The More Ackman Gets Attacked, The Better His Herbalife Trade Looks
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Bill Ackman has received a lot of criticism for publicly disclosing his short bet against Herbalife (NYSE: HLF).
Most recently, Josh Brown (in a piece that’s actually favorable to Ackman), writes that he didn't agree with “the flamboyant rollout of his short position in Herbalife.”
Brown is missing the point.
Every time a member of the press mentions Ackman’s Herbalife short, his case gets stronger. Although investments by Dan Loeb, Carl Icahn and now George Soros have pushed the share price of Herbalife up significantly, they've made Ackman’s $0 price target possible.
Price target $0
In a letter to investors, Loeb’s fund Third Point perfectly summarized Ackman’s case against the multi-level marketing firm:
The short thesis rests on the notion that the FTC has been asleep at the switch, missed a massive fraud for three decades and will shortly awaken (at the behest of a hedge fund short seller) to shut down the company.
If Herbalife shares are going to $0 (as Ackman argues they will), it will have nothing to do with revenue, free cash flow, or any other familiar metrics investors look at.
Rather, it will depend on the government -- in this case, the FTC -- acting against Herbalife, and shutting down the firm.
But will the FTC act?
But Loeb doesn’t think that will happen, calling the notion of such an occurrence “preposterous.”
Given that Icahn owns about 16.5% of Herbalife, he obviously agrees, but has provided a deeper explanation based on Ackman’s legal counsel.
In an interview with CNBC, Icahn insuitated that Ackman’s attorneys, the firm Sullivan & Cromwell, were unqualified to tackle the pyramid scheme allegation. In the past, the firm defended Microsoft against the FTC, which might incline one to assume that Sullivan & Cromwell was an experienced FTC firm.
Not so, according to Icahn. The FTC is made up of two divisions -- consumer protection and competition. When defending Microsoft, the FTC was dealing with the bureau of competition, but when it comes to Herbalife and a pyramid scheme allegation, it will fall to the FTC’s consumer protection department.
Icahn’s attorney -- who he has said deals with the FTC’s consumer protection bureau frequently -- has assured the activist investor that Herbalife is running a lawful multi-level marketing operation.
Of course, Ackman believes something very different, telling The Wall Street Journal in February that the FTC missing Herbalife would be like “the SEC missing Madoff.”
Getting on the FTC’s radar
I’m not sure if the FTC will shut down the firm. Unless one has contacts within the agency, the answer to that question seems little short of a coin flip.
However, there is no doubt that the agency is -- at the very least -- aware of the accusation. Consider the cascade of events that have hit the company in just this year:
- Jan. 25: Icahn debates Ackman on live TV. Commentators dub it the “greatest moment in financial TV history.”
- Apr. 9: KPMG resigns as Herbalife’s auditor because a senior partner was insider trading.
- Jul. 31: George Soros takes a stake in Herbalife.
- Aug. 5: Ackman accuses Soros of insider trading.
- Aug. 13: Former Herbalife employee turns whistleblower and says Herbalife was in violation of food safety regulations.
- Mar.-Aug.: Ackman’s J.C. Penney investment turns into a quagmire. As an American icon, J.C. Penney’s issues are covered in a variety of media outlets; Herbalife is frequently lumped in as another of Ackman’s failings.
The worst case scenario for Pershing Square would've been a media blackout. Had Ackman’s Herbalife accusations been ignored, the probability of the FTC investigating the firm might’ve been low.
This is likely why Pershing Square bought up Google Ad Words for its website, factsaboutherbalife, but that advertising was unnecessary. Given the unprecedented activity surrounding the company, and the flurry of media coverage, the regulators working at the FTC must be aware of Ackman’s allegations.
What about the other MLMs?
Ackman has not addressed the other two firms one way or the other. And while Dan Loeb made a profitable trade betting on Herbalife earlier this year, he was reportedly short Nu Skin.
But all three firms operate under the same business model, which makes them susceptible to regulatory action -- an FTC shut down on Herbalife could be interpreted as open season on other multi-level marketing firms. After the FTC shut down Fortune Hi-Tech Marketing back in January, shares of all three firms moved lower.
Of course, if the FTC does not act -- or even exonerates Herbalife -- shares of Nu Skin and Usana should enjoy a rally. After all, both are profitable companies with solid balance sheets.
Usana’s price-to-earnings ratio of 14 is cheaper than the market, and it’s generating operating cash flow. Analysts have been getting increasingly bullish on the stock, with DA Davidson slapping a $92 price target on the stock back in July. Also, as I've written previously, Usana could be set up for outsized gains, as its high short interest could trigger an aggressive short squeeze.
Nu Skin does not benefit from a high short interest, and it’s also more expensive than the market on a pure PE basis. But analysts have been equally as praise-happy. In January, Deutsche Bank called Nu Skin one of its two “top picks” in 2013. Thus far, Nu Skin has earned the designation. In the last two quarters, the company has beat estimates for both earnings and revenue, while raising guidance.
Nu Skin is now trading at an all-time high, which could make some investors nervous. Still, it's hard to argue against the fundamentals in addition to beating earnings and raising guidance, Nu Skin has channeled its cash flow into share repurchases. In May, it announced a $250 million share repurchase program, and upped that to $400 million earlier in August. Given that the company's market cap is only about $5 billion, those share repurchase programs are quite significant.
Investing in the MLM space
The unprecedented media coverage surrounding Herbalife has made the possibility of an FTC shut down -- what Ackman is angling for -- possible. At the very least, the constant barrage of news stories cannot be flying past the FTC unnoticed.
If the agency does take action against Herbalife, other stocks in the sector -- specifically Usana and Nu Skin -- could take a hit as well. Both stocks have traded with remarkable correlation to Herbalife, as they share the same underlying business model.
The multi-level marketing space is fraught with danger. Although Ackman's short position looks to have gone against him for the time being, it would take but a single announcement from the FTC to vindicate his investment.
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Sam Mattera has no position in any stocks mentioned. The Motley Fool has the following options: long January 2015 $50 calls on Herbalife Ltd.. 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!