Wednesday, June 6, 2012

Here Are My Puts...So $CALL Me Maybe?

MagicJack (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

1 comment:

Wexboy said...

Congrats, Saj, on the blog! - regular reader, not sure I've left a comment before. This type of article annoys me, especially coming from the WSJ!

It reminds me of those articles about countless ittle wittle municipalities who were duped by Wall St and lost 10s of millions on evil interest rate swaps... They didn't! They simply want to forget and/or weasel out of their commitment to a high (in retrospect) fixed rate - for example, the variable rates on their debt kept falling, while losses on their swaps just drags them back up to the fixed rate. A child could understand it after 5 minutes...but not a politician, I guess!

I'll read the $CALL 10K when I have a chance, but I see nothing sinister here. I ran a multi-billion share buyback plan at one point, and merrily wrote as many short term puts as I could! The fact the Street would pay us 10s of millions of dollars was amazing, and tasty gravy for 'formalizing' a commitment that we had already made: i.e. to do large-scale share repurchases!

$CALL is to be commended here, and this certainly isn't a risky strategy at all!

Think about it, as its share price develops (or even better, falls) a company in share buyback mode will be consistently buying/increasing its buying of shares. Writing puts is just harvesting extra income from your specific share buyback plan - and not risky in any way as long as your put commitment remains within the confines of your cash/share buyback plan.

Gains/losses on the options are really an illusion - a loss just reflects the fact you had to buy shares (from the put holder) at a price higher than the market (because the share price was falling). So what, with no put options in place, you would have bought shares at that (higher) price level anyway - you just don't measure a loss on that transaction..! [Of course, this doesn't address whether you are buying at idiotic prices! I've written about this - rather cynically, I've never yet met a corporate who performed an intrinsic valuation on their stock before buying - that's not what motivates their stock buybacks anyway, in most cases].

Finally, I'm confused by the commentary about the impact on net income. Put income (on your own stock) should normally run through your equity statement, not your P&L. I wasn't aware that treatment had changed, perhaps it has - or possibly $CALL could opt for a P&L treatment in advance. Either way these options gains/losses are irrelevant, and should be stripped out for analytical purposes.