Herbalife Vs. Ackman: The Saga Continues

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

From the eyes of an ordinary investor.

Bill Ackman never fails to surprise year after year.

From 2002 to 2008, the press followed closely on his legendary battle with municipal-bond insurance titan, MBIA Inc. (MBI). In 2011, he went live on CNBC, declaring an unexpected wager that the Hong Kong Monetary Authority will revalue the Hong Kong dollar against the USD.

And entering into the first month of 2013, the battle against Herbalife (NYSE: HLF) has put Ackman on center stage once again. Armed with what many of his peers consider a remarkable 334 page presentation. Ackman's team spent hours outlining why Herbalife is a pyramid scheme that is bad for America.

Sensational. Truly sensational. As the presentation hit midway, my fingers were dying from the itch to hit the button. So I decided to make a small trade on some Jan 2013 Put options, in which I took profit 7 days later with a very satisfactory gain.

Now, since I am recommending Herbalife as a potential short idea, it is important to make clear a few points:

  1. When going short, fundamentals are not sufficient. Catalysts are necessary. In this case, Ackman's presentation outlined a lack of external customers as the catalyst.
  2. Never go short on a stock without taking into account potential short squeezes and margin implications. You can be wiped out. The bottom will outline a few of the margin implications that could occur for Ackman and also short sellers who are currently in the trade.

We will analyze certain key factors relating to the company, and decide if they are valid points to be considered before initiating a short position:

A. Weakness in Herbalife Financials - Valid Point

Taking some numbers from the YAHOO finance website:

Return on Equity(ttm) 104.67%
Return on Assets(ttm) 26.45%
Year 2011   2010   2009
Revenue 3,454,537 +26% 2,734,226 +18% 2,324,577
Gross Profit 2,774,453 +28% 2,175,415 +19% 1,831,443
Net Income 412,578 +38% 299,215 +47% 203,346

At a glance, Herbalife seems to be a growth company on steroids, and at current price an outstanding value play. Advocates in the form of activist Chapman have taken a Long position against Ackman, proposing a gigantic "mother of all short squeezes" that could wipe him out almost completely.

I however do not share this opinion. Although many analysts advocate Herbalife as a strong buy based on fundamentals, a look at a two tables here will pinpoint some cracks in the company:

P/B ratio 10.62
D/E ratio 136%
Operating Cash Flow 515.59M

as of 30/9/2012

  30/09/2012 31/12/2011
Total Current Liabilities 663,948 548,689
Total Non-Current Liabilities 582,744 337,332
Total Liabilities 1,246,692 886,021
Inventory 313,581 247,696
Property, Plant & Equipment (PPE) 198,562 193,703

(Source: Yahoo Finance)

Book Value

The company has a 10.62 Price to Book Value. Hardly attractive to be considered by any conventional Benjamin Graham valuation model.

Debt to equity ratio

Taking into account that the debt to equity ratio is 135%. Any writedown of inventory or assets could easily push the company into negative equity territory.

Liabilities & Cash Flows

Although the company produces an operating cash flow of $515 million a month, it has increased its liabilities by another close to $360 million in the 9 month period from end of 2011 to Sep 2012.

Inventory and Plant, Property & Equipment has not increased significantly, thus we can assume no acquisition for PPE has been made nor is the company gathering inventory in anticipation of increased sales next quarter.

The increase in debt has yet been justified by any activity to increase capacity, and thus the strength of the company's cash flows should be put into question.

In short, Ackman is shorting a company which is likely to be overvalued and has balance sheet flaws which have yet to be uncovered.

B. Pyramid Schemes - Valid point

Herbalife has very,very credible earnings results and revenue growth. But like all pyramid schemes the tipping point occurs when the company's operating performance is on maximum steroids - (y-o-y record growth of revenue, profits etc).

C. Legacy - Invalid point

It is true Herbalife has a 31 year legacy, but lest we forget Lehman had a 100 year plus legacy and is now in the dumps. A favorite defense used by analysts, CEO Johnson and pro-Herbalife traders. But nevertheless not a concrete determinant to decide if the company will not collapse eventually.

D. Government - Half valid point

I consider it naive to hold the perspective that the government shutting down Herbalife is the only way the company will collapse. It does however, affect the time period of this trade, a point noteworthy for all option speculators or even shortsellers of the stock. Having to spend too many years on a trade results in diminished returns.

E. Showdown- Catalyst (Valid Point)

The two main determinants of whether a shortseller will succeed in this trade is both the ability to hold their position and the outcome of Ackman's showdown. 

This is an important catalyst. The success of Ackman's crusade will help the short trade as herd mentality exists in the stock market, and when shorting a stock, I try to ensure that the herd moves in my favor.

If Ackman succeeds to overcome a short squeeze or manages to win over his audiences, the share price of Herbalife is in for a continuous decline over time.

3 points to determine if Ackman will succeed:

1. Hedging

At this point we are (or at least I am) unaware as to whether Ackman has hedged his bets with call options. But following his previous rendezvous with MBIA and Target, which were but all accounts costly and damaging in terms of margin and holding power, I would assume yes.

If the position is hedged, then Ackman may use his hedged profits to aid his holding power and avoid covering his positions.

2. Trade structure/ Leverage

Is the trade done in a Special Purpose Vehicle (SPV)? If an SPV was set-up with unique financing terms have already agreed between Pershing Square and his financiers, the availability of financing will impact his holding.

What are the margin requirements of the trade?

The initial margin for a short sale account under Reg T is 150% of the position value. Assuming Bill Ackman shorts $1 billion of HLF stock, he needs to set aside $1.5 billion of cash as initial margin.

To identify the margin requirements or the amount of cash he will need to cushion a short squeeze; we need to:

I: Identify the Trade Price

II: Calculate the margin/cash requirements for various prices as a result of a short squeeze

I: Identifying the Trade Price:

Based on the latest Bloomberg news yesterday, assuming that Bill Ackman started accumulating his short position on May 1 (the day Einhorn made his call); we can assume his short position started at the average price of $60.

Date High Low Volume Adj.Clo Avg of High/Low
May 4 49.27 46.55 10,454,500 46.06 47.91
May 3 52.64 45.55 24,934,000 45.34 49.09
May 2 59.28 52.16 23,207,600 51.71 55.72
May 1 70.75 51.93 30,779,700 55.25 61.34

modified from Source: Yahoo Finance

The average volume in normal days before the Einhorn call was 1-3 million.

Now, I'm doing some magic with my numbers, because SEC filings do not cover short sales.

  • Assuming 20% of volume excess of 3 million is contributed by Ackman.
Date Volume 20% Excess volume Avg of H/L Value
         
May 4 10,454,500 1,490,900 47.91 71,429,019
May 3 24,934,000 4,386,800 49.09 215,369,946
May 2 23,207,600 4,041,520 55.72 225,193,494
May 1 30,779,700 5,555,940 61.34 340,801,359
  Total 15,475,160 55.10 852,793,819
  • In the period of mid May-early Dec HLF was trading at a rough range of $45.00-$55.00.
  • It would be prudent to not assume that Pershing Square built a billion dollar position within 4 days.

**But from the above analysis, choosing the upper range of $55 as our reference point is justifiable.

II: Calculating the margin/cash requirements for various prices:

Before we begin, we shall refer to an infamous short squeeze in our 21st century. The Volkswagen case study is an outright classic, one which is worthy of textbook coverage by every financial course.

(click to enlarge)

Background:

Volkswagen (NASDAQOTH:VLKAY) was a cut throat because many short sellers were trading on leverage, a factor which accelerated the short squeeze when they rushed to cover their positions.

  • The entire drama unfolded within a short period of two weeks. (16 Oct- 4 Nov) Time measurement is based on stock price not events
  • Volkswagen became the largest company (Market Cap) in the world for that period, and the stock went from €400+ to €1000+ -----2.5 times /+150%
  • At the height of the saga, Volkswagen went from a bottom €210.85 to over €1000 in less than 2 days.----- 5 times /+400%

Comparing both cases:

  • Volkswagen is a company in the size of hundreds of billions, Herbalife at a reference price of $55 is a company around $6 billion.
  • Volkswagen alone is bigger than the size of most funds, but Herbalife itself is smaller than the size of the average large hedge fund.
  • Volkswagen has large committed institutional shareholders. Herbalife has more segregated shareholders, thus making the outcome of this event more susceptible to how much Ackman or Johnson can influence the audiences.
  • Based on market capitalization, Herbalife could have a bigger short squeeze than Volkswagen. However, Bill Ackman ALONE is shorting a huge part of Herbalife. This could limit the impact in the event shorts run for cover.
  • Assume maintenance margin is 30%, thus requiring a cash of 130% (Value of short + Maintenance margin) to be set aside.

From average price of $55

Stock Price Increase Short Position Margin requirements
$55.00 +0% $1,000,000,000 $1,500,000,000 (150% initial)
$82.50 +50% $1,500,000,000 $1,950,000,000 (130% of position)
$110.00 +100% $2,000,000,000 $2,600,000,000 (130%)
$137.50 +150% $2,500,000,000 $3,250,000,000 (130%)
$165.00 +200% $3,000,000,000 $3,900,000,000 (130%)
$192.50 +250% $3,500,000,000 $4,550,000,000 (130%)

From bottom price of $24 ~ $25:

Stock Price Increase
$25.00 +0%
$50.00 +100%
$75.00 +200%
$100.00 +300%
$125.00 +400%
$150.00 +500%
$175.00 (still less than $192.50) +600%

The point of this analysis is not to demonstrate pin-point accuracy. Using market capitalization to pin-point the potential increase would be inaccurate, as it ignores behavioral finance forces. In everything, herd mentality and investor psychology apply, the impact of which is hard to quantify. Nevertheless, the assumptions and measurements used are subject to the author's opinion & judgment.

At this point it would be safe to say that it is very unlikely the short position would require a cash support exceeding $5 billion.

That means if things go wrong, Ackman has to top up another $3.5 billion. Something that can be done by liquidating profitable trades.

3. Stock buyback/Defense

Does Herbalife have a concrete defense? Chapman mentioned that a buyback could really mess things up for Ackman. But do take note that at the current stage Herbalife's debt to equity ratio is 136% (Sep 2012). 

Herbalife's defense:

The amount of stock buybacks the company can implement may be subject to debt covenant restrictions. (Anyone willing to do the homework, please feel free to analyze and comment below ). With the ratio above, I really doubt buybacks is much of a threat here.

Ackman's defense:

Ackman may have to liquidate his profitable holdings in his portfolio to maintain his margin. His previous crusade against MBIA, he has done this before and I doubt he will be hesitant to do so if the situation requires.

With the exception of J.C. Penney (JCP), most of his positions can be liquidated profitably and relatively quick as a majority of them are very l0arge cap companies.

Speaking from experience.

Hailing from a South-East Asian country, MLM is something that is close to my heart. I too, have once considered participating in an MLM sstructure. The promise of wealth may be enticing to the citizens of a developed country such as USA, but this temptation is only greater for citizens who hail from a third-world country.

MLMs do make people rich, but only for the ones at the top and the occasionally gifted salesman.

Conclusion

A short squeeze is inevitable. But as to how far it can go remains a question in doubt.

Buying now in anticipation of a further short squeeze can be a profitable venture. But just like in a game of poker, I prefer to bet my chips on the best poker hand - The eventual demise of Herbalife.

And like a vulture I will be waiting, for the right opportunity to scoop up a short at the right price.


JamesHoJuice has a long position in Volkswagon and  may initiate a short position in HLF over the next 72 hours. The Motley Fool has no position in any of the stocks mentioned. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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