- Herbalife booked an important victory by securing a clean audit from PricewaterhouseCoopers.
- I judge regulatory action with the intention of shutting down Herbalife to be of extremely low likelihood.
- The long side of the trade consists of highly successful value investors with a convincing long-term track record.
- Leveraged Buyout/Taking private transaction would be major catalyst for Herbalife's stock.
It's not good to be short in light of Herbalife's (HLF) upcoming earnings release. The nutritional supplements company is going to report fourth quarter 2013 earnings on February 18, 2013 which investors are sure to put under the microscope. Herbalife pre-released earnings on February 3, 2014 which point toward very decent quarterly results for the company:
- Net sales for the fourth quarter 2013 are expected to grow 19.8% while full-year net sales are estimate to increase 18.5%
- Fourth quarter adjusted earnings on a diluted basis are expected to come in at $1.26-1.30 per share. Fourth quarter reported EPS is expected to come in at $1.13-1.17 vs. $1.00 in the year ago quarter
- Full year adjusted earnings on a diluted basis are expected to hit $5.35-5.39 per share. Reported diluted EPS for the full-year is expected to come in at $4.89-4.93 vs. $3.94 in 2012.
Most notably, on February 3, 2014 Herbalife announced a $1.0 billion convertible notes offering with the intention to use the majority of net proceeds for share repurchases. The following excerpt from Herbalife's press release breaks down the use of the $975 million in net proceeds the company expects to receive:
The company estimates that the net proceeds from the sale of the Convertible Notes will be approximately $975 million, after deducting the initial purchasers' discounts and commissions and the estimated offering expenses payable by the company. The company intends to apply approximately $686 million of the net proceeds to fund the cost of purchasing common shares by entering into prepaid forward share repurchase transactions and approximately $111 million of the net proceeds to fund the cost of certain capped call transactions, each as described below. The company expects to use the remaining net proceeds from the offering for working capital and general corporate purposes, including, without limitation, the repurchase of outstanding common shares.
Two things have been made clear by Herbalife by its two press releases in the beginning of February: First, there is no sign that EPS growth loses traction and that Ackman's Short campaign is having no impact on its business whatsoever. And secondly, the company will do whatever it can to defeat Ackman and inflict as much harm on him as possible.
While I am all for a constructive dialog and support Herbalife's approach to share repurchases, the company should have clearly refrained from launching a campaign against Ackman and instead counter his claims factually and without interference of emotions. I think Herbalife actually put itself in harm's way by trying to get Pershing Square investors to withdraw their funds. On December 9, 2013 Bloomberg reported:
Now Herbalife is approaching investors in Ackman's hedge fund, suggesting they pull their money from the $12 billion firm, according to three people with knowledge of Herbalife's strategy. Herbalife's argument: Ackman's bet, which has lost as much as $500 million, is risky and irresponsible, said the people, asking not to be named because the campaign is private.
Moelis & Co., an investment bank working for Herbalife, arranged a meeting with Cliffwater LLC, which advises clients on hedge-fund investments, and Herbalife executives, according to two people with knowledge of the gathering. Moelis also reached out to New Jersey's $76.7 billion pension fund, which has $207 million invested with Ackman, said the people. Executives of the New Jersey fund haven't met with the Herbalife camp.
Short thesis carries little weight
Ackman's Herbalife Short thesis had two key pillars until recently:
- PricewaterhouseCoopers not signing off on Herbalife's financial statements
- Regulatory action with the intent to shut down the company and drive the stock price to zero.
The first pillar has been crushed as PricewaterhouseCoopers indeed successfully completed the re-audit of Herbalife's financial statements for fiscal years 2010, 2011 and 2012 in December 2013. Ackman previously tried to sway Herbalife's new auditor by sending a 52-page letter (here) to the Chairman of PricewaterhouseCoopers. Potential liability issues and standard risk management practices will have made sure that the lead partner on the Herbalife job did a most thorough job.
The second pillar of Ackman's thesis relates to regulatory action, domestic and/or abroad, that would classify the nutrition and weight loss company as a pyramid scheme. I personally think that regulatory action is a low-probability event. Regulatory agencies have educated, experienced staff at disposal that has dealt with multi-level marketing companies before. Regulators now have had more than a year time to conduct the necessary due diligence.
Many investors refer to Ackman's famous Short of MBIA (MBI), which he initiated in the early 2000s and held on to until the share price collapsed at the beginning of the financial crisis, as an example of his analytical skills. The financial crisis came exactly at the right time and a collective punishment of financial stocks certainly helped. However, Ackman doesn't have a reputation or an extended record as a shortseller. In fact, Ackman's street credibility actually has taken two massive hits: The first refers to his ill-advised outsized bet on Target (TGT) and, most recently, his investment in department store company J.C. Penney (JCP).
A group of highly acclaimed investors have taken the opposing position to Ackman's Short. Investors like Carl Icahn, George Soros, William Stiritz and Stanley Druckenmiller are formidable investors whose Herbalife endorsement I would take seriously. At the time being it looks as if Ackman is fighting the world and I doubt that regulatory agencies are going to dance to the beat of Pershing Square. After all, Herbalife is not a newly established company but in business for decades and working right under the nose of regulators. Also, Icahn does not appear to want to sell his Herbalife shares despite sizable profits and the end of his lock-up period.
I think Herbalife's Q4 2013 results are going to create new momentum for Herbalife especially when the company manages to surprise to the upside. An aggressive financing maneuver in the form of a leveraged buyout/taking private transaction would be a major catalyst for Herbalife's stock price. Stiritz already indicated his willingness to participate in a LBO.
Regulatory action is unlikely and with PricewaterhouseCoopers' clean audit, Ackman is as isolated as never before. I judge an intervention by regulators to be a very low probability event and will hold on to my Herbalife shares.