How Mike Ashley took a punt on Tesco

Sports Direct’s revelation that it entered into a stock option agreement on Tesco shares looks like a welcome piece of good news for the beleaguered supermarket group.

Sports Direct, of which Mike Ashley is founder and deputy executive chairman,  said  it agreed a put option deal covering a small stake in Tesco stock, betting  the  shares will rise.

Britain’s biggest sporting goods retailer said the agreement with Goldman Sachs  International referenced 23 million ordinary Tesco shares, representing a 0.28%  stake in the world’s No. 3 grocer.

Since Sports Direct’s agreement is a ‘friendly’ deal, yet also  involves a put option, this means Mike Ashley’s firm is selling a put option in  Tesco shares.

A quick lesson in stock options

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding deal.

The two basic types of options are call options and put options.
Calls give the right to buy a stock at a specific price. Puts give the right to sell a stock at a specific price.

Normally, a call option would be bought by a party that expected the underlying stock to rise over time. If the stock rose, the option buyer would have the right to purchase the stock cheaply and could then sell it in the market for a profit.

A put option would normally be purchased in the reverse of the above scenario. The put buyer would have the right to sell the stock at more than the current market price, in the event that the stock fell.

One can go long or short (buy or sell) both types of options, but a major difference in going short an option is that in doing so, the seller (known as the ‘writer’ of an option) is obligated to buy or sell the underlying stock if it reaches the specified ‘strike price’. 

 What’s in this for Sports Direct?

Under the deal, if Tesco shares fall below a pre-set exercise price in future, Sports  Direct must buy a stake of 28 million shares at the agreed price, or pay the cash  difference between the share price and the exercise price.

The benefit for Sports Direct and the essence of Mike Ashley’s bet, is that his company will receive a premium payment if the stock price rises to or above the  option’s exercise price.

Sports Direct said its maximum exposure under the option was about £43m.

It has not disclosed when the option will expire or what the exercise price is.

Tesco and Sports Direct stock are little-changed so far this morning.

News of Sport’s Direct bet that Tesco shares could rise, comes in a tumultuous week for Tesco.

On Monday it revealed that an accounting issue had led it to overstate first-half profit forecast by £250m, sending its shares plummeting.

It was essentially giving a third profit warning in as many months.

Late in August, it had also announced a profit warning.

At that time, we noted a moderate increase in put-selling activity in Tesco stock. However, we also pointed out that selling puts was a common strategy used by institutional investors who were also holding large short positions in a specific underlying stock.

In such cases, the short put position would provide a protective ‘hedge’ in the event the short bet in the underlying stock went wrong because the shares rose strongly.

There’s no way of knowing if Sports Direct wrote its put as a hedge for a short position in Tesco stock, because the relatively small size of the deal means it falls outside of the disclosure rules.

Still it seems unlikely.

More likely, the bet by the colourful Mike Ashley that Tesco will turnaround is just that and a little bit more.

It’s win-win, for Mike Ashley

Ashley has certainly seemed much more aware of the need to maintain a public image as a ‘goodie’ in the world of business rather than the ‘baddie’ he was commonly portrayed as being in years past.

Witness his seemingly uncharacteristic backing down from drawing the controversial bonus from Sports Direct’s employee benefits scheme earlier this summer, when public outrage about him doing so reached a peak.

That was the behaviour of a different Mike Ashley than the days when he was an unpopular owner of Newcastle United, and apparently quite prepared to put the public’s nose out of joint if it suited his purposes.

This positive bet on Tesco is one Ashley almost cannot lose. (£43m is small change both for Sports Direct and Mike Ashley, although shareholders might have a different view.)

Whether Tesco turns around or collapses completely (very unlikely) Ashley will be seen as the bloke who rode to support of the venerable British grocer when it was losing friends left right and centre.