Considering Our Options Again – $HLF: Management Strikes Back

by Enis February 3, 2014 11:24 am • Commentary

Herbalife continues to be a battleground stock.  Bill Ackman uses all the stops in trying to increase scrutiny and pressure on the company, with Massachusetts Senator Edward Markey’s letter to regulators a couple weeks ago the most recent salvo.

Today, Herbalife management responded with its own attack.  The company pre-announced earnings this morning, and added impact to the pre-announcement offering a convertible note to investors.  The proceeds of that note are going to mostly go towards buying back HLF stock, as another part of management’s attempt to boost the stock price and hurt Ackman and other shorts.

The interesting aspect of HLF’s capital raise / buyback is that it was done with a convertible note.  I saw many of these types of structures as an options trader, and here is what it entails:

Essentially, the company offers its convertible notes (in HLF’s case, with a maturity of 2019) to investors. It uses most of the proceeds to buy back stock (through transaction with investment banks). But it also uses a portion of the proceeds to buy a call spread (capped call transaction), which is a way for the company to hedge its risk that HLF stock goes far above its convertible note strike (since the company has given investors a call option through its convertible note issuance).

It is standard operating procedure for companies who issue convertible notes to enter into capped call transactions with the banks to hedge that risk.

The main difference in HLF’s case is that it is using most of the proceeds from the convertible note issuance to buy back its own shares rather than spend it on the business.

In this manner, HLF has raised money more cheaply than a pure bond issuance, but reduced the risk of having to dilute shareholders significantly if the stock is much higher in 2019.

While it’s a clever bit of financial management, the net result for our own bearish options position (Feb Put Butterfly – below) is quite positive. With the earnings event is out of the way and a new buyback in place (which will dampen downside volatility in the near-term), we’re seeing 30 day implied volatility in HLF move lower:

30 day implied volatility in HLF, Courtesy of Bloomberg
30 day implied volatility in HLF, Courtesy of Bloomberg

Moreover, the stock is actually red on the day, even after what the company’s management obviously meant as a shock and awe type move to scare the shorts in the name. The short interest is still about 27% of the float (20 million shares short vs. about 75 million shares of free float).

The stakes are higher than normal given that management is under a very high degree of scrutiny. But they can’t seem to shake Ackman off like a bad case of the fleas. He’s here to stay, which likely means more headline risk in HLF going forward.

As a result, we’ll probably look to take off the put butterfly position when it’s worth $4-$5. At that point, the risk/reward of holding this structure for another 2.5 weeks does not seem worth it to us. For now, we’re hanging on.



Considering Our Options – $HLF – Senator Smokes Herb, January 23, 2014

Herbalife got a tape bomb this morning in the form of some initial congressional investigations into their business practices:

(Reuters) – Massachusetts Senator Edward Markey is asking for more information about the business practices of nutrition company Herbalife, which has been accused of running a pyramid scheme by prominent hedge fund manager William Ackman.

Markey sent letters to the Securities and Exchange Commission, the Federal Trade Commission and to Herbalife itself to try an obtain more information, his office said in a news release on Thursday.

This has been Ackman’s point all along and the reason we recently highlighted some big options activity (Big Options Activity Looking for Herb to Get Smoked) as well as placing a bet on a change in fortunes in the stock sometime in the near future (New Trade $HLF: A Small Hit of Herb)

So now that the stock is down on this headline, let’s look at our position and consider what our options are here. To recap, here’s the trade from Friday:

TRADE: Bought the HLF ($71.10) Feb 70/60/50 Put Butterfly for $1.50

– Bought 1 Feb 70 Put for $7.05

– Sold 2 Feb 60 Puts at $3.72 each ($7.44 total)

– Bought 1 Feb 50 Put for $ 1.89

With the stock around $64, this structure is worth about 2.20 but that could change quickly if the stock settles in here or keeps melting a little lower. Right now, the trade is intrinsically worth about 6 dollars. That means that there is nearly 4 dollars of extrinsic premium that has not been realized in the structure. Obviously with about a month to go until expiration, you would expect a difference between extrinsic and intrinsic but in this case it’s pretty massive. Why is that? Vol.

February volatility has spike higher by about 20 points today. What that means for an in-the-money butterfly is a worse mark to market price vs the intrinsic value of the structure. If the stock was outside the wings of the trade (below 50 or above 70) the increased volatility would actually be helping the structure keeps it’s value. But in this case, with 60 as the sweet spot and the stock very close, it’s hurting.

So a couple things can happen to start to get that intrinsic value. The stock could creep lower towards the sweet spot, as anything close to 60 is the best possible spot for the trade, all other things being equal. The other thing that can happen is the stock settles a little and February vol comes in a little.

So we’ll stay in this trade even after the initial headlines as we have it right where we want it. We’ll be keeping our eye on vol and the headlines and look to take this off at a more opportune time.