Bill Ackman eventually threw in the towel and took his losses in his short position in Herbalife (HLF). He initiated his short position in 2012 thinking that the stock would go down to zero but instead he incurred excessive losses. In this article, I will analyze why Ackman should not have shorted the health products company.
First of all, Ackman claimed that Herbalife would never get a major internal auditor and a clean audit opinion, it would be shut down by the FTC and it would not be able to refinance its debt. All these expectations were proven wrong so most investors think that these unfulfilled expectations explain why Ackman lost his bet. However, this is not true. In fact, the FTC has posed to Herbalife very strict limitations, which have pronouncedly hurt the results of the company. To be sure, its Q3 sales plunged 17% in its major region, North America, while they also fell 2% in China, which is viewed by the management as a critical growth area. Moreover, the total sales of the company have fallen 10% in the last three years while the earnings per share are still 10% below their level in 2013. This poor performance confirms that the restrictions posed by the FTC have markedly affected the business model of the company and its results. Consequently, Ackman did not lose his bet due to his wrong allegations on the business model of the company.
The major reason for his loss is the fact that time works against short sellers and usually exhausts them. To be sure, short sellers have to pay for the cost of borrowing the shares they short. Therefore, the longer it takes for their thesis to materialize the heavier the cost to them. In addition, short sellers pay for the dividends distributed by their shorted stock. Herbalife paid dividends of $1.50 per share in 2013 and 2014. Although the amount may seem negligible, it is 4% relative to the stock price at the end of 2012. And even though this cost still seems low, it adds up to the other time costs that short sellers incur and hence it renders short positions even harder to maintain.
While dividends exert pressure on short sellers, Herbalife decided to eliminate its dividend in 2014 in order to hurt Ackman with a more powerful tool, namely an aggressive program of share repurchases. It is remarkable that the market found the bearish view of Ackman credible and thus punished the stock of Herbalife with a 50% plunge due to its high risk. As a result, the stock started to trade at a markedly low P/E ratio, around 10. Consequently, the share repurchases of the company became much more efficient, as the earnings were sufficient to reduce the share count by up to 10% per year. Indeed Herbalife has reduced its share count by 30% since Ackman initiated his position. Therefore, ironically the adoption of Ackman's thesis by the market backfired to him, as the cheap valuation of the stock greatly enhanced the efficiency of its share repurchases.
This is a precious lesson for those who consider short selling stocks. If a company wants to make its short sellers suffer, it has many ways to achieve this. By leveraging its balance sheet, it can distribute excessive dividends or execute aggressive share repurchases. Even worse for short sellers, while the company tries to make its short sellers suffer, time works against them. Moreover, even if the bearish view eventually proves correct, the market can remain irrational much longer than the short sellers can tolerate bleeding.
Herbalife certainly leveraged its balance sheet in order to torture its short sellers. To be sure, its net debt (as per Buffett, net debt = total liabilities - cash - receivables) has almost doubled, from $0.8 B in 2012 to $1.5 B in the most recent quarter. This amount of debt is 7 times the book value of the company. Moreover, this stretch of the balance sheet has caused the interest expense to jump from 3% of the operating income in 2012 to 22% of the operating income this year. Due to this pronounced increase in its leverage, the stock has now become highly exposed to any unforeseen headwind it may face at some point in the future. Nevertheless, short sellers cannot wait till then because they keep paying for maintaining their short positions year after year. Even worse for them, as long as the broad market remains in an uptrend, which is the case most of the time, leveraged stocks usually perform well.
It is also ironic that the continuous bleeding of the short position of Ackman forced him to close it at a time when Herbalife seems to have much more downside than upside. More precisely, all the positive catalysts, such as the FTC clearance and the tender offer for share buybacks, have played out and have thus resulted in a markedly rich valuation for this specific stock, which is trading at 15 times this year's earnings and only 15% off its all-time high. While this valuation may seem reasonable for other stocks, it is rich for Herbalife, as the company is making a major transition in the aftermath of the FTC requirements. This transition is certainly taking its toll on the performance of the company, as its sales are suffering in North America and China. All in all, Ackman threw in the towel now that the stock has much more downside than upside potential but no-one can blame him, as the time cost of a short position can easily exhaust even the most confident investor.
To sum up, even if a bearish thesis eventually proves correct, short sellers are likely to lose great amounts of money (and sleep) from their short positions, as time works against them in several ways; borrowing cost, dividends and share repurchases. As a result, they are likely to throw in the towel long before their thesis materializes. This is why Ackman should not have shorted Herbalife.
Disclosure: I/we 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.