Herbalife Convertible Debt Deal Screams Risk-LBO Dead

Feb. 3.14 | About: Herbalife Ltd. (HLF)

Herbalife (NYSE:HLF) investors awoke to a flurry of news items this morning. Are they bullish or bearish?

First, Michelle Celarier of the NY Post reported that FTC Chair Ramirez will be meeting face to face February 5th with consumer advocates and former distributors to listen to the concerns of this group.

Second, Herbalife released an 8-K to pre-announce its 2013 earnings and reiterated its guidance for 2014. These numbers seem much ado about nothing maybe?

Third, the company announced an increase in their share buyback program from $1.0 billion to $1.5 billion.

Fourth, the company announced the planned issuance of a $1 billion convertible debt offering. I have not read a prospectus for this debt deal but look forward to examining the details.

Ostensibly, this flurry of news may look good for HLF longs. Longs have been awaiting a debt deal to finance a levered recap for quite some time now. In the end, the news is likely disappointing. Here's why.

For a quick tutorial on convertible debt visit here.

Q. Why is Herbalife doing a convertible debt deal?

The simplest way for a company like Herbalife to raise money would be to borrow it from a bank. A company with a solid investment grade credit rating should have no trouble raising capital at a low rent. Evidently, this option was not available to HLF or if it was the cost of the money was likely usurious.

A second way the company could raise money would be by selling bonds to institutional investors. A straightforward 5 year note with a healthy coupon should equally find a bid from pension funds and other big money investors. This should certainly be true in a world that is starved for yield. Did Herbalife opt for this option? No.

Instead, what investors are left to digest is the following. Herbalife is issuing $1 billion worth of notes to buy back stock (accretive?) so that the notes can then be converted at some later date to reissue stock (dilutive).

The company will likely benefit on a cashflow basis as the coupon they will have to pay will in all likelihood be lower than a traditional note. It is important for investors to understand, however, why the coupon is lower. The coupon is lower because the investors also get an embedded call option/warrant with the note to acquire HLF common at some point in the future.

If, for example, the conversion price for the note is $75 and HLF common trades up to $80. Bond investors will be "in the money" $5 per share. Upon conversion the total return would be recovery of principal plus coupon received plus capital gain on mark to market value of the equity.

The way to think about a convertible bond is that the coupon/yield is deferred. The company receives the cashflow benefit in the short run but in the long-run the convertible issue is far more expensive to the company than a traditional bank note and/or traditional debt deal.

Also, consider where this debt ranks in the company's capital structure. The debt deal is not being used to refinance the existing credit facility. Rather, it is layered below this facility at a more subordinate layer of the capital structure.

Herbalife is now a levered entity with very little collateral on its balance sheet. Equity holders now find themselves decidedly subordinate to the company's bank group and noteholders.

This new dynamic should result in the following outcome. Herbalife's common shares should see a contraction in the P/E multiple going forward as an offset to the risk profile of the newly levered balance sheet.

Investors must now, also, consider the following potential outcome.

Herbalife notes will trade in the secondary markets one would expect. Investors may be able to short the bonds outright and/or buy credit default swaps on the debt. Common equity typically trades off whatever is happening in the bond market.

Historically, HLF bank debt has not seen a secondary bid/offer spread. Only the equity has been used as a security to proxy the risk profile of the HLF pyramid scheme thesis. This dynamic now changes and it changes in a material way.

Who will buy these convertible notes?

Your guess is as good as mine but here's one thing I don't get. If you were an investor like Bill Stiritz which part of the capital structure would you want to own?

a) the most junior level or

b) a more senior level that pays you a coupon while giving you a conversion option?

Hard to say.

Herbalife's new debt deal stinks. It reveals a level of desperation by the company's board.

Why?

The bond market is known as the "smart money". Here's what the smart money is telling you. If HLF common was truly undervalued a debt issuance wouldn't be so expensive. If repurchasing HLF common was an obviously accretive transaction at these prices bond market investors should seem to be content to receive a straight 5% coupon on a simple term note. IF HLF's business plan was straightforward and riskless, HLF bond investors would not be able to demand a conversion option in the terms of their debt.

Instead, the only way HLF seems to be able to raise money is by giving-up some future percentage of the company's equity to its bond investors. These are the terms the bond market demands.

Is this the levered recap investors were looking for?

You be the judge. Certainly, an LBO seems increasingly unlikely. Heck, if these are the terms for $1 billion in debt what would the terms for $5 billion required for an LBO look like?

Over the next chunk of time HLF will borrow $1 billion from investors who will then receive a coupon paid semi-annually plus some kind of warrant/option to buy HLF common in the future. In the interim, the cash will be used to reduce the Herbalife share count.

Whether or not investors like Mr. Icahn or Mr. Stiritz begin to sell their shares into this buyback remains to be seen.

Whether or not equity investors will discount this news as positive or negative remains to be seen.

Still, 3 things are for certain.

For investors in HLF new notes and/or HLF common to get their capital back 3 things have to happen.

1) The business must continue to recruit more people in the future.

2) The company's operating results must remain stable and

3) The company must escape regulatory action in multiple jurisdictions around the world.

Yesterday, Herbalife was a pyramid scheme. Today we learn that Herbalife is about to become a levered pyramid scheme. Now, not only do equity investors bear the risk of a government shut-down but so too will the company's new noteholders.

How long will it take for us to learn that Mr. Ackman has acquired CDS on the new notes or sold the bonds short too?

We'll see.

Still, if you are long HLF common beware, your position just got riskier.

The company just piled $1 billion worth of debt on top of your position in the capital structure.

Are you getting paid enough for that risk on a go forward basis?

Buy, Sell or Hold?

That is the question.

Disclosure: I am short HLF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.