The first part of the Herbalife (HLF) action arose in December when billionaire Bill Ackman announced a 20 million share short position. Bronte Capital's John Hempton first coined the phrase "hedge fund porn" when describing the Ackman accusations against Herbalife. Ackman of Pershing Square Capital has made a case for why he is short Herbalife and why the company is a pyramid scheme. Ackman's short comes after David Einhorn of Greenlight Capital questioned the company's business model in early 2012. T2 Partner's Whitney Tilson has also gone on public record as backing Bill Ackman, stating he has a short position in Herbalife (check out Ackman's top picks).
Part two came earlier this month when the company made an attempt to rebut Ackman's claims. At the same time, Dan Loeb of Third Point has taken an opposite position as Ackman - taking an 8% stake in Herbalife. The New York Post also reported that billionaire activist Car Icahn could be in on the long side (see all of Icahn's stock picks).
Stacking up the fund sizes: On the short side Pershing is an $8.9 billion hedge fund and T2 a $175 million one. On the long side Third Point is $5 billion and Icahn $11.2 billion. Although it remains uncertain as to whether Einhorn actually has a short position, his fund size is upwards of $7 billion. Pershing has been in an activist battle with Canadian Pacific - 22% of its portfolio - for some time now and recently showed signs of giving up on his push for a sale of General Growth Properties - 16% of its portfolio. Third Point was instrumental in ousting Yahoo's former CEO Scott Thompson and remains an advocate of the company - 23% of its portfolio (read about other stocks Loeb is bullish on).
Herbalife, to no surprise, says its company runs a legit business model. Herbalife President Des Walsh said the company adheres to Federal Trade Commission rules requiring that the vast majority of purchases are motivated by resale or consumption, not rewards. In a recent CNBC interview, Bronte Capital's John Hempton makes very good points about Herbalife saga, with the key being that Ackman's major investment thesis of is that the government is going to shut down this highly profitable company. He then uses tobacco companies as an example:
Tobacco companies kill 5 million people globally per year - 400 thousand of them in the USA. Is anyone stupid enough to think the government would close them?
It's tough to value the stock since what really matters is whether or not the company turns out to be a pyramid scheme. As a result, it is less about where Herbalife trades relative to other MLM companies. In trying to wrap our heads around the possibilities for the stock I broke out best-case/worst-case scenarios. The worst case scenario is the stock goes to $0. Assuming a 5% likelihood - which is driven by the fact that the SEC investigated the company in 2006 and found no wrong doing and in the 30 years the company has been operating only one court in Belgium has found that Herbalife is a pyramid scheme. If things go south for Herbalife we see $0 as the only floor, as there is also not a sufficient level of assets to provide a downside floor and its debt ratio is nearly 50%. The other scenario is that Ackman backs out early, which is around 20% likelihood. In this case there should be return to Herbalife's normalized P/E -- 5-yr. average where it generally trades at 80% of the S&P 500 price-to-earnings ratio. The current S&P 500 price-to-earnings ratio is 15, and so Herbalife should return to a normalized P/E of 12x. Based on its 2013 earnings per share estimate of $4.47, the 12-month price target comes in at $53.46.
What is the likely scenario is that things are dragged out for the next twelve months, with a handful of back and forth arguments between Herbalife, Loeb, Ackman and whatever other hedge fund managers decide to chime in. Under this scenario the stock should remain pressured and trade near current price-to-earnings levels -- roughly 10x. The company will still be able to generate earnings and cash flow in this scenario. Using the $4.47 2013 earnings estimate the stock should see an upwards cap of $44.70. There is a 75% likelihood on this. Combining all the scenarios and using a little probability theory the theoretical value for Herbalife is somewhere around $44.20. At its current trading price of $45, the stock appears to be fairly valued.
The likelihood of Herbalife being shut down is minimal, but we also see any upside to the stock already accounted for. Worth noting is that Ackman is short 20 million shares with a price target of $0, and Loeb is long 9 million shares with a $61.50 (the midrange of his $55-$68 valuation) price target.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
