Carl Icahn's Long Synthetic Option Strategy

Anh is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Recently, Netflix’s (NASDAQ: NFLX) rocketed up when Icahn reported owning nearly 10% of the company. Since October 24, Netflix has increased more than 32.5%, from $58 to $76.90. However, the gain is nothing compared to the loss it has experienced, when the share plunged from $295 in July 2011 to $63.80 in November 2011, a loss of 78.3% within just 5 months. Indeed, Netflix has had a wild ride in the previous 5 years. 

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The media reported that Icahn had a nearly 10% stake in Netflix. However, a closer look at the company’s 13D filing reveals interesting facts that investors might not know about.

Icahn used different entities, such as Icahn Partners Master Fund LP, Icahn Partners LP, High River LP, Icahn Partners Master Funds II and III, to initiate positions in Netflix. Currently, he owns a total 5,541,066 shares. However, 4,291,066 shares are call options. So Icahn actually owns only 1.25 million shares outright (22.6% of his total reported position). Between September 24 and October 25 he bought 500,000 shares for $54.75. The rest was American call options for a call premium ranging from $18.94 to $24.78. The call options were set to expire on September 4 2014 with a strike price of $36.05. So Icahn bought two-year in-the-money American call options for Netflix’s stock.

Looking deeper, I was more surprised to see that along with buying American call options, Icahn sold put options with the same amount of underlying shares and with the same maturity date, September 4, 2014. We do not know exactly the strike price of the put options. Those put options he wrote were not American, but rather, European style.

Why buy American call options?

Call option gives Icahn a right, but not an obligation to buy Netflix stock at a certain strike price. Icahn needs to put less capital at risk whereas maximize his stake in the company. If Icahn exercised call options, his effective purchase price would be in the range of $54.99 to $60.83. Icahn has two more years to decide whether he should invest to take the full benefits, or just walk away with the cost of call premiums. He purchased American call options because he would have the right to exercise at any time before expiration date. With short-term volatility in the stock price, American options would give Icahn much flexibility during the two year period until September 2014.

Why sell European put options?

Simultaneously, Icahn sold put options on the same amount of shares with the same maturity date. Icahn would receive the premium on the put options, maybe to cover the premiums of the calls he bought. So by selling put options, Icahn has the obligation to buy back the shares when Netflix’s price is below the strike price. By writing European put options, Icahn reduces his risk as the put buyer can only exercise the options when it comes to expiration. 

Why both?

If we assume that both American call options and European put options have the same strike price, as it has the same expiration date with the same amount of underlying Netflix shares, this strategy is called a Long Synthetic. A Long Synthetic behaves exactly the same as buying the shares outright. Icahn must be quite bullish about Netflix to execute this option strategy. The advantage of this strategy is that it is much cheaper than owning stocks outright.  Indeed, he mentioned that Netflix was currently undervalued, and implied that there was a high probability that Netflix could be acquired by other competitors, which would bring shareholders a lot of potential gain. He said: "I believe that there is going to be great consolidation between Netflix and, everybody's read about it, Amazon (NASDAQ: AMZN) or Microsoft or Verizon or Google, there are so many possible combinations.”

As of September 2012, Netflix has around 31.8 million subscribers, and the majority of them (nearly 80%) subscribes for streaming in the US. International streaming subscribers’ number is only 4.3 million and domestic DVD’s is only 8.6 million. Its competitors including Amazon and Hulu have much fewer subscribers. The Amazon Prime Service has around 9 million; around one third of Netflix’s. Hulu has around 2 million subscribers only. Amazon Prime is trying to be more competitive. In addition to a $79 yearly subscription, the service has recently released a new streaming subscription option, with the price of $7.99 per month on its website, similar to Hulu's and Netflix's price. What Amazon Prime provides but Netflix does not is the free two-day shipping and an e-book library. Although Amazon Prime currently does not have a large video database like Netflix and Hulu, but it has been spending hundreds of millions of dollars to acquire more contents from different sources. 

My Foolish Take

Netflix is still the leading player in the streaming industry. With 31.5 million subscribers, much more than that of Amazon’s and Hulu’s, the business has been generating double digit return on invested capital since 2004. With a trailing twelve month revenue of $3.54 billion, each subscriber would bring $112 in revenue for Netflix. In addition, a long synthetic option strategy has indicated Icahn’s optimism for the company’s future, in two years’ time, with a good probability of being acquired. I think investors would be fine following Icahn to consider Netflix to be an opportunistic play in their portfolios. 

Know What You Own

The precipitous drop in Netflix shares since the summer of 2011 has caused many shareholders to lose hope. While the company's first mover status is often viewed as a competitive advantage, the opportunities in streaming media have brought some new, deep pocketed, rivals looking for their piece of a growing pie. Can Netflix fend off this burgeoning competition, and will its international growth aspirations really pay off? These kinds of issues are a must know for investors, which is why The Motley Fool released a brand new premium report on Netflix. Inside, you'll learn about the key opportunities and risks facing the company, as well as reasons to both buy and sell the stock. They’re also offering a full year of updates as key news hits, so make sure to click here and claim a copy today.

hoangquocanh has no positions in the stocks mentioned above. The Motley Fool owns shares of, Google, Microsoft, and Netflix. Motley Fool newsletter services recommend, Google, Microsoft, and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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