It just keeps getting worse and worse for Bill Ackman.
A few weeks after the epic humiliation, not to mention even more epic losses, he suffered on his now defunct JCP long position (despite ample warnings by the likes of Zero Hedge who said long ago JCP is merely a melting icecube and fast-track Chapter 11/7 candidate) all those who predicted (such as Zero Hedge back in January) that an epic HLF short squeeze would result in the aftermath of Ackman’s Herbalife short announcement leading to Ackman’s ultimate capitulation, have been proven correct. Moments ago, in a letter to investors, Bill Ackman just announced that he has covered over 40% of his Herbalife short position, with his forced buy-in explaining the endless move higher in Herbalife stock in recent weeks. The explanation of being forced out of nearly half of his position is amusing: “we minimize the risk of so-called short squeezes or other technical attempts by market manipulators to force us to cover our position.” So Ackman is forced out by his Prime Brokers so as not to be forced out by market manipulators? That’s an interesting explanation for what is a far simple situation: booking your paper losses.
But instead of doing the right thing and slowly but surely bailing on the entire losing trade, and admitting defeat (as he did in JCP, as he will ultimately do here as well, but only after even more booked losses – he still has a massive 60% of his original short in the name) he has decided to double down and go the levered, option rout. Only this time with time-decay, by buying puts. So while before Ackman may “not have been wrong, just very early”, as of this moment the time of his trade is really going to start hurting him as every passing day that the trade doesn’t work out results in a drop in the put value, and also in total margin value available to Pershing Square.
Finally, while we provide our annotated thoughts to the Ackman letter below, we have two key questions: First: having “only” 60% of your original short remaining does not in any way make the ongoing squeeze and future margin calls any less likely; it only means those who are eager to crush the residual short shares will double down: because in addition to Ackman there are millions of other shorted shares who will take the cue and scramble to cover next). Secondly: one wonders who is on the other side of the “Put” trade. Would his name potentially begin with “I” and end in “cahn”?
Full justification of Bill Ackman’s most recent bizarro trade from his letter (pdf)
During the quarter, Herbalife stock price rose from approximately $45 to $70 per share, and from approximately $60 to $70 per share during the month of September alone. The principal driver of the stock price appears to be the belief by bulls that government regulators will do nothing, and that the Company will continue to generate strong earnings and cash flows which will be returned to shareholders in the form of share repurchases, which could force shorts, including Pershing Square, to cover.
ZH – so far it seems to be having that effect as 8.8 mm shares have covered shorts
The stock price appreciation this past month appears to have been driven by commentary from Tim Ramey, a perennially bullish Herbalife analyst from D.A. Davison, who stated a few weeks ago that in September 2013 PriceWaterhouseCoopers (PwC) would complete its re-audit of the Company’s last three years of financial statements, and Herbalife, shortly thereafter, would launch a $2 billion investment grade bond issue at an interest rate of 4%, the proceeds to be used to fund a share repurchase at $75 per share. According to Ramey, the buyback would serve to refute the bear case on Herbalife as shorts, including Pershing Square, are forced to cover.
ZH – see above
The high degree of specificity of Ramey’s bullish call has led investors to believe that he is speaking on behalf of the Company. While September has come and gone without PwC’s completion of Herbalife’s re-audited financials, bullish investors apparently continue to expect the re-audit to be completed shortly, and a large buyback to be forthcoming.
We are skeptical of Ramey’s pronouncements for several reasons. While we do not know the timing of PwC’s re-audit of Herbalife’s financial statements, we have identified a substantial number of serious issues with Herbalife’s accounting, disclosure, and tax policies that we have brought to the attention of PwC and the SEC in a series of three letters that we delivered to them in recent weeks, the first of which we shared with you earlier this month. At a minimum, we would not be surprised if the re-audited financials provide further disclosures about the Company which will raise additional questions about its business practices and its previously reported results.
ZH – nothing new here – same ‘ponzi’ thesis as before. In fact the same “most remarkable piece of investment analysis” proclaimed by Whitney Tilson in December 2012, when we first suggested – long before Icahn or any other famous activist and short-hunting investor appeared – that an epic short squeeze was imminent. The stock then was $25. It is now 200% higher. As Tilson further added: “For the many young people on this email list who are looking for a job in this industry, study this carefully – if you can do analysis even a tiny fraction this comprehensive, there will always be a job for you…” Unclear where though: perhaps in JC Penney?
With respect to the supposed $2 billion investment grade bond issue at an interest rate of 4%, we believe it is extremely unlikely that Herbalife will be able to garner an investment grade rating and raise $2 billion, let alone at an interest rate of 4%. As of March 2011, when Moody’s withdrew its ratings on Herbalife, the Company was rated Ba1, a junk rating. When the ratings were withdrawn, Herbalife had only $178 million of debt, approximately 0.5 times the then 12 month trailing operating profits, and there was little public scrutiny of the Company’s business practices. If Herbalife were able to issue $2 billion of additional debt today, the Company would have $3 billion of total debt, or 4.3 times 12-month trailing operating profits. With more than 16 times as much debt, substantially greater scrutiny of the Company’s business practices, and a regulatory cloud over the Company, we believe that it would now garner a substantially lower junk rating than that of early 2011.
ZH – even if the rating were lowered, in this environment of infinite ZIRP and record credit bubbles, even the junkiest C- crap is well bid, oversubscribed and breaks above par at issuance. See recent bond offerings by Rwanda, Zambia and Kenya.
Furthermore, we question whether a bank would be willing to take on the potential underwriter liability associated with a debt issue for Herbalife. If the Company were later deemed to be a pyramid scheme, an underwriter could find itself liable for the face amount of the entire debt issue, as recoveries to creditors of a pyramid scheme are likely to be de minimis. To earn a 150 basis point fee and risk losing 70 times that amount in a lawsuit is a risk-reward proposition that we believe no financial institution would find attractive.
ZH – Not true courtesy of boiler plate indemnification – remember the existential “risk” facing the underwriters of MF Global’s big bond issue just prior to filing and how massive their punishment was? Yeah, didn’t think so.
All of the above notwithstanding, if Herbalife could achieve a $2 billion financing, we believe the interest rate would be much higher, and the buyback could only be completed at a price that would be minimally accretive to the Company, factoring in the after-tax cost of debt and the buyback price required to acquire nearly 30% of the outstanding float. When one considers the high degree of leverage that would result from the buyback, we would expect the Company’s earnings multiple to compress accordingly. As a result, we believe that such a leveraged recapitalization would generate minimal, if any, shareholder value.
ZH – this is one of the most ridiculous statement ever made: the last 3 years have seen management and shareholders handily rewarded for leveraged recaps or buybacks – even if, or rather, especially credit risk rises. In fact, the primary source of “growth” in earnings have been leveraged buybacks.
Based on an analysis of comparable situations with our prime brokers, we believe that such a buyback would not require us to cover our position. Furthermore, if a large amount of debt were issued, an Herbalife CDS market would likely develop, presenting us with an even more attractive method to bet against the then highly leveraged Company. We could then choose to add to or replace all or a portion of our existing short position with an even larger notional short position in the debt through the purchase of CDS. We would welcome such an opportunity, although for the reasons described above, we do not believe that the Company will be able to borrow funds to complete such a transaction.
ZH – so after your prime brokers stepped you out of your unlevered short and you think that post-issuance and buyback (when you’re already massively underwater) they will ‘allow’ you to increase you collateral exposure and run a leveraged short credit position on the same credit, even though the thesis catalyst is now well-known by all, and the only impact has been a near doubling in the stock since your entry? Who does Perishing Square bank with: JT Marlin.
Since our presentation on Herbalife at the end of last year, we have not learned any facts that are inconsistent with our belief that the Company is a pyramid scheme that engages in unlawful and deceptive marketing practices. In fact, there have been a number of materially positive developments that increase the likelihood of regulatory intervention and the Company’s closure.
ZH – and the stock price has reacted… how exactly?
Numerous state, federal, and international regulators have launched investigations or inquiries into the Company’s business practices and products that we believe are ongoing. Many federal, state and local elected officials, consumer protection and community organizations and other advocates have publicly called for the FTC and state regulators to investigate the Company. A number of whistleblowers have contacted us, several in the last few weeks alone, and provided us with information that is confirmatory of our thesis that Herbalife is a pyramid scheme while raising additional concerns that we had not previously identified. Bottom line, we continue to have enormous conviction in our investment thesis.
ZH – see above, but when was the 52 week high in the stock? Hint: today.
While we have endured mark-to-market losses on this investment as Herbalife bulls have promoted the stock and downplayed the probability of government intervention, we believe it is only a matter of time before the Company is shut down and prosecuted by regulators.
ZH – so just early… never wrong.
In order to mitigate the risk of further mark-to-market losses on Herbalife, in recent weeks we have restructured the position by reducing our short equity position by more than 40% and replacing it with long-term derivatives, principally over-the-counter put options. The restructuring of the position preserves our opportunity for profit – if the Company fails within a reasonable time frame we will make a similar amount of profit as if we had maintained the entire initial short position – while mitigating the risk of further substantial mark-to-market losses – because our exposure on the put options is limited to the total premium paid. In restructuring the position, we have also reduced the amount of capital consumed by the investment from 16% to 12% of our funds.
ZH – in other words, your prime brokers tapped you on the shoulder. The share price has doubled during the period of your covering 40% of your short – how about the other 60%? Is your prime broker increasing haircuts on that? Adding puts won’t help – now your capital is bleeding away every day as theta eats into it – limited risk (but still 100% of the capital in the puts), with guaranteed bleed. Will the proceeds from the puts also go to charity? Or will the LPs finally ask who is footing the losses? Also, we eagerly await the confirmation of this note: surely the reported Short Interest will tumble any second…
We were able to restructure the position cost effectively due to several factors. Over the last 60 or so days, the cost to borrow Herbalife shares has declined substantially while the stock price has risen. Shortly after we filed a formal complaint with the SEC regarding what we believe to be unlawfully manipulative conduct by other market participants, the cost to borrow Herbalife shares dropped substantially to the lowest rate since prior to our presentation last December. In an unrelated recent enforcement action, the SEC confirmed that attempting to engineer a short squeeze by removing stock from the available lending base is a form of market manipulation.
ZH – from several sources, HLF remains hard-to-borrow and costs are high. It ranks 4 (out of 5) on Markit’s scale of diffulty to source and on-loan volumes – as seen here – are soaring
Because of the rise of the stock price, the low cost of borrow, and the fact that we are betting on the failure of the Company, we have been able to purchase long-dated, privately negotiated out-of-the-money put options on terms that offer us an attractive opportunity for profit versus their cost. Furthermore, by substantially reducing the size of our short position as a percentage of the share float, we minimize the risk of so-called short squeezes or other technical attempts by market manipulators to force us to cover our position. In that a substantial component of the bull case on Herbalife is predicated on forcing us to cover, we think the restructuring of our investment negates this important pillar of the bull case.
ZH – you still have 60% of your position, there is still 38% of the float short and now you are levered short too… the pressure to cover just increased on any new stock price move higher
The biggest risk of the restructured position is that time begins to be a factor with respect to a portion of our investment. We believe, however, that the long-term nature of the options we own will provide sufficient time for us to be rewarded on this portion of our position. In that the options are privately negotiated, over-the-counter contracts, we have the ability to extend their terms, if we deem it prudent and attractive to do so in the future.
At yesterday’s closing price of $72.84, we believe the potential reward from being short Herbalife is extremely attractive relative to the risk of loss. Using the average analysts’ price target of $77 per share – which assumes that the Company is operating entirely legally – investors have less than 6% upside compared with 100% downside if the Company is determined to be a pyramid scheme by regulators.
In my career, I have not seen a less attractive risk-reward ratio than a long investment in Herbalife common stock at current levels.
ZH – with trades like this, which has now become an ideological obsession and moved beyond and semblance of rational investing (any normal person would have pulled the plug on the nearly half a billion dollar losing trade long ago) and is rapidly morphing into a replica of Pershing Square IV, said career may not be too long. Especially since it is now that the upside/downside analysis in a long trade like JCP that actually does make sense. Remember JCP?
* * *
Finally, one wonders: would Carl Icahn happen to be on the other side of the puts? If so, the right entity to inquire about buying CDS on wouldn’t be Herbalife, but Pershing Square.