Seeking Alpha
Macro, contrarian, bonds
Profile| Send Message|
( followers)  

Those that are, or thinking about, buying Herbalife (NYSE:HLF) in the belief that Mr. Ackman might face a short squeeze could be in for a rude surprise. Granted the more recent short interest report for Herbalife showed over 34 million shares being short. That is a good portion of the outstanding shares, and reports have suggested Pershing Square being short at least 20 million shares.

Let's look at Mr. Ackman's well-known short, MBIA (NYSE:MBI). This article from 2005 suggests that MBIA was shorted on July 24, 2002 and a credit default swap was purchased July 17, 2002.

The chart below shows the stock performance of MBIA, AIG, Citigroup (NYSE:C), and GE for comparison purposes. Notice how they all dropped?

MBI Chart

MBI data by YCharts

Let's compare General Growth Properties with MBIA from July 2007 to year-end 2009.

MBI Chart

MBI data by YCharts

It is unknown what the duration and payment structure of the MBIA credit default swap was. It has been reported to have turned out to be a very profitable holding when the markets collapsed.

Why bring up MBIA when today's action and interest is in Herbalife? Many useful lessons can be learnt from studying history. Notice that the initial MBIA short stock position was underwater for years? Why would a losing position be held for years? It could have been a hedge for other positions. While the performance of an individual issue is worth reviewing, the more important or key metric is the performance of the total portfolio. It also demonstrates conviction and the ability to withstand an adverse price move.

Strictly from a risk-reward basis the Herbalife trade is interesting, I've done a rough calculation of the average price Pershing Square might have established for the short position and peg it in the 50's. Thus the position is making money today, but far less than it did back in December 2012 with the stock at $25. At $50 the upside risk would have been roughly $25 should the stock move to a new high at $75, with the reward at $50 if the stock fell to zero. Risk $1, for reward $2. At $25, the risk profile changed to risk $3 to reward $1.

The trading volume in Herbalife year to date has been huge, over 388 million shares, or over 3 times the outstanding shares and it is only February 15th. The questions surrounding Herbalife has attracted traders.

What are the odds of Herbalife going to zero? Hard to tell, but given that General Growth Properties entered bankruptcy protection in April 2009 and not only failed to go to zero, but paid a cash dividend.

On December 18, 2009, the Bankruptcy Court approved the payment of a $0.19 per share dividend to holders of GGP common stock declared by the GGP Board of Directors. The dividend, comprised of a combination of cash and common stock, is payable on January 28, 2010 to stockholders of record on December 28, 2009.

The odds for Herbalife, with its foreign markets exposure, might suggest that a price of zero is unlikely.

Here is a chart of General Growth from April 2009. Nice rebound wouldn't you agree?

GGP Chart

GGP data by YCharts

Where is the risk in the Herbalife trade? The downside risk is clear, the government coming in and attempting to shut the firm down. Given the Better Business Bureau rating of A+, the minimum number of complaints at the BBB and FTC the tipping point doesn't appear to have been reached. I read the entire FTC complaint list that was recently released. There were many complaints regarding the "do not call" list. I could be missing something, but the volume and content of complaints seems weak.

The upside risk? Continued strong business performance, the FTC and or SEC releasing a clean bill of health (never seen a report like this so it is unlikely to happen), weak shorts / leveraged forced to cover, and or Herbalife going private. It has gone that route before, as did Pre-Paid Legal. In the event that Herbalife went private, say at $80 (or 16x of $5eps, or 20x $4eps) the cost to Pershing Square might not be that severe from a financial perspective. From an entry point of $50, the hit could be $600 million, or from the low point of $25 the hit would be closer to $1.1 billion. At December 31, 2011 J.C. Penney's (NYSE:JCP) was $35.15 and closed February 15, 2013 at $19.80. The ability to withstand adverse price movements should not be a question. It has been done multiple times over the past decade.

As long as capital remains with Pershing Square it is doubtful that a short squeeze would derail the short Herbalife position. Pershing Square has set up a Guernsey based fund with 132 investors contributing over $1.142 billion. This article from 2011 suggests an IPO providing permanent capital was being considered. Time will tell what happens with that project and the level of disclosure investors might enjoy. Might an IPO force the disclosure and identity of short positions? That would be interesting.

Bottom line: Making a trade based upon rumors or a hoped for short squeeze is not investing, it is speculation. Nothing wrong with speculation as long as one can afford and/or understand that the risk of loss can be high. Time will tell what side wins with Herbalife and what the next move will be.

Source: Herbalife: Do Not Expect A Short Squeeze