How The Herbalife Short Squeeze Would Work

| About: Herbalife Ltd. (HLF)

The only thing driving the price of Herbalife (NYSE:HLF) right now is news about Bill Ackman's campaign against the company, and the major long and short positions being taken by hedge funds. Last week, on CNBC, Carl Icahn said there would be "the mother of all short squeezes" and Ackman would take a huge loss. Most assume the short squeeze would come from the company ramping up stock buy backs, others say the company has no need to do that. To understand how the short squeeze could happen, you need to first understand how Ackman took his position.

How do you short 20 million shares of the stock?
When an average investor wants to short a stock they just put in the order with their broker, who arranges for them to borrow the stock from someone else or the brokerage itself. They need to have a certain amount of equity in the account (usually 50% of the trade value) before the order can be placed. They must also pay interest on the amount borrowed and pay the owner for any dividend amounts that the stock pays.

If a hedge fund wants to short 20 million shares of stock when there are only 97 million shares available to the public, the process is a little bit different. Broker-dealers often arrange for short sellers to borrow from large institutional investors, like pension funds. This would normally be a conflict of interest, to lend someone your asset so they can devalue it, but the funds take part because they can realize current income on investments they view as long term. So, at this time, there are a lot of investors who have lent Bill Ackman their shares of Herbalife even though they believe the stock will still be worth something when they get their shares back. If they were to decide that they do not want to risk the stock being driven to zero, as Ackman says it will, they would either increase the cost to borrow the stock or call their shares back all together.

Borrowers of the stock have to pay the owner the amount of any dividend that they would have received. Herbalife currently pays a $0.30 quarterly dividend, with the next one near the end of February. Short sellers will have to pay a collective $11 million in dividends to maintain their position, Bill Ackman will account for about $6 million of that. It is estimated that the cost of borrowing at this point, including dividend payments, could top 20% of the trade, annually.

It is important to remember that the investors allowing Ackman to borrow the stock are collectively making a $1 billion bet that he is wrong, and that the stock will not be worthless in the long term. They are essentially letting him pay them interest to use their shares to try to fight the company, but they will take the shares back and sell it themselves if they really believe it will soon be worthless.

The Short Squeeze
A short squeeze generally happens when there are large short positions in a stock that runs up too much and the shorts have to buy back at a loss. This buying triggers even more buying and the stock runs way up because there are no sellers left in the market. In Herbalife, this is not the only way a short squeeze could play out, even if the stock is already moving down. When investors want to sell the stock they own, the brokerage may start calling back short sellers to cover the shares they borrowed from the brokerage clients, essentially causing the short seller to have to buy immediately to replace the shares. If a third of investors decide they want to be sellers of the stock, that will cause all of the short sellers to become buyers of the stock. The unprecedented amount of short interest could actually turn into a temporary price floor. That price support could conceivably cause some investors to want to stay in the stock longer, further propping up the price by reducing the number of sellers in the market. The short squeeze, in this instance, might not be a crisis of outsized buying but rather a lack of supply in the market.

Fundamentals are still there, and it's not illegal.
The real basis for Ackman's short is that the business model is illegal and will be shut down by the government. The government has had years to look into Multi-level Marketing companies like this, and has passed. Herbalife has not done anything recently that is going to make it more of a target than it has been in the past and it, by many accounts, is a legitimate business. The company has also proven its ability to generate revenue growth in new and emerging markets, and its ability to move to more of a retail sales model, when necessary.

For an extensive analysis of the company's financial situation, read Buy Herbalife For These Compelling Reasons. You can find out more about how the Multi-Level Marketing model works by reading Insight From A Former MLM Partner.

CNBC's Jim Cramer believes that the only thing that can drive the stock to zero is government intervention, saying "The charge of a pyramid scheme just hasn't created a mass exodus in the stock. And the preannouncement of a good quarter suggests the business remains in tact." Cramer adds that he does not recommend the stock for anyone, and he believes that money can be put to work elsewhere. (article here)

Herbalife does not seem to be going anywhere quickly, and is not as easily influenced by short sellers as many of them would like you to believe. It still is not for the faint of heart but, if it is a stock you're interested in for the future, this may be an incredible opportunity to get in at a great price while a few billionaires duke it out in the media.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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