the shares. But since he couldn't buy the shares unil FTc approval came, he would instead use the OTC market (options), to "purchase" the shares with the intention of receiving the shares (through exercise), once he was ready and legally able to accept them.

The structuring of the deal leaves no risk for the counterparty. They bought the shares in the market and sold an option for the current market price (with no premium) and, simultaneously, they purchased a put option for $.01 for the same strike price that settled only in cash. They were perfectly hedged. They already received the amount of the market price for the security above the strike price in cash from Icahn and he has sold them a put so that they would be 100% protected should the price of the stock drop below the strike price prior to exercise/expiration.

This also explains why the puts expire automatically at exercise. Once they are exercised, the counterparty has no more risk at that point. But the counterparty had something valuable up until the exercise, they now had over 11 million shares that could now be put into the stock loan area for short sellers to borrow. This is how the counterparty benefited. They then had a large supply of a hard to borrow security. This, I believe, is exactly what Icahn wanted. He knew they wouldn't just sit on those shares and wait for him to come calling. Why would they? They weren't making money on this position otherwise.

In the same interview with Scott Wapner on February 15th, Icahn stated that he intended to exercise all of the options in the next 30 days (once he receives approval from the FTC). He clearly has a vested interest in doing this as quickly as possible.

  1. In his 13d filing, it states that the exercise price of the options will be adjusted for any dividends or payouts by the company. The upcoming dividends on his option shares amounts to $3,462,703 (11,542,344 shares at $.30/share quarterly dividend). He would get this cash payable in March as a dividend. If he rolls it into the exercise price and just lets it sit there in the option, then it is dead money. Not to mention the possible tax treatment shifting from a dividend to a Short term CG.
  2. But I think, more importantly, until he exercises the shares, they are still in broker hands which means they can be loaned out to short sellers. Once they are exercised and he gets physical possession, he will likely lock them up further reducing the number of shares available for shorts and tightening the overall supply.

And, the situation got better for him. When he filed his 13d, he stated that he owned 12.98% of the outstanding shares. But we now know from the company's earnings press release that they repurchased 4 million shares in just the first two months of this year. According to that same release, the number of outstanding shares as of 12/31 was 107 million. Factoring in the 2013 repurchase, Icahns holdings now represent 13.48% of the outstanding shares (derived as follows):

From his 13d, we know that Icahn held 14,015,151 shares which represented 12.98%. This implies a total outstanding share amount of 107,974,969 (14,015,151/.1298) as of 12/31/2012. Since the new outstanding share amount after repurchase is 4 million less (103,974,969), his stake is now 14,015,151/103,974,969= 13.48% of the outstanding shares.

The last part of the equation is to determine when can we expect to see these shares start to be recalled and transferred to Icahn. He likely filed his request on January 28th (the day he crossed the reporting threshold and he started his buying spree). This would mean that sometime around the 25th of February (as the call backs are undoubtedly underway already), we should start to see the effects of some shorts having to cover.

As an indication of what to expect, look at the table above on the days with his biggest Icahn buying activity. You'll notice huge volatility in the stock on those days with the biggest share purchases. For example, the day he bought the most shares on Feb 4th, the difference between the high and low of the day was $5.06, on Jan 28th it was $5.83. Other days also exhibited large swings as well.

We can expect more volatility and upside pressure when the exercise is effected because:

  1. There are less shares outstanding due to confirmed share repurchases.
  2. There are less shares available for short purposes.
  3. Short borrows will be recalled all at once forcing a massive short cover.
  4. The short position is 34,185,820 shares as of 1/31/2013. This represents 32.87% of the outstanding shares. (Based on the outstanding share balance after the Jan/Feb 2013 repurchases).

It appears that this will be end up being a test of wills. I can't say who will win this war, but it appears that this upcoming battle will be heavily favoring Carl Icahn.

Source: Handicapping The Icahn Position In Herbalife