Q. for all Herbalife (NYSE:HLF) investors: Who is the "smart money"?
If you answered John Hempton or Tim Ramey guess again.
If you said the bond market you win a prize.
Below is an image from a Bloomberg terminal.
This image shows the daily price action for Herbalife's convertible bond that was offered less than 6 months ago at par to investors with a conversion price just shy of $90 per share.
Today, secondary market investors are treating this issue like a "busted convertible" (easy to learn what this is by Googling this term).
Most importantly, the YTM on this 5 year bond has exploded out to North of 6%. Michael Milken would no doubt be impressed by its junky nature.
Bloomberg is kind enough to tell us the spread v. the comparable US Treasury Note. 400 + bp seems Grand Canyon-like. Until, of course, you actually examine Herbalife's balance sheet in detail.
Recall, Herbalife has two main pieces of debt on the books. A bank loan just shy of $900 million made up of a term loan and a revolver. The term loan matures in 2016.
Subordinate to this bank debt is the company's brand spanking new $1.2 billion convertible bond which pays a measly 2% coupon but promises investors upside potential if and when HLF common trades north of $90. Today the stock is below $50.
Herbalife doesn't really offer junior bondholders much in the way of collateral. Cash balances are held mostly off-shore and must be haircut by $109 million for the fictitious accounting of the Venezuelan Bolivar employed by the ever creative John De Simone. Property ownership is scant but for the new facility in Winston-Salem. Inventory is worth something to someone I am sure but hardly a bloated account. As for the intangibles? Hard to say.
Of course, you have all of the potential contingent liabilities too if Herbalife is prosecuted as a pyramid scheme. This could be a massive number. Bottom line, if you aren't the bank group you don't have much security as an HLF convert holder unless you are short the common stock.
The fact that spreads on this bond have blown out is a material event.
a) The more senior part of the capital structure is generally more desirable if you are a creditor of the company. If the rate of return demanded in the bond market goes up, equity investors, too, shall seek a higher rate of return for the risks they are taking. Put another way, the discount rate for the company's cashflow changes materially. Is it any wonder HLF common now trades below $50 per share?
b) More ominously, the bond market is sending investors a big smoke signal here. What the bond vigilantes are telling investors is "We're worried. We're worried about your ability to repay this debt when it comes due. We're worried that your cashflow is deteriorating. As a result, we need a higher rate of return to hold your paper."
Q. Are these fears rational?
For the answer to this question let's turn to Nu Skin's results this morning. Nu Skin (NUS) reported negative YOY sales numbers, an increase in their inventory on hand and a weak guide for Q2. In the pre-market the stock is quoted at less than $50 per share. As recently as January 1 the stock was north of $100. How quickly things change.
Nu Skin's revaluation is a problem for HLF longs.
a) The company has a cleaner balance sheet than HLF with positive Book Value
b) The company seems to have less regulatory risks, maybe, than the good ship HLF
If Nu Skin investors have revalued the common to 1x Revenues give or take, what should HLF be trading at? (If you said $30 or so you are on the right track)
Mr. Icahn always wanted to recapitalize HLF's balance sheet from the moment he went long HLF common. Unfortunately, the Scott London insider trading scandal derailed his timeline. A year later, he finally pulled off the convertible debt deal and took down a huge chunk of HLF common in the process. Unfortunately for Mr. Icahn, two other events occurred at the same time.
a) The entire MLM sector was revalued and
b) Operating results deteriorated in the space
Ergo: Herbalife's share multiple contracted making much of the buyback seemingly dilutive. Oops!
In an ironic outcome, the bonds so coveted by arbitrageurs are now an albatross around the necks of longs like Mr. Stiritz and Mr. Icahn. What we can say for certain is the following: As long as the bond vigilantes dislike HLF's credit worthiness the common stock's valuation is likely to remain suppressed.
In the interim, various regulators continue to wind their way through the company's opaque nature in order to get at the truth. As a reminder, the truth is that Herbalife is the sponsor of a global confidence game that defrauds low-income people in places like Mexico with precision and calculus. Ever wonder how come Mexico is only 2% of global GDP but 11% of Herbalife's sales? If you said that Club Ciento targets unsophisticated affinity groups you are on the right track.
At this point I have to admit I feel a bit sorry for some of the sell-side analysts who actually listen to what company management tells them as if they are credible and unbiased sources of information. I suppose it is human nature to want to see the good in people. Then again, isn't this exactly the sort of psychology that Herbalife preys upon with its exaggerated earnings claims and its mathematical fallacy? Of course it is.
I also wonder what Tim Ramey and Bill Stiritz talk about when they pass one another in the hallway at POST's headquarters. Whatever it is, the bond vigilantes seem to be in some state of overall disagreement.
I don't really get the long thesis here for HLF I must admit. Growth metrics are deteriorating, the business model is long in the tooth, customers have little to no lifetime value, evidence of business failure is ubiquitous and apparent, the products aren't particularly unique nor differentiated nor competitively priced. Meanwhile, intelligent regulators with PhDs in Mathematics or Law Degrees from Ivey League schools are working away feverishly and analyzing mountains of evidence that clearly shows distributors and management caught with their hands in the cookie jar.
Q. Will Mr. Icahn's foray into HLF common ultimately result in a round trip of epic proportion or perhaps even worse?
Based upon the smoke signals coming from the bond market, the odds have certainly increased.
25 Million shares between Mr. Icahn and Mr. Stiritz is an awful lot of stock to move. Though I suspect that Mr. Ackman might be a willing buyer when the common is a hat size.
The bond vigilantes don't like what they see. Refinancing and or rate risk looms on the horizon. If HLF prints a bomb like Nu Skin just did today in future quarters it could only get worse. Then again, Herbalife might be able to find 3 million new "members" in Burundi and Vietnam.
Disclosure: The author is short HLF. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.