Memo by Hedge Fund Manager Robert Chapman: Bill Ackman’s Attempt to Goad Regulators Into a Baseless, Unnecessary Legal Battle

The attacks on Herbalife have been staged on many fronts.  Almost two years into Ackman’s bear raid against Herbalife, the clock is ticking and Ackman undoubtedly needs a government bailout / regulatory action against Herbalife.  Ackman’s thoughts about those on the long-side of $HLF: they’re all idiots.  Kenny Moelis, Bill Stiritz, Carl Icahn, Joele Frank, Boies Schiller, PWC, “uneducated” Herbalife distributors….all operating with inferior minds to his own.  Do Ackman and his gang have an explanation for the 0.25% rate of return on Herbalife products (which offers a 100% buyback)?  Sure they do. It’s magic.  I’m not kidding.  Brent Wilkes, director of a Latin American advocacy group, attributed the low rate of return of inventory to a “magical hold” Herbalife has over its distributors.  In other words, consumers, if they were thinking clearly, would demand more refunds.  

This is not even the tip of the iceberg on the elitist logic used by MLM critics.  Lately, the “influence-by-insult” strategy has been directed towards federal regulators.  With titles like “Does Herbalife Think The FTC Is Dumber Than A Bag Of Hammers?,” the critics are directing their ammo at regulators.  In other words, if the FTC fails to intervene, they’re “asleep at the wheel” and stupid like the rest of us.

Robert Chapman calls out this strategy in a very well-researched memo.  With his permission, I’ve included the full content below.  The actual PDF can be downloaded here.

Begin memo

DATE:            August 8, 2014

TO:                  Herbalife Regulators and Related Parties

RE:                  Bill Ackman’s Attempt to Goad Regulators Into a Baseless, Unnecessary Legal Battle

Introduction.  As has been covered widely by the media, Pershing Square Capital Management’s Bill Ackman has been engaged in a nearly two-year campaign to profit by putting Herbalife out of business.  Ackman’s goal appears quite obvious:  to add $2 billion to Pershing Square’s and his own wealth while feeding his apparently insatiable appetite for ego and reputational aggrandizement.  The first goal – earning profits for himself and his investors, is the cornerstone of legal and socially acceptable capitalism.  As such, it deserves no rebuke.  However, Ackman’s unconventional method of accomplishing that profit goal – making what I and an indisputably respectable list of Herbalife institutional and individual investors view as a seemingly endless string of false, exaggerated, and/or misleading statements via an unprecedented $50 million “research” (propaganda) campaign–  is worthy of the high volume of criticism it has received.

My Motive.  Unlike Ackman and his gang, I shall not attempt to obfuscate the motive underlying this communication, nor will I make false claims about what conclusions I believe the short sellers have drawn.  Unlike the short sellers preposterously stating that the shareholders of Herbalife believe it to be an illegal operation, I shall not baselessly state that the short sellers of Herbalife believe it to be a legal operation, although there are various signs that Ackman belatedly has come to realize that is the case and thus shall pivot next to goading lawmakers into changing the law itself.  I shall state my motive honestly and clearly: to portray accurately my view of this last ditch tactic being used by Ackman and his gang – to goad and attempt to shame regulators into a baseless, unnecessary legal battle against Herbalife.

Desperate Situations Require Desperate Measures.  Having incurred an estimated $200 million – $400 million in realized and unrealized losses on this one investment, Pershing Square finds itself in a fragile reputational position.  Particularly following Ackman’s unapologetic yet highly influential role in the dismantling and near bankrupting of 100-year old retailer JCPenney, his status as an investment superstar is in further jeopardy with Pershing Square’s Herbalife debacle, which unlike massive money losers JCPenney or Target, is far from over. Having proclaimed ubiquitously that Pershing Square’s research on Herbalife had led to this “best investment idea ever,”  — this despite Ackman’s reported decision not to have even one meeting with Herbalife management before launching his bear raid in December 2012 — his reputation, and potentially his franchise should there be legal repercussions, is on the line.  Indeed, the investment and regulatory worlds appear to be converging on an agreement that Ackman’s claims vs. Herbalife are mostly wrong.  Moreover, there exists no shortage of those who believe that Ackman now appears to know that his emotionally fraught analysis was and remains “wrong.” Even so, he persists in a quixotic and  most un-valiant holy war against an enemy of his own fabrication.

Ackman’s Final, Desperate Strategy:       Goad/Shame the FTC into a Self Serving, Baseless Legal Battle

  • Goading/Prodding Just the Latest Tactic at Manipulating Regulators:  It is no coincidence that Bill Ackman kick started his July 22nd Herbalife-bashing presentation with John Hempton’s thoughtless categorization of the global nutrition products company Herbalife as “scumbags” in a 2012 CNBC interview.  Ackman’s nutrition club presentation followed Bruce Craig’s letter from the day earlier to FTC Chairwoman Edith Ramirez, in which the anti-MLM campaigner went over the heads of both FTC Bureau of Consumer Protection (CPB) Director Jessica Rich and FTC CPB Marketing Practices Director Lois Greisman in an overtly hostile attack.  Essentially, Craig publicly accused Ramirez subordinate Jessica Rich of having the wrong priorities (based on a March 2014 speech whereof in a MLM clampdown was not highlighted) and preposterously seemed to categorize her subordinate Lois Greisman as a feckless shill for the MLM industry, based apparently on the absurd theory that since her prior boss at the FTC was Amway’s lawyer, she must be aligned with the MLM industry herself.  I can only imagine how Ms. Rich and Ms. Greisman felt when they read how they were being depicted by Ackman ally Mr. Craig to their own common boss.
  • The Order Apparently Has Been Sent Down from Pershing Square:  Very recently and non-coincidentally, one can hardly read any of the myriad Seeking Alpha “articles” or other short seller propaganda without recognizing an obvious pattern of the short sellers trying to shame the FTC into shutting down or otherwise impairing Herbalife.  In the most recent post by Bill Ackman’s close personal friend and Herbalife short seller Whitney Tilson, Tilson claimed that many of Herbalife’s investors “concede the company is deceptive, but invest because they think regulators are spineless.”  Tilson is surprisingly shameless in displaying his coopting of Ackman’s “goad the FTC” tactic.  As one of his correspondents (per Tilson’s own concession) wrote to him on July 26 and then published proudly by Tilson, “I believe you are correct that the regulators will ultimately be goaded into action.” Tilson’s correspondent then took a shot at goading the regulators himself:  “Many of our regulators are not fond of complex cases and hard work.”  One can expect more disrespectful propaganda like this coming from those who stand to strike it rich by maiming or dealing a “death blow” to Herbalife.  They indeed seem willing to try virtually any tactic to manipulate the markets, media or regulators to that dire end.
  • Short Sellers Must Know Their Claims Are False:  The short sellers are spreading these transparently manipulative and, in my view, knowingly false depictions of the true investment thesis of Herbalife’s investors.  The true long/bullish thesis I actually do hear is that the Company is a legitimate, legally operating global MLM selling products desired and purchased by ultimate consumers, both internally and externally.  Again, whether it be D.A. Davidson’s (Tim Ramey) or Barclays (Meredith Adler) with their in-depth sell-side research, or 19% Herbalife owner Carl Icahn’s repeated public statements that he believes Herbalife is a legitimate, legally run company selling products that help people worldwide, there is not a single Herbalife investor amongst the many with whom I have spoken who ever has indicated in any way that Herbalife is ‘deceptive’ or ‘fraudulent’.  Even John Hempton’s careless choice of words in 2012 was intended to convey his view that the MLM industry has participants, including some distributers of Herbalife products, who are overly aggressive and opportunistic.  Moreover, that singular statement, no matter how taken out of context by Bill Ackman, did not represent anyone but John Hempton’s apparent view at that particular time.
  • Short Sellers Insult the Regulators’ Collective Intelligence:  The irony and hypocrisy of the Herbalife Short sellers vis-à-vis the MLM’s regulators is nothing short of astounding.  Ackman and his cabal of profiteers are not dissimilar to a small but high pitched gang of school yard bullies who repeatedly egg on an honors student to start a fight by shouting, “Come on!  He called you a wimp!  You really gonna take that?”  As I shake my head in disbelief, I wonder how Ackman & Co. actually believe that these truly sedulous regulators, who have a history of taking on the likes of the Mafia, international drug dealers and money launderers, possibly could be goaded into doing the short sellers’ bidding with this patently obvious shaming tactic.
  • Charming, Cajoling, Overwhelming, Bullying and Now Goading and Shaming Regulators:  In mid-late 2012, nearly two years ago, it appeared that Bill Ackman began his version of a charm offensive with the FTC, SEC and other state regulators.  Exhibiting a typical lack self-awareness, Ackman essentially told the FTC, the SEC, and state regulators that Pershing Square was doing these regulators a huge favor by blessing them with his propriety analysis that supposedly proved Herbalife to be a “criminal enterprise.”  Again, allow me to emphasize, Ackman essentially accused these regulators of having been asleep at the switch for nothing short of decades, and, as such delinquents, they all require Pershing Square’s collective perspicacity to finally do their regulatory jobs.  When his unique form of enchantment predictably failed, Ackman moved on to overwhelming the regulators with a deluge of documentation estimated into the thousands of pages.  As that tactic did not attain the immediate prosecution Ackman sought, Ackman moved onto his well-practiced approach of bullying, enlisting a relatively small segment of LULAC and a U.S. Senator to replace his own public face of his war.  In March this year, some 15 months after his first public presentation, Ackman’s final bullying thrust seemed to pay dividends when the FTC launched the formal investigation for which Ackman had agitated.  However, there is a great distance between the investigation and shutting down of Herbalife, as the now 1.5 year SEC investigation exhibits.  One may want to ask the following hypothetical:  “What might Ackman do if the SEC has turned its focus on Pershing Square and/or one of its current or former employees involved in Herbalife? What theoretically might Ackman do if he begins to sense that the results of the FTC investigation were heading toward actually vindicating rather than crucifying Herbalife? Might Ackman and his gang then begin to goad, prod and attempt to shame the FTC into a fight that was baseless and solely served the interests of those who have sold short Herbalife’s stock?”  This is precisely what I believe is happening.
  • Regulators of Herbalife are Diligent, Not Spineless:  At the risk of stating the obvious, every bull on Herbalife shares I know thinks the FTC/SEC/AGs/DOJ are anything but spineless.  Instead, they are extremely diligent in prosecuting truly illegal, endless chain pyramid schemes that primarily compensate distributers for ENROLLING their downline (vs. selling product/inventory to that down line).  The FTC, and the Illinois, Kentucky and North Carolina attorneys general hardly were “spineless when they worked for years together ahead of halting truly illegal pyramid scheme Fortune High Tech Marketing.  For over half a decade, the FTC investigated and then prosecuted truly illegal pyramid scheme BurnLounge, successfully pursuing justice through 2014 all the way to the Ninth Circuit Court of Appeals. The diligently laboring Securities and Exchange Commission (SEC) hardly was “spineless” when it slapped TelexFree with a lawsuit on charges it sold fraudulent and unregistered securities to mostly Brazilian and Dominican immigrants, who served as its promoters.  New York Attorney General Eric Schneiderman, amongst a plethora of other effective and legitimate law enforcement, ferociously has pursued enforcement against the High Frequency Trading players, whose business model involves front running the investments made indirectly and directly by America’s hard working citizens.  California Attorney General Kamala Harris has risen to superhero status on a national scale for her hard charging battle against the nation’s top banks to win a $20 billion settlement for mortgage fraud.  This is but a tiny sample of many examples of strict, appropriate enforcement.  The list of “fully spined” regulators and their persistent pursuit of justice via the prosecution of legitimate, non-falsified or fabricated cases is truly endless.  Therefore, I apologize for the many I failed to include in my list above.

ConclusionThat regulators refuse to be cajoled, bullied, prodded, goaded and “shamed” into pursuing Bill Ackman’s profiteering and self- aggrandizing agenda does not come anywhere close to making them “spineless.”  This is so obvious that any reasonable observer, Herbalife investor or otherwise, would have to agree. Bill Ackman and his compliant operatives should feel ashamed for their transparent attempts to manipulate not only the markets[1], but those who assiduously and honorably have been regulating them for decades.

[1] Herbalife’s illiquid convertible bonds (2’s of 2019) in the past few weeks have been sold down aggressively and disproportionately to the common stock, with some speculating that Pershing Square directly or indirectly (via CDS bidding) having influenced their lower pricing to create the appearance and related media “reporting” of a symptom of financial distress, despite the company’s healthy debt service coverage.

End

Herbalife: Why I Made It a 35% Position after the Bill Ackman Bear Raid

This is a guest post prepared by Robert Chapman. Chapman is the founder of Chapman Capital LLC, which is a Los Angeles based investment company specializing in takeovers and turnarounds. In 2000, Chapman Capital was an activist versus Herbalife following the death of Herbalife’s founder Mark Hughes. This is an amazing article. It’s well-researched and easy to understand.  If you’re remotely curious about the future of Herbalife after Ackman’s attack, the mechanics of short selling and the potential value of Herbalife’s stock, this is a MUST read. If you find this article informative, hit the +1 or Like buttons above. Sincerely, +Kevin Thompson

Note: Note: Below is the opinion of Chapman Capital LLC and is not a recommendation or an indication of Chapman Capital’s current or future intent to buy, sell or otherwise transact in Herbalife common shares.

Update: Robert Chapman made some slight revisions to the article. His points are the same; however, he made a few stylistic changes.

As anyone even remotely connected to the world of multi level marketing is surely aware, the perpetually sanctimonious Bill Ackman and his extremely successful investment advisory firm Pershing Square formally launched a massive bear raid on Herbalife (HLF) on 12/20/2012, conducting a 3+ hour, media-packed, web-streamed 300+ PowerPoint slide deck presentation in New York after first selling short 20MM HLF shares for as estimated $1 billion plus in proceeds.   In his presentation and numerous interviews with the business media that day, Ackman declared a target price of zero for HLF’s shares.  In other words, he claims to be so convinced that Herbalife operates an illegal pyramid scheme, he is certain that government authorities and/or HLF’s distributors/salespeople/customers will shortly put the company out of business.

SUMMARY INVESTMENT THESIS: Despite beguiling and specious reasoning, Ackman will fail to influence/cause a material regulatory response or a HLF distributor exodus. Consequently, he will suffer a merciless short squeeze, catalyzed and augmented by a fast and furious combination of HLF share count shrinkage (buyback) and excellent operating performance (beat and raise dynamic).

REGUATORY SUMMARY: FTC has been there, done that.

The Ackman Tell. Many poker games are won and lost upon that infamous turning point when a player properly reads his opponent’s “tell.” To wit, I am confident that during an interview with CNBC’s Andrew Ross Sorkin on “D-Day” (12/20/2012), Bill Ackman slipped his “tell”, confirming my suspicion that he already realized the FTC wasn’t going to make his day by shutting down HLF. I strongly recommend all HLF traders/investors read the transcript of this interview, as Sorkin does a masterful job of fighting the media urge to genuflect before Ackman’s drawn down zipper, otherwise known as “The Whitney Tilson”. Specifically, Sorkin, after hammering Ackman, asked toward the end of this interview, “This is somewhat dependent on the FTC taking action. If they don’t, what happens?” Now, remember that Ackman’s entire thesis rests on his certitude (so he claims) that HLF is an illegal pyramid scheme, which the FTC has a mandate to shut down. If you were 100% certain (with 20% of HLF shorted in your funds alone) of this claim, wouldn’t your answer be, “There is no way the FTC doesn’t take action to shut down the illegal pyramid scheme run by Herbalife.” Instead, Ackman diffidently responds, “I think the FTC is going to take a very hard look. But I think most importantly the new distributor someone is trying to suck into the scheme will be better informed …”

The moment I read this response, after having researched HLF on/off since 2000 (when Chapman Capital had been an activist in HERBA/HERBB shares during Mark Hughes’ LBO efforts), I decided I had to place a monster long bet on HLF. I believe Ackman already had concluded the FTC wasn’t going to assist his crusade. Instead, he realized that he had to focus on existing and prospective HLF distributors, praying the media attention would have a materially deleterious impact on any decision to join or to continue with the HLF team. Indeed, without the FTC taking injunctive actions against HLF, Ackman’s crusade toward “zero” is doomed.

Here are key bullet points on the lack of real regulatory risk to HLF shares:

Internal Consumption Issue Already Clarified/Resolved by FTC in 2004: “the amount of internal consumption in any multi-level compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme” is a quote from an FTC letter dated 01/14/2004. Essentially, the letter states that if a product is marketable, the FTC is OK with the MLM, making Einhorn’s 05/01/2012 call focusing questions on this internal consumption issue far less relevant than was (mis)understood.

FTC Material Adverse Actions Near Zero Probability:  during my due diligence, I spoke with the country’s top lawyer specializing in MLM/regulatory dynamics. During our conversation, he offered his legal opinion, pointedly stating that there won’t be any FTC injunction, much less any regulatory action to put HLF out of business (“hell freezes over before this happens”). If there is regulatory action of any kind, it simply will be some type of consent order/settlement addressing better disclosure.

Few Consumer Complaints:  the FTC has not received many consumer complaints on HLF products – only 37 in 2010, 36 in 2009, and YTD 05/2012 was only 18 (again around 40 annually).

HLF is Big, Time Tested Veteran:  the FTC can and will shut down companies violating MLM rules, just as it did BurnLounge (online music retailer) in 03/2012 and Equinox in 2000. While such action is rare, the FTC will act aggressively to shut down companies when it sees the need. During the 32 years of HLF’s existence, the FTC has yet to see the need to pursue Herbalife.

Ackman Relied Greatly on Old Cases, Leaving Out Material Facts – Ackman failed point out that the FTC has already commented about the relevance (or lack thereof) of the cases he referenced in his presentation. In fact, most of the post Einhorn reporting has been misleading information;

No Federal Clarity – lots of Grey:  No “bright line” federal statute against pyramid schemes; even the guy with jihad against MLM’s, Pyramid Scheme Alert’s Robert FitzPatrick, conceded that FTC decided too complex to regulate MLM’s in 09/2011 and other anti-MLM consumer protectors have as well; this MLM lawyer thinks DSA should fight for bright line federal standards to eliminate opportunity for short sellers to exploit the grey;

Vast Preponderance of Sales and Growth are International (i.e., Outside Ackman/FTC): 80% of HLF’s business overseas.

The DSA is an Effective Lobby: The DSA serves as a lobbying entity designed to protect the MLM industry from burdensome government regulations. It led a campaign in 2006 where 17,000 comments were submitted to the FTC, all requesting an exemption from the restrictive requirements in the Business Opportunity rule. The DSA was successful. The DSA is more powerful that Ackman’s ally, Pyramid Scheme Alert’s Robert FitzPatrick

DISTRIBUTOR SUMMARY:  “Bill who?”

Chapman Capital’s distributor surveys show no meaningful percentage of distributors had even heard about Ackman’s circus show. Moreover, their evangelical commitment to HLF and confusion as to what 300+ pages of PowerPoint means seem to be causing an acceleration of business growth. Ackman’s payment for Google Ads (pegged to “Herbalife” search) exhibits his desperation to influence distributors, efforts which appear to have negligible effect.

TAILWINDS — FAT TAILS AND BUSINESS BAILS  HLF has two secular tailwinds in its favor: lots of fat people (fat “tails”) and no shortage of structurally un/underemployed humans. In fact, one thought for a short in HLF to consider is the following: net/net, does the U.S. government benefit from fewer overweight Americans (lower insurance costs) and fewer people standing in unemployment lines (ever hear of a fiscal cliff problem with U.S. budget?)? If the U.S. government benefits from HLF’s impact on the country’s physical and fiscal health, while enduring only 40 complaints/year about HLF, why shut down HLF? Ponder that for a moment.

BACKGROUND: Short seller roadkill HLF shares were trading as high as $45/share on 12/14/2012, and had been over $70/share (a high teens P/E multiple) earlier this year before the highly respected investor David Einhorn of Greenlight Capital asked some leading questions on an earnings call that implied he was skeptical that Herbalife was operating within the Amway safe harbor guidelines for multi-level marketers. Fear of Einhorn’s excellent record of identifying overvalued short sale targets sent HLF shares into the $40’s in the spring. In contrast, Ackman has been somewhat vague as to when he built the preponderance of his short position (i.e., did he start before Einhorn’s 05/01/2012 questions or was he an unoriginal shadow to Einhorn’s trailblazing?), but I am guessing $50-55/share is his average short cost basis. There is no evidence Einhorn went short at that time or since, but I would be shocked if Greenlight would maintain HLF short positions anywhere near $30/share based on HLF’s international value alone.

Open interest on HLF puts accelerated and the stock’s relative weakness worsened in the fall of 2012 as, I suspect – No evidence here. I’ve just been around the block a few times – people “around” Ackman shorted HLF or bought HLF puts ahead of 12/20/2012 presentation. In fact, I have a pet theory that Ackman’s interest in going massively public was heightened (if not driven) by the HLF stock’s reasonably strong response (into mid-$50/share) attendant with impressive late July and October 2012 financial results. Essentially, my hypothesis is that Ackman, with overall 2012 performance impaired by JCP’s descent into the teens, came to conclude he needed a big winner before year-end 2012.

As word leaked into the market of Ackman’s intention to present publicly the bear case on Herbalife, the stock began a gradual decline, then fell suddenly from ~$41/share to $36/share in the closing market hours of 12/19/2012, when a CNBC reporter with big hair reported that market rumors were true. The next morning, as the PT Barnum of the hedge fund industry delivered his presentation in a New York hotel ballroom on 12/20/2012, and especially through the early trading hours of 12/21/2012 (a very illiquid trading day), the shares went into free fall, reaching a nadir of $24.40/share. My funds made their last purchases at $25.30/share in a brief but painful period of negative marks. HLF shares have since rebounded to ~$30/share as traders/investors have taken a closer look at whether the emperor is running around New York denuded (figuratively speaking . . . fortunately).

ACKMAN’S TIMING OF “INTEREST” Ackman’s end-of-same-year-that-Einhorn-showed-up timing was masterful – when it comes to the power of influence, only top hypnotists can compete. A classic bear raid involves creating abject panic in the market. Concurrently using the proximity to Christmas, the December option expiration, and the depth of his presentation, the Ackman impact on the shares was maximized. The last ten days of December are as quiet as it gets on Wall Street, with most decision makers leaving for vacation, drying up market depth and liquidity. Also, at the peak of the panic not many institutional investors felt the urge to have HLF show up in their 12/31/2012 Form 13-F filing. December is also the final month of HLF’s fiscal year, which puts them in a “blackout period,” prohibiting the company and insiders from repurchasing shares under the $950mm authorized buyback. Moreover, due to the extensive audit period that attends year-end, it will be several months before year-end 2012 results were reported. This blackout removes HLF’s most effective defense to the bear raid: executing a nearly $1 billion share repurchase authorization. Again, if timing is everything, Ackman is every woman (with a nod to Whitney Houston).

PERSHING SQUARE/ACKMAN RESUME:  Let’s review some history on Bill Ackman and Pershing Square, some color on the mechanics of short selling, and Herbalife’s response to the bear raid to date.

Bill Ackman manages a New York based hedge fund called Pershing Square with exceptionally good long-term results. Ackman is not known as a short seller. His fund is generally a long-biased fund. He achieved some notoriety for predicting that muni-bond insurer MBIA was undercapitalized, which eventually proved true during the financial crisis of 2007-2009. His enormous investment in General Growth Properties (GGP) at less than $1/share remains one of the most impressive brains/balls combinations I have ever seen. All the while, however, his ego seems boundless.

He is somewhat unusual among usually media averse hedge fund managers in that his strategy involves publicly trumpeting the merits (and genius) of his investments, which he generally holds for a long time. He manages a concentrated portfolio comprised of very few, very large investments. He also is considered an activist investor. He frequently badgers the board and management of the companies in which he invests with what start as suggestions and frequently escalate to demands as to how they should conduct their business, what their capital structure should be, and the composition of its board.

Though he will rarely, if ever, publicly concede, Ackman makes mistakes just like the rest of us, even catastrophic financial ones (e.g., call options on Target). Indeed, Ackman closed down a previous hedge fund advisory entity called Gotham Partners after he reportedly marooned his investment funds in an illiquid and devastating combination of a closely held REIT (First Union Real Estate) and a portfolio of golf courses (Gotham Golf) for which no exit was possible. So while Ackman is quite good at what he does for a living, his hubris makes him vulnerable to spectacular failure. He has a high financial IQ, but it may be the delusional and narcissistically 15 surplus IQ points he awards himself that have been, and may again be, his undoing. Think of him as the Reggie Jackson (I’m dating myself here) of Wall Street: he swings for the fences, but can cause a lot of pain and break a lot of hearts – or the bank – when he whiffs.

SHORT SELLING PRIMER: A bit more on short selling for those inexperienced in the sport. Short selling is a vital component of the markets. The ability of investors to sell short shares of overvalued companies keeps market valuations in check, and permits investors to hold hedged portfolios that are not dependent on constantly rising indices to make a positive return. There are risks, however, of going short that do not exist on the long side. For instance, if one purchases the shares of Acme Widget at $10/share, and Acme fails, you know precisely how much you will lose – your $10/share, and no more. If you were to short Acme Widget at $10/share and Acme were to discover a vast plutonium mine under their headquarters, those shares that were shorted at $10/share may have to be repurchased in the market at $100/share, $500/share, or even $1,000/share. The potential loss on a short sale is unlimited. For this reason, most professional long/short investors keep the size of their short positions much smaller than their long positions. For instance, if a core long position is 5% of capital, a core short may be 2%. Last week in Barron’s, famed short seller Jim Chanos discussed his lessons learned from the 1999-2000 internet bubble when he saw his AOL short go up eight times in value in his face. The lesson he drew was to keep individual shorts small relative to capital. Ackman’s $1 billion short in Herbalife is almost 10% of his reported $11 billion fund. If he is wrong, he may very well be putting his firm at risk due to the enormity of his short position relative to both Pershing Square’s and HLF’s size, and the potential difficulty of covering a short position of that magnitude in a “short squeeze”. Google the notorious Volkswagen/Porsche trade to see how dramatically these events can play out at the extremes.

To go short a company’s stock, one must borrow the shares to sell from a broker. Shorting without a proper borrow is called “naked shorting”, and is illegal. Holders of stock give their broker the right to lend out their shares in exchange for the flexibility of keeping margin accounts, and to participate in a portion of the fees short sellers incur for access to those shares. Short selling is conducted by the investor calling his broker, securing a borrow, and then executing the sale. Most companies have ample shares available to borrow, and this process yields little drama. However, in the case of controversial stocks, the demand to borrow shares may exceed the supply in the brokers “box”. If long holders sell shares brokers had out on loan to short sellers, the short seller must replace those borrowed shares he has lost access to with newly sourced shares. Should none be found, he will be forced to cover that portion of his position, and if unwilling to cover, the broker will involuntarily “buy him in”. This dynamic is what leads to short squeezes, where heavily shorted issues rapidly appreciate in the absence of any fundamental reason. Just look back to 2008 when the US government suddenly prohibited the shorting of financial stocks to see how painful that result can be for short sellers.

One effective defense for the short seller would be to have his broker contract on his behalf with a lender of shares to provide a quantity of shares for a specific term, at a negotiated payment. This insulates the short seller from buy-in risk for the duration of the contract. However, these contracts are individually negotiated, and somewhat rare. Also, they frequently permit the long holder to regain access to his shares if the company were to, for instance, conduct a self-tender offer for its shares. It is not known if Ackman has such an arrangement.

Ackman’s self-reported short position of 20 million HLF shares is over 75% of the reported short interest in Herbalife. At this point, the “borrow is tight” – there appears to be a near zero supply of shares available to sell short. The few brokers that will supply a borrow are charging as much as 20% of the value of the short annually for that access. This is a monster number – between the 20% negative-borrow and HLF’s dividend, it would cost nearly 25% each year to stay short HLF, all things remaining constant on those two variables.

HLF’s DEFENSE IS COMING:  Given the holiday timing, the best defense HLF has been able to muster has been to put a video of CEO Mike Johnson on its IR webpage defending the company broadly, and to schedule an investors’ day two weeks later, for 01/10/2013 in New York to address Ackman’s accusations in detail. The company has hired an impressive team of advisors. While most would have expected Bank of America/Merrill Lynch to get the assignment given their execution of last spring’s $400mm share repurchase, the task has been given to Moelis & Company, a well regarded, Los Angeles-based boutique investment banking firm. The firm’s namesake, Ken Moelis, is a disciple of Mike Milken from the height of Drexel Burnham’s power in the mid-1980’s. Moelis went on to a successful career at DLJ and UBS, where he became the premier investment banker to the casino gaming world, before launching his own shop.

Additionally, Herbalife has reportedly hired Boies, Shiller & Flexner the law firm founded by famed litigator David Boies. Consider Boies’ HLF team to be the Navy Seals Team 6 of litigation – you really don’t want them on the other side of your war. Note, I have no evidence that Bill Ackman is related to Osama bin Laden, and thus worthy of being targeted by DEVGRU (figuratively speaking, of course).

HLF promises a detailed rebuttal of the Ackman allegations on 01/10/2013, and I expect it will blow away the skeptics with a point-by-point dissection of Ackman’s claims. I presume Boies was brought on to bring suit against Ackman for some combination of libel, slander, defamation, tortuous interference and other imaginative causes of action. No matter how this turns out, the discovery, depositions and testimony should be highly enlightening and probably quite entertaining.

HLF’s DIRT CHEAP VALUATION:  So now, how might one value the shares of HLF in the bull case where Ackman is convincingly discredited by HLF CEO Johnson (a singular American bad-ass, according to my sources who know him personally here in L.A.) on 01/10/2013, and the market no longer ascribes risk to the feared FTC intervention (if I hear “headline risk” one more time …). EBITDA is a preferred valuation metric for a company like HLF that doesn’t have heavy capital expenditure requirements, and converts much of its reported earnings to cash that can be distributed as dividends or used to repurchase shares. Herbalife will produce over $725mm of earnings before interest, depreciation, and amortization (EBITDA) this year, a growth-stock worthy increase from $634mm in 2011 and $480mm in 2010. The few analysts that cover the stock project $800mm in 2013. Think of HLF’s gushing cash flow this way – HLF is printing EBITDA of over $2mm/day. That’s a heck of a lotta cheese with which to fight Ackman, who has and will be spending his own and his investors’ money on litigation and other matters (which won’t bother his limited partners until the stock is going up on a daily basis). HLF is lightly leveraged, with $500mm of bank debt, and quite liquid with $700mm of unused borrowing capacity and $300mm of cash. HLF currently pays $1.20/share in dividends annually on its ~108 million shares outstanding.

In the absence of controversy, the market would typically accord a fast growing, capital efficient company such as HLF a premium multiple. Let’s just assume the S&P 500 index current multiple of 8x EBITDA. This would yield a total enterprise value of 8x $725 of EBITDA = $5.8B. Deducting ~$500 million of debt, but giving credit for $150 of the cash (that is excess to the operating needs of the business), would yield a total equity value of $5.45B, which divided by the 108mm shares works out to $50.46/share. The current price of ~$30/share implies an EBITDA multiple of 4.7x. Tupperware, which is a MLM free from controversy, trades at 9.3x EBITDA, and Avon trades slightly higher. At $50/share, the share still would sport a dividend yield of 2.4%. Herbalife should report net income of about $4 per share this year and $4.50 in 2013 (ignoring the massive buyback I see coming). $30/share implies a 2012 P/E multiple of around 7x. The current S&P multiple is about 13x. For a company growing 15%+, you would expect to see a premium multiple, which is why brokerage firm analysts who cover the stock have target prices from $65 to $101. My valuation is lower, but should the Ackman-induced cloud be lifted, I can’t say those targets are absurd.

In fact, between the technical short squeeze that is in the making, the massively accretive impact of a $1B buyback, and the FTC risk fading away, I can’t say that I’d be surprised to see HLF trade back to its old highs of $70/share. If HLF has $500mm of 2013 net income, and buys back 30mm of around 110mm shares, the ultra-low interest rate environment makes the net income impact from interest expense miniscule (the HLF 13% EPS yield is 3-4x borrowing costs). Getting over $6/share in EPS is really not that hard to financially engineer, and between the short squeeze, comparable valuations, a below-market 11-12 P/E multiple would take HLF back into the $70s. Indeed, it could turn out even more financially salubrious than even these scenarios.

Ackman’s essentially fired nuclear missiles at HLF’s business model and its legality. When (and not “if”) HLF’s regulators and distributors essentially blow off Ackman’s claims as either old or no news, HLF will for all intents/purposes become bulletproof and battle tested. This may/should garner it a higher valuation than before Einhorn or Ackman ever showed up. That “what if” scenario gets you a $100/share stock price potential (again, only 15x $6-7/share in EPS gets you there; I’m not talking about a NFLX-level valuation here).

This hypothetical rally toward triple digits is not farfetched. In the event of a self-tender by HLF, or even without one, should the large institutional shareholders proactively remove their shares from the stock loan supply, there is great potential for short sellers being forced to cover as the borrow dries up. A panic to the upside could occur as the shorts are forced to buy in 25 million shares in a market unable to induce that many sellers. I am sure HLF and its capable teams of advisors are looking at the myriad of options to create value out of the chaos caused by this spectacular bear raid. Indeed, it does not take great imagination to see what could make these numbers dance.

In addition, Ackman has no shortage of enemies from my own polling of the audience. The odds favor Herbalife in this aspect of the battle. Ackman truly went all-in telling the world he has shorted ~20% of a relatively unlevered company trading at ~4x EBITDA.

BUT WHAT IF ACKMAN IS RIGHT?  His target price of zero implies the company is shut down globally, not just here in the US, which comprises only 20% of HLF’s global revenue. Is it possible? I guess so, but in my view no more than a very slim probability. More probable, in the unlikely case the FTC responds to Ackman’s presentation and reopens the same issues they have been policing for 32 years in the case of HLF, it is possible that the company could be forced to change some elements of how it conducts business in the US, and maybe elsewhere, leading to lower sales and margins. No doubt this would spook the market with fears that there was even more scrutiny to come, leading the market to value Herbalife at a discounted multiple on reduced earnings.
So let’s take a cut at that. Let’s say the FTC somehow compels business practice changes that reduce sales by 20% and lead to current pre-tax margins contracting by 25%. This would yield EBITDA of approximately $450mm, which at 5x would yield a share price of $17. Personally, I think there is about a 10% chance of this outcome. So weighting a 10% chance of $17/share, and a 90% chance of $50/share, I come up with a fair value of $47/share, which is why I own a boatload of shares purchased into the panic created by the bear raid. In fact, there is far more likelihood of another LBO of HLF (Golden Gate/Whitney stole it the first time around) than any other “headline risk.”

Ackman took his shot; now it is HLF’s turn.