Welcome to Episode 107 of Special Situation Investing.
Can investors use options to pull investment returns forward or to enhance overall results? After some reflection on the question, I think the answer is a qualified yes. Qualified yes because not all categories of investments are enhanced by the overlay of an options strategy.
My co-host and I classify our investments into three broad groups which include generals, workouts and controls. For a more detailed discussion of the three categories see Episode 60 entitled Warren Buffett’s Ground Rules but for now you only need to know the following. Generals are investments in wonderful businesses that you intent to hold for years, decades, or even permanently. Controls are investments in which the investor’s direct control of the business allows for the realization of value. In a control an investor might take over a business and sell under-performing assets and distribute the cash to shareholders in a way that entrenched management is unwilling to do. Finally, we have workouts, which are essentially special situations. These investments aren’t meant to be long-term holds but rather have a value and time bound thesis associated with them where the investor expects a specific return over a set period in order to realize their investment return.
Because the strategy highlighted in today's episode involves the sale of call options, and because those options could be exercised at any time, it is not a fitting strategy for either a control or a general investment. Having either a control or a general “called away” from you is counter to the investment thesis behind that category of investment, and therefore is not a risk worth taking. Workouts can successfully be blended with an options strategy because holding the investment for an indefinite period of time is not embedded in the original investment thesis.
This concept can best be illustrated with an example. Regular listeners will be familiar with our investment thesis in Garrett Motion (GTX). We purchased shares in the company prior to, during, and after its bankruptcy, based on the belief that the company was basically sound but had been saddled with an onerous debt burden at the time of its spin-off from Honeywell. Assuming we believed the company to be worth $10-$20 per share when we first started buying it, and assuming that those shares traded for, at times, less than three dollars, would we not have parted with the shares years ago had someone offered us between $10 and $20 for them at the start? Of course we would have because GTX isn’t a company that we intend to hold for years, decades, or forever.
GTX is a workout and as such has a defined thesis, timeline, and catalyst that we’re betting will play out. Our thesis was that it would pay off its debt, normalize its capital structure and then trade in line with its peers. Our timeline at this point is the end of 2024 and our catalyst is a credit upgrade from BB- “junk” to BBB investment grade.
For more on this history of this special situation see Episodes 27 and 74 where we describe the company’s path from debt-laden spin-off, to bankruptcy restructuring, and finally to its present iteration with a single class of stock and soon to be investment grade credit rating. We believe that CEO Olivier Rabiller is focused on the company’s credit rating because of statements that he’s made publicly, most recently at the 2023 Q3 earnings call when he stated:
During the quarter, we repurchased $161 million of stock through our approval $250 million share repurchase program in line with our capital allocation priorities. We also executed an early repayment of $200 million of debt within the quarter, a strong step towards delivering our target net leverage ratio of 2.0 times, consolidated EBITDA to net debt by the end of 2024. All of this contributed to Garrett being upgraded by Standard & Poor to a BB- stable rating.
GTX’s EBITDA is currently $630 million implying, based on Mr. Rabiller’s statement, that the company will carry no more than about $1.2 billion in debt in 12 months time. Current debt is around $1.671 billion as of Q3, leaving GTX to pay down nearly $500 million in debt by the end of 2024 assuming that EBITDA remains flat.
GTX enterprise value currently hovers around 5x EBITDA and as we know enterprise value is the sum of a company’s market cap, outstanding debt and pension liabilities, minus its cash. GTX’s enterprise value is $3.38 billion, of which $1.671 billion is debt and $1.896 billion is market cap with the remainder in cash and pension liabilities.
Now, if GTX pays off $500 million of debt but keeps EBITDA steady near $600 million, then its enterprise value should still be 5x EBITDA or close to $3 billion. As we stated before, enterprise value is the sum of the company’s market cap, debt and pension liabilities minus its cash, meaning that the market cap must increase by the amount the debt decreased in order to keep enterprise value constant. Put another way, GTX’s market cap must, all else being equal, rise by $500 million because the debt decreased by $500 million. $500 million added to the current $1.896 billion market cap implies a nearly 30% increase in GTX common share price.
A second valuation bump could come to GTX in the form of a credit rating upgrade. The company’s closest comparable peer is BorgWarner which, over the last several years, traded at an enterprise value close to 6x EBITDA. A move up from 5x EBITDA to 6x EBITDA for Garrett would add another $600 million to its market cap. Combined with the $500 million increase in market cap from the debt repayment this adds up to a $1.1 billion increase in market cap over the company’s current $1.897 billion, or a final market cap of nearly $3 billion.
At this point we need to circle back to the options discussion.
If you owned all of the stock of GTX today at $1.897 billion and somebody offered you $3 billion for all of it would you take it? Of course you would as they’re offering you exactly what the company is worth and you don’t have to wait a year to get your money. Now, if that same person offered you $1.9 billion for the whole company would you take that? Of course you wouldn’t as the return is essentially zero and you’re foregoing the possibility of a much greater return if you just wait the full year for your thesis to play out.
At this point we’ve established that, given an expected return and timeline for workouts, there is a valuation at which we’d sell the company today and a valuation below which we would continue to hold the company in hopes that our original thesis would play out. In the case of Garrett Motion, let’s assume that the company’s stock will return 50% over the next year. This is not a prediction its just an example. Now if that’s true, then beginning today and continuing forward each month we can anticipate what the price of GTX would be given a 50% CAGR.
This information is useful because we know at what price and below the investment is not worth selling and at which price and above it is worth selling. If six months from now the investment has returned 40% but was only expected to have returned 25% at that point then it can be sold. Selling six months early at 90% of your expected gain in the investment will yield a much higher CAGR because most of the return was already earned but in only half the expected time.
Selling call options on GTX shares you already own is simply selling another investor the right but not the obligation to purchase your shares at a set strike price. The payment or “premium” you receive in exchange for offering this option to another investor is money that you keep and that adds to your overall return. The options strike price should be above the pre-calculated value of a GTX share at a 50% CAGR on the date the option expires to ensure that you’re not selling the stock for less than you believe its worth.
Using specifics to add clarity, we can see that a $7.74 share of GTX today compounded at a 50% CAGR would be worth $8.44 in two months time. If we sold a call option with a strike price of $9.00 due in 73 days then we would earn $0.15 per share from the option or nearly a 12% return (.15 cents X 6)=$0.90 and $0.90/$7.74=0.1162 or nearly an 12% return. Note: there are six two month doubling periods available in one year which is where the six in the above math came from.
Again this is only an example. Each investor must decide which strike price and option premium justifies them capping their overall return through the sale of a call option. By selling calls, the investor is in essence turning their common shares into a type of preferred share because they’re receiving a set dividend (premium from the sale of the option) in exchange for limited upside (the strike price of the option).
In theory you could sell an option on GTX stock for nothing with a strike price of $100 that expires in 45 days. If the price rose dramatically and the option were exercised at that price the investor could rightfully claim that they’d received a better return than if they’d waited a full year for the anticipated 50% rise in the stock but because they didn’t receive any cash for the sale of the option the whole exercise would be pointless and would serve only to limit their potential return. I use this rather extreme example to highlight the importance of receiving an adequate premium in exchange for having capped your upside return in the stock.
Again, calculating the strike price and premium needed to justify capping your investment upside is a decision that each investor must make for themselves. Even if the investor decides not to employ an options strategy, however, the mental clarity that comes from having worked through each potential outcome is well worth the time spent. This is because you must have a very clear understanding of your investment thesis and timeline along with the total return you expect to receive in order to have any hope of understanding which options could be profitable and which will not.
With that we wrap up another episode of the show. As always we hope you’re getting value out of our real-time investment research. We appreciate all of your support and engagement and especially thank those of you who’ve sent us boosts over the Fountain podcasting app. We look forward to bringing you more actionable investment write-ups again next weekend. We’ll see you again soon.
Pulling Returns Forward With Options