Herbalife (HLF) investors have digested a lot of information in the past 24 hours. This morning, the company released an 8k outlining the final pricing and terms of its brand-new convertible debt deal.
Beauty is in the eye of the beholder, they say. Longs who may believe that Herbalife common trades at a meaningful discount to its intrinsic value will laud the deal as a responsible capital allocation decision on the part of the HLF Board.
Shorts, like me, equally celebrate this news. It is my thesis that HLF common trades at a meaningful premium to its intrinsic value, and that therefore, this debt deal will turn out to be an albatross around HLF's neck and a tailwind for Mr. Ackman.
My guess is that Mr. Ackman is licking his chops too.
Here is why.
First, a quick look at Herbalife's balance sheet reveals that this is a company that lacks "hard assets" to collateralize any material debt obligation. This is likely the reason HLF was unable to secure a bank loan and/or a straight term loan.
Remember, it is the job of the Herbalife Board to negotiate for the best terms and conditions available on behalf of equity holders when doing a capital raise. The convertible debt deal was the best deal available. I view this as an ominous signal for stockholders.
Convertible debt gives bondholders a unique ability to hedge their position. Because of the conversion option embedded in the note, bondholders can immunize themselves against downside risk by shorting HLF common (in this case, by way of a forward contract/swap). It strikes me as obvious that HLF was unable to raise new debt without offering investors downside protection. Hence, the convertible.
Why would investors want downside protection against capital loss for a company that gushes so much cashflow?
Perhaps concerns over the legitimacy of Mr. Ackman's pyramid scheme thesis have some gravitas?
Consider too the additional expense of the conversion option. Notwithstanding the fact that this note has a 2% yield, there are extra costs layered into this deal. For starters, the capped call contracts are a cost, then there are the underwriting fees, and finally, there is the inevitable redilution to equity holders 5 years hence if the stock trades materially higher. As a short, of course, this does not worry me too much.
This morning, investors awaken to the knowledge that Herbalife has more financial leverage than it did yesterday. This may juice EPS to the $7 range for 2014 (as of this a.m., HLF seems to trade around 10x that adjusted number). Alternatively, it may feed right into the short thesis.
Mr. Ackman remains unrelenting in his pursuit of his short thesis. Perhaps inspired by the FBI's Most Wanted List, yesterday Pershing Square launched a new website that will build out over time the Herbalife "Wall of Shame". Private investigation of some of Herbalife's Top Distributors has revealed a long running pattern of deception and misrepresentations by HLF's top recruiters. Canadian Shawn Dahl is Pershing's Public Enemy #1. This new website shines sunlight on this conduct and places direct reputational pressure on HLF's most senior networkers. How these individuals will respond is anyone's guess.
Pressure is also being applied by activists who continue to seek face-to-face meetings with senior regulators to help expose the HLF fraud. How much traction is being gained remains to be seen. We are told that tomorrow FTC Commissioner Ramirez will meet face-to-face with Latino advocates.
Equity investors seem confused, to say the least. True, the likes of Mr. Icahn and Mr. Stiritz are committed to their long thesis as they now own over 30% of the company post buyback. And yet, HLF common continues to struggle to gain a bid in excess of 10-12x EPS. This is a meaningful discount to the market at large and certain industry peers. Seemingly, many equity investors don't necessarily share Mr. Icahn's nor Mr. Stiritz's enthusiasm.
Is this a value gap for these investors, or are they just wrong?
In the interim, HLF's shares seem to see-saw +/- $10 dependent upon the newsflow of the day.
As investors, we have no evidence that either Mr. Icahn or Mr. Stiritz or Mr. Ackman are about to abandon their positions. On the contrary, each one of these guys seems to be digging in deeper in their trenches/defending their turf.
For certain, Mr. Icahn has thrown the kitchen sink at Mr. Ackman over the past year. Short of an LBO, Mr. Icahn has squeezed Pershing Square and squeezed them hard. Still, bloodied but unbowed, Mr. Ackman remains committed to his thesis.
This begs the question:
What might Mr. Ackman know that the rest of the world doesn't?
In the not-too-distant future, we are likely to learn quite a bit about how this pathetic convertible debt deal impacts the shares of Herbalife. The equity market will start to discount the short-run impact of the recapitalization, if it hasn't already.
We have also been told in the past that any new debt deal by HLF would be met with enthusiasm by Pershing Square, as they would be able to then buy Credit Default Swaps on the HLF debt. Might we come to learn that Pershing Square has purchased CDS contracts in size, restructured its short position yet again or some combination of the two?
How will the market react if Mr. Ackman actually adds to his short position in the face of what might, ostensibly, be a positive deal for longs?
I suppose we will have to wait and see.
Over time, Mr. Ackman's thesis plays out if either:
a) HLF's business fundamentals deteriorate or
b) regulators shut down the pyramid scheme
Either way, $1 billion of new debt is not a tailwind for equity holders should either of these outcomes materialize.
For certain, we have no idea if HLF's recruiting juggernaut will continue to succeed in 2014. We also have no idea if regulators are going to drop the hammer too.
Mr. Ackman's thesis is that Herbalife is an illegal pyramid scheme that will be shut down by regulators. I agree with this thesis. As a result, this new debt deal is seen through my lens as an added layer of stress to the HLF balance sheet at a time when its business prospects seem most uncertain.
Mr. Stiritz sees Herbalife as a legitimate business with a valuation that is temporarily being stressed by the malevolent musings of a hedge fund manager. Once this cloud lifts, the levered buyback should yield windfall profits.
These two positions could not be more opposite. Only one can be correct.
Herbalife's Board of Directors has acted very aggressively over the past 48 hours. One could argue that a prudent course of action would be to allow free cashflow to build up in the company's coffers until such time as the pyramid scheme cloud has been lifted from the company's reputation. Instead, the Board has decided to gear the balance sheet to buy back stock under less-than-ideal terms and conditions.
If you think this debt deal is a vote of confidence for HLF common, think again. The only way that HLF could raise this money was because bondholders are basically set up to arbitrage a risk-free 2% yield that is fully hedged. If anything, this debt deal tells us that the bond market is petrified that Mr. Ackman is correct.
Whether or not this aggressive capital allocation decision turns out favorably remains to be seen. In the short run, it looks good maybe ($70 plus this a.m.). Of course, a single headline can change all of that overnight.
Levered or not, Herbalife remains a global pyramid scheme that deceives recruits with a complicated, rigged, and opaque marketing plan. Is it any wonder the company's debt deal was anything but simple too?
When you trade in complexity, smoke and mirrors habits are hard to break.
The sooner regulators close down this confidence game the better.
Finally - is Mr. Icahn now out of bullets short of an LBO? Does the upper hand now shift to Mr. Ackman?
Stay tuned ...