Seeking Alpha
, Barel Karsan (413 clicks)
Long only, deep value, contrarian
Profile| Send Message|
( followers)  

magicJack (NASDAQ:CALL) made an interesting move with respect to its share repurchase program last quarter. As reported by the Wall Street Journal, the company actually sold puts on its own shares. As a result, it increased its profits (through the sale of the puts) some 20%!

(If you're not a subscriber to the WSJ, just Google the article's headline and you should be able to avoid the pay wall that way. The WSJ doesn't want you getting full article access when you click through this site, but will provide the full article when you click it through Google! I look forward to the day the WSJ breaks this anti-trust story!)

The WSJ basically sees this as a risky move for MagicJack, for if the company's share price had moved south, not only would the profit on the puts have disappeared, but losses on the puts could have been high. Fear is justifiably evoked when companies play around with their own stock or derivatives thereof, as it can lead to trouble ranging from price manipulation to insider trading to financial statement shenanigans that can topple companies (as seen at Enron, where company shares were used as collateral to guarantee the worth of the company's own assets, as described in The Smartest Guys In The Room). But I would argue that the sale of put options for MagicJack doesn't have to be particularly risky.

If a company's market price is higher than the price at which it is willing to buy back shares, it may make sense to sell short-term put options to enjoy extra income should the price never get to that level. If the price does fall to the exercise price, that's no problem, as it was the company's intention to buy back shares at that price anyway!

For example, Warren Buffett has said he is willing to buy Berkshire shares if they get as low as 1.1x book value. If Berkshire were to trade at 1.2x book, perhaps Buffett could make a profit by selling puts at a strike price of 1.1x book. If the shares were to fall, this would force him to buy at 1.1x book, but he would have done that anyway! As such, he can make a profit if the stock price goes up or stays where it is, and doesn't really lose anything if the price falls, because he's doing what he would have done anyway.

It's important to stress, however, that there is an added risk that the company's circumstances change; in that case, a company may no longer wish to buy back shares at a certain level. Having sold puts, however, the company is locked into its position. For this reason, companies employing this method should try to keep the time to expiration of the puts as short as possible. This way, there is less likely to be a change in the competitive or operating environment that catches the company off-guard.

Unfortunately, it's not clear that MagicJack has been doing this. The company does not appear to disclose its strategy with respect to the length of its put contracts, nor does it appear to disclose the length of these contracts. The company has, however, been employing this strategy for a while. Since it constantly has a number of sold puts outstanding, the company may be constantly at risk of an adverse turn in its business conditions being amplified by this financial strategy! As such, it may in fact be quite risky - we just aren't privy to the info.

Disclosure: No position.

Source: Here Are My Puts...So CALL Me Maybe?