Is Pershing Square Done Restructuring?

Includes: HLF
by: Matt Stewart

In a recent article I wrote I pointed out that Carl Icahn is unable to sell his stake in Herbalife (NYSE:HLF) until the stock trades above $73 for 5 days in a row.

Pershing Square's revelation that they have covered 40% of their short position has knocked the wind out of HLF's share price. Today, the stock trades around $68. Effectively, Pershing Square has boxed Icahn in at least for the time being. If HLF continues to trade below $73 Icahn will be boxed until February absent some kind of takeover transaction.

There are 4 variables Pershing Square has taken advantage of with the restructuring of its position.

1) The Passage of Time

2) A Decline in the Cost to Borrow HLF shares

3) Valuation Asymmetry

4) Bullish Sentiment

The Passage of Time

Both Carl Icahn and Dan Loeb effectively took advantage of the time lapse between Pershing Square's allegation that HLF is a pyramid scheme and the time required for any investigation to be completed. Aggressive purchases of HLF shares have driven the share price higher. However, the longer time goes by the more likely it is that regulatory investigation/due diligence will have run its course and the result of any investigation will be revealed. If HLF is found to be a pyramid scheme, the passage of time does not favor long investors but rather begins to favor the shorts.

Ackman has done a sound job of blocking and tackling against Icahn's push for a levered buyback by questioning HLF's accounting and now covering his short thesis. It is also unlikely Mr. Icahn predicted that the KPMG insider trading case would delay his plans for an aggressive buyback. He probably hoped to get that done before the regulators could complete their work. My guess is Icahn planned to punt his stock into the levered buyback at a price north of $73. Increasingly, this strategy seems tenuous due to the passage of time.

Decline in Borrowing Costs

A decline in the cost to borrow HLF shares likely reduced the Time Value of the HLF put options acquired by PS. The swap from a short sale to a long put transaction was a win/win if the pyramid scheme thesis comes to fruition. Return on Invested Capital should be higher if all goes well on this new, levered position.

Valuation Assymetry

If HLF is a pyramid scheme in all likelihood the stock is worth $0. If it is not, let's assume that Tim Ramey's $92 price target is reasonable. If Ackman is likely to be right 80% of the time and Ramey right 20% of the time the expected Value of HLF stock becomes roughly $19 (NYSE:EV) = ($0 x 80%) + ($92 x 20%) The higher the HLF share price trades the greater the risk/reward ratio tilts to the short side. This makes the acquisition of put options tenable and prudent.

Bullish Sentiment

The bullish side of the trade has been somewhat crowded of late. Soros, Icahn, Stiritz, Ramey plus the company's own share buybacks have corralled a good chunk of the public float into friendly hands. Ackman has managed to escape this squeeze at least on some level by covering roughly 10 million shares while also delaying the buyback.

This begs the obvious question: Is he done?

The revelation that PS covered ten million shares snapped 7% off the share price. Might PS go back into the market and continue to swap out its short position in favor of additional put options with the stock in the high $60s?

The advantages of this idea would seem prudent.

1) PS could continue to reduce the amount of capital it has exposed to this investment thesis

2) The upside profit potential could remain intact

3) The revelation that additional shares sold short have been covered would likely place additional downward pressure on the stock price leading to a rise in the value of the Put options

4) The possibility for a short squeeze would be eliminated

5) If regulators act some time between today and February of 2014 (4 months of time value) Mr. Icahn would stand to lose a huge % of his investment giving PS a psychic victory over Icahn.

6) PS could realize tax losses on the mark to market losses on its short sale for the current fiscal year for investors while remaining exposed to the potential for profits in the future.

7) If HLF does in fact gear its balance sheet PS seems intent upon reallocating capital to CDS securities on the debt.

In the interim, investors continue to wait for clarity on HLF's financials. In spite of Tim Ramey's prediction that HLF's audited results would be released in September, no results have been released. The company will report 3Q earnings in 3 weeks. How will the company explain itself if its financial results are still not ready?

PS has fired a number of warning shots of late. It has warned HLF's auditors to make sure they are thorough in applying FASB guidelines to HLF's audited financials. They have forewarned bankers to be careful if they decide to underwrite an aggressive HLF buyback. De minimus, these bankers are being asked to question the price of the debt. PS has also broadened the scope of its regulatory investigation to include issues like product quality and safety in addition to pyramid scheme allegations.

The battle for analytical supremacy rages on.

If I were a betting person I would assume that PS will continue to whittle away at its short exposure here in the coming trading sessions as the company is in its quiet period leading up to its Q3 earnings release.

Of course, if regulators can get out ahead of Mr. Icahn's self-inflicted February deadline while PWC continues to review its financials such an outcome would only be a "cherry on top of the Sundae" for PS

It remains to be seen who will have the last laugh in this unfolding drama. One thing is for sure, as each month goes by the final act moves ever closer.

As for whether or not PS is done covering their short? I wouldn't bet on it if you are long.

Pershing Square has mark to market losses on its short sale of HLF. Icahn has mark to market gains. A single piece of newsflow could change that outcome overnight.

I remain convinced that HLF is a pyramid scheme that should be shut down because it markets a business opportunity that does not exist.

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.