Friday, February 22, 2013

Ackman, Icahn and Herbalife: no longer a blitzkrieg, now a siege

So by now now most people are familiar with key events in the Herbalife drama: The conference call questions by David Einhorn, The massive Ackman powerpoint, The entry of Dan Loeb, the televised Ackman/Icahncatfight, the Icahn 13D, the Ichan CNBC interview, the HLF earnings and the HLF conference call at which Pershing Square may or may not have been prevented from asking questions David Einhorn style.

The drama of the personalities has been so intense I think that many investors who watch this stock, think that there will be some kind of quick dramatic resolution. In this post I will argue that there will not be. I do think that the odds favor one side over the other but I think that we are a very very long way from a resolution, and when it comes most people who trade the name will not be part of it.

First, let's have a look at Ackmans position. He has done 18 months of research and has made a massive presentation outlining it. When the company responded that he simply didn't understand their business he sent them a list of 284 follow up questions and dared them to answer them. In summary, the Ackman thesis is that Herbalife is nothing more than a pyramid scheme. An extremely well managed one, but a pyramid scheme nonetheless.

He claims that the primary rewards to distributors are generated not by actual sales but by recruiting new distributors. In support of this thesis he points out that the company does not really track sales to end users and accuses the company of overstating the value of its sales by recording them generally at the suggested retail price when in reality many of these products are available on the internet not only below the SRP but also below the levels implied by the distributor discounts. 

He also makes the following additional arguments if I may paraphrase his executive summary: 1.) the company exaggerates the chances of success as a distributor, 2.) the company exaggerates the rewards of being a distributor, 3.) there is a high failure rate for distributors, 4.) Herbalife has been the subject of litigation on this issue 5.) the company targets the poor, 6.) the company hides its true nature through obfuscating its compensation scheme, 7.) Herbalife distributors quickly saturate their markets, and 8.) the top 1% of distributors earn almost 90% of all rewards.

Of course, as is well known, Ackman did more than just claim this was a pyramid scheme. He announced his belief that all pyramid schemes are ultimately destroyed, either by running out of new suckers to become distributors or by legal action on the part of the regulatory authorities. Ackman expressed his belief that one or both of these outcomes was likely in the near future. As a result he decided to short 20% of the float of the company, about $1 billion worth. He announced that his target price was zero. As you might imagine the shares of the company cratered, falling from the $40s to the $20s in short order but then began a rather miraculous levitation and have whipsawed around $35 with all the recent news.

Ackman is an excellent dramatist and clearly his firm is thorough. The presentation is well made and has a good narrative arc. It is very long but it doesn't feel like it takes a long time to read and at first glance it seems pretty convincing. There are a number of factors, aside from his research and presentation skills, which help Ackman in this case. 

First of all is the way that the regulatory authorities work with regard to pyramid schemes. They never come out and say “this company is NOT a pyramid scheme.” This is quite logical because there would be nothing to stop someone from then turning such an officially sanctioned firm into a pyramid scheme. So the only proof that the authorities will not intervene in HLF is that that are not intervening, which they may do at any time. Thus there is no way for them to definitively disprove Ackman. 

Second there are a great many regulators involved. The FTC and the SEC at the federal level and all 50 state Attorneys General, so Ackman has 52 bullets and as he has said, all it takes is one. This is quite true. Ackmans publicity campaign, if successful enough, also has the capacity to materially harm Herbalifes ability to recruit new distributors or frighten old ones thereby hastening the effect that Ackman claims is already underway. Ackman is also helped to some extent by the company itself. Whether it is a pyramid scheme or not it certainly does not keep records clearly enough to instantly demonstrate that it is not one. So, Ackman talked a good game and once you read the presentation you can see why the stock went over a cliff after it.

That said, there are a few very important weaknesses to Ackmans case, some of which were pointed out in the Loeb letter. Loeb pointed out that no pyramid scheme has ever survived for more than 10 years and that the majority of those that the FTC shuts down are exposed in less than 5 years. HLF has been in business for 30 years, that's quite a lot of time for a pyramid scheme to survive. While the Loeb letter makes some interesting points I think he is remarkably silent about some of the other weaknesses of Ackmans position.

The first weakness I think is the most glaring: the size of the position itself. HLF has about 108 million shares outstanding. Ackman is short 20 million of them. Now remember before HLF became the darling of the daytraders it traded about 1.5 million shares a day, and let me assure you that once it's known that Ackman is a buyer that's the same side the day traders will be on, so that 1.5 million shares is a good estimate for the real interest in the name. That means that in order for Ackman to close his position he would have to be, under normal circumstances, 100% of the buyside volume for an entire month. Even in the event that he was able to do that in secret, he would almost certainly drive the price much higher. In the event that he was not able to keep it a secret so many people would try to front run him he would soon have to seek an off exchange accommodation with someone who happened to have a lot of shares. I think his price target is zero for a very good reason: short of the company going to zero he can't get out. 

Then there is the issue of the catalysts which would send the stock to zero, remember: it is not enough that Ackman be correct that HLF is a pyramid scheme, it must be a pyramid scheme that comes undone on a time horizon that rewards him and his investors. If HLF keeps the thing going for another 30 years he's in big trouble.

There are basically two things that could kill HLF and Ackman correctly identifies them: regulatory intervention or total market saturation and/or a depleted supply of idiots/distributors. It's true that Ackman gets 52 bites of the regulatory apple but lets look at that a little more closely. He correctly points out that HLF targets the hispanic community. The company has something like 360,000 “distributors” and 90,000 “sales leaders” there's some confusion as to what this means but these people believe that Herbalife is a business they own. Let's imagine for a moment that you are a state AG, how eager are you to shut down a business which has millions of end users and tens of thousands of micro-entrepreneurs, who just happen to be members of an extremely important voting bloc? What's more, even though Ackman has promised to give his share of the spoils to charity, whoever kills HLF will be seen to have done the bidding of a New York billionaire hedge fund manager. You'll need an alchemist like Axelrod to live that down but Axelrod probably won't take your calls. 

“But wait!” our hypothetical AG might exclaim, “I'll be a hero if I shut this thing down because obviously it is victimizing these people.” Will he? Is it? HLF has 90,000 sales leaders, around and a 50% "retention rate" meaning 45,000 of them fail every year but that 90,000 number is pretty consistent so they are also replaced by another 45,000, every year. Yet the FTC has received only 210 complaints over the past several years. How can that be? In the past 5 years hundreds of thousands of these micro-entrepreneurs have failed but generated only a handful of complaints. Not a powerful motivator for our hypothetical AG. “But wait!” he might think, “Even though the damage may not be material, this company is giving them false Hope! We have to stop that.” Now hold on a second, what was the slogan of perhaps the most persuasive political candidate in the adult lifetime of most people reading this? What was his campaign slogan? Hope. Let me assure you, if there is one thing the American political system is not prepared to deny the voters, it's hope.

Well what about the possibiltiy of HLF running out of "suckers" to peddle their products? Well, the trouble for Ackman is that, as far as suckers go, there's another one born every minute. Not only that, though we may have more than our fair share, they make suckers outside the US as well and HLF is all over them. The company operates in 88 countries and though their main growth is in established markets they're not going to run out of people who are concerned about their waistlines or want to be millionaires any time soon. This is borne out by the earnings of the company which have been remarkably consistent as you can see.

So where does that leave Ackman? Well, he has a massive position that is cost prohibitive to close in the open market, he may have seriously misunderstood the incentive structure in which the regulatory authorities operate, and he may have to wait for HLF to run out of countries to open in before the economics start affecting the stock price. This isn't a great position to be in, but it's actually worse than that.

If I had to bet, I'd say that what drew Loeb into this wasn't the economics of HLF but the size of the Ackman short. As Kyle Bass mentioned, being on the other side of Dan Loeb is bad enough, but then Carl Icahn hopped into the mix and now everyone is talking about a “short squeeze.” For a discussion of this and why I think it's unlikely I need to talk a little about what precisely a short squeeze is, so bear with me. 

Short selling is where you borrow the shares of a company from someone and sell them in the open market. Then at a later date you buy them back, hopefully at a lower price, and return them to the person from whom you borrowed them, keeping the difference in price. The lender of the shares is paid a small fee for this called “the borrow cost” which varies with the supply of shares that can be lent and the demand for borrowing them. The way the market generally works is that as part of the custody agreement that an investor will sign with his custodian the investor gives the custodian the right to lend out his shares an the custodian might share some of the proceeds with the client.

It was probably quite easy for Ackman to borrow the shares as the vast majority of the shares of HLF are held by institutions who are more than happy to lend out the shares for a little more edge or lower custody fees. There are, however, a few technical issues that the short seller faces. First of all, the rate at which he borrows the shares can only be fixed for a certain amount of time maybe overnight or maybe Ackman negotiated longer terms with his prime broker but it's not forever and so it is possible that the cost to him over time might increase. Ackman might have to pay higher costs if borrow gets tight but he's well enough financed that increased costs alone will not be able to force me out of the trade.

The more serious threat is that the HLF shareholders from whom Ackman borrowed might want their shares back in a hurry.  In that case Ackman would have to go out and buy them at whatever price he could get or make a off exchange arrangement to get them from a large holder. There are two  ways in which Ackman might be forced to close his short at what would be, given the lack of liquidity, ruinous prices. 

The first is one where all the shareholders needed to have their shares in their physical possession, such as in the case of a tender offer. In the event of a take-private transaction, someone would make a tender offer for the shares, say at $55 a share and everyone who wanted to get $55 would have to get possession of the shares and tender them to the buyer. So when Fidelity or some other company goes to their custodian to get the shares, the custodian would turn around to Ackman and say, “OK, games over, give us the shares back, we have to turn them over to their original owners.” Then Ackman has to go get them at whatever price he can which, as discussed, might be quite high indeed. 

Interestingly the tender offer doesn't even have to be for the whole company, even a partial tender would destroy Ackman. Imagine the following scenario: the company says, “OK, we've got $787 million left on our buyback. Here's what we're going to do. We're going to take $750 million of that and offer to buy 15 million shares at a price of $50 from anyone who tenders their shares to us on March 31st. In the event of an oversubscription shares will be bought on a pro-rata basis from those who tender their shares.” 

That is let's say you have 1,000 shares of HLF. You tender them to the company and let's say that they get a total of 30 million shares tendered to them, twice what they are offering to buy. What happens is this: they send you a check for $25,000 and your other 500 shares back. With the stock trading at $37, I think quite a few people would tender their shares at $50 even if they knew the tender would be oversubscribed. As mentioned, they would need actual possession of the shares to submit them to the tender. Thus their custodians would have to deliver them to the company which means they would have to get them back from whomever they lent them. So you see, a partial tender is just as dangerous for Ackman as a full take-private transaction. 

That said, I don't think either a partial or full tender are likely to happen. From their recent 10Q, the company only has $350 million in cash. Sure they could borrow the money from Icahn, but it might be hard to justify in subsequent lawsuits why you spent the shareholders money buying back shares for $50 though a tender when the shares are out there in the market offered at $37. I also don't think that Icahn is likely to tender for the whole company. Even in the event that it's actually worth $70 a share or more, that doesn't provide nearly the margin of safety required to handle the additional debt the company would have to take on in order to buy back the shares.

The second thing that might force Ackman to close is if enough holders simply refused to let their custodians lend the shares drying up the pool from which Ackman is borrowing. This is the theory that people who are rooting for a squeeze post the Icahn options exercise believe. It's true that Icahn will probably withdraw his shares from the borrow pool once he exercises his options, but I don't think that will decisively affect Ackman's borrow cost.

First of all, while it's true that institutions are probably selling HLF and hedge funds who think the stock is cheap and/or subject to a squeeze are buying them, you would need an awful lot of people to cooperate in order to lock up enough stock to force Ackman to close. Even at it's zenith the short interest in HLF was 37 million shares leaving more than 60 million out there. At the time, you could still borrow it, it was expensive, but it could still be done. So even if Ackman and Lobe both locked up their shares and as many people piggy backed Ackman as in late December, there are still more than enough shares for Ackman and let me assure you he is getting better terms than any of the other shorts so he'll be the last guy to get forced out. 
What's more is that engineering a short squeeze is a non-trivial undertaking and it requires a high level of trust among the participants. Imagine the following. You're a hedge fund manager and you've been following this whole thing. Then one day you get a call from Icahn who says that he's putting together a team to run up the stock price of HLF and try to squeeze Ackman. He asks for you to participate by buying some shares of HLF and locking them up, preventing Ackman from borrowing them. Let's say you do this and sure enough the stock starts floating, then leaping, then screaming higher.

This presents everyone involved in the short squeeze with a dilemma: do I close out, take the money and run, or do I stick around and wait till Ackman folds? The trouble for the squeezers is that if enough of them close out, the squeeze is over before Ackman gets pushed out and the stock crashes back to Earth burning them all. This isn't even the worst case scenario. Imagine a world in which Ackman is able to negotiate with a few of the squeezers in order to safe himself and he does an off exchange transaction to close his position. Everyone who is not in on it is holding the bag when it is announced that the squeeze is over because Ackman is out. Then remember that the leader of the anti-Ackman faction is Carl Icahn, is he the kind of guy you would have to be worried about cutting a separate deal for himself with Ackman? Yes he is. Thus I think it will be very very hard to engineer a squeeze. 

The last thing that might force Ackman to close out is that he just runs out of money to maintain the position. Recently there was a  bizarre Reuters article that claimed that since Ackman put up cash to fund his short position in HLF that he was not vulnerable to a short squeeze. This is preposterous. It's true that he's not borrowing money, but it is also true that he IS borrowing shares and therefore there is a price at which he may have to buy back those shares which would exceed his capacity to do so. His prime broker is well aware of this fact and so in the event that the shares go higher he is going to have to put up more cash in order to maintain the position.

The thing is, for Ackman, it doesn't even have to be losses on HLF itself that force him out. Ackman is the head of Pershing Square Capital, a hedge fund that has concentrated positions in a number of companies. Even in the event that he fully funded the HLF short with cash as Reuters alleges, it is important to remember that Ackman's positions are almost certainly is cross margined.Thus the exposure of the entire firm needs to be taken into consideration. If a reversal in the fortunes of JCP, or Canadian Pacific depletes the capital of his firm, his prime broker may force him to trim his risk in HLF and as discussed, once the hype dies down and it's only trading 1.5 million shares a day, that could take some doing.  Personally I don't think this is likely to happen any time soon but it is a possibility and it is an issue that Icahn does not face. Icahn has the money, and it's his money.

So where does that leave us? Basically it leaves us in a waiting game between Ackman and Icahn, something totally different than the exciting clash of wills that is being portrayed in the press. Whether HLF is a pyramid scheme or not is only cosmetically the central issue. For Ackman to win it is necessary condition that HLF is a pyramid scheme but it is not a sufficient condition. Either the company must be investigated and destroyed by the authorities or they have to be destroyed by the economics of being a pyramid. And one of those things has to happen before 1.) someone decides to initiate a tender or partial tender offer. 2.) either losses in HLF or elsehwere or redemptions from his fund force Ackman to close the position. Since none of these events is likely to happen in the near term, by far the most likely outcome is that the company continues to operate as it has for the preceding 30 years, and the stock grinds higher albeit with a lot of volatility as all the weak hands piggybacking Ackman and Icahn are shaken out with each new announcement of positive or negative news.

So what's Icahns game in all this? I'll tell you. Icahn doesn't need to actually cause Ackman to be forced out, he just needs to be there when it happens. You see, if and when Ackman goes to the wall, for whatever reason, it will not be possible for him to close out his position in the open market. It's simply too big and the market is too thin. He's going to have to negotiate a private transaction with someone who can give him the shares he needs and he'll have to pay whatever price that guy wants. Icahn wants to be that guy. Doing off market transactions in size with a highly motivated counter-party is what made Icahn famous back in the 1980s. I'll tell you what though, you don't want long HLF when that happens because once the drama is over, the stock will crater the next day. The retail daytraders may help Icahn run up the stock, but for the same reasons other hedge fund managers will hesitate to get involved in a squeeze, they won't be part of the payoff. In the meantime Icahn gets to buy a large stake in a company that is growing at double digit rates for about a 9 PE and when Ackman needs him, he knows how to find him.


craigalfred kimball said...

Great blog WTF. Pershing limits investor redemptions to 12.5% per qtr, so investors are pretty much in it to win it. Unless, of course, everyone wants there 8th now!

Ken said...

Thanks, I think I might add that point to the text.

Anonymous said...

whata whata whata GR8 article !!!

you have explained concepts and strategy in layman terms and for once I GET IT !

Thanks WTF