During the quarter, Herbalife (HLF, Financial) stock price rose from approximately $45 to $70 per share, and from approximately $60 to $70 per share during the month of September alone. The principal driver of the stock price appears to be the belief by bulls that government regulators will do nothing,and that the Company will continue to generate strong earnings and cash flows which will be returned to shareholders in the form of share repurchases, which could force shorts, including Pershing Square, to cover.The stock price appreciation this past month appears to have been driven by commentary from Tim Ramey, a perennially bullish Herbalife analyst from D.A. Davison, who stated a few weeks ago that in September 2013 PriceWaterhouseCoopers (PwC) would complete its re-audit of the Company's last three years of financial statements, and Herbalife, shortly thereafter, would launch a $2 billion investment grade bond issue at an interest rate of 4%, the proceeds to be used to fund a share repurchase at $75 per share. According to Ramey, the buyback would serve to refute the bear case on Herbalife as shorts, including Pershing Square, are forced to cover.
The high degree of specificity of Ramey's bullish call has led investors to believe that he is speaking on behalf of th e Company. While September has come and gone without PwC's completion of Herbalife's re -audited financials, bullish investors apparently continue to expect the re-audit to be completed shortly, and a large buyback to be forthcoming.
We are skeptical of Ramey's pronouncements for several reasons. While we do not know the timing of PwC's re - audit of Herbalife's financial statements, we have identified a substantial number of serious issues with Herbalife's accounting, disclosure, and tax policies that we h ave brought to the attention of PwC and the SEC in a series of three letters that we delivered to them in recent weeks, the first of which we shared with you earlier this month. At a minimum, we would not be surprised if the re-audited financials provide further disclosures about the Company which will raise additional questions about its business practices and its previously reported results.
With respect to the supposed $2 billion investment grade bond issue at an interest rate of 4%, we believe it is extremely unlikely that Herbalife will be able to garner an investment grade rating and raise $2 billion, let alone at an interest rate of 4%. As of March 2011, when Moody's withdrew its ratings on Herbalife, the Company was rated Ba1, a junk rating. When the ratings were withdrawn, Herbalife had only $178 million of debt, approximately 0.5 times the then 12 month trailing operating profits, and there was little public scrutiny of the Company's business practices. If Herbalife were able to issue $2 billion of additional debt today, the Company would have $3 billion of total debt, or 4.3 times 12-month trailing operating profits. With more than 16times as much debt, substantially greater scrutiny of the Company's business practices, and a regulatory cloud over the Company, we believe that it would now garner a substantially lower junk rating than that of early 2011.
Furthermore, we question whether a bank would be willing to take on the potential underwriter liability associated with a debt issue for Herbalife. If the Company were later deemed to be a pyramid scheme, an underwriter could find itself liable for the face amount of the entire debtissue, as recoveries to creditors of a pyramid scheme are likely to be de minimis . To earn a 150 basis point fee and risk losing 70 times that amount in a lawsuit is a risk-reward proposition thatwe believe no financial institution would find attractive.
All of the above notwithstanding, if Herbalife could achieve a $2 billion financing, we believe the interest rate would be much higher, and the buyback could only be completed at a price that would be minimally accretive to the Company, factoring in the after-tax cost of debt and the buyback price required to acquire nearly 30% of the outstanding float. When one considers the high degree of leverage that would result from the buyback, we would expect the Company's earnings multiple to compress accordingly. As a result, we believe that such a leveraged recapitalization would generate minimal, if any, shareholder value.
Based on an analysis of comparable situations with our prime brokers, we believe that such a buyback would not require us to cover our position. Furthermore, if a large amount of debt were issued, an Herbalife CDS market would likely develop, presenting us with an even more attractive method to bet against the then highly leveraged Company. We could then choose to add to or replace all or a portion of our existing short position with an even larger notional short position in the debt through the purchase of CDS. We would welcome such an opportunity,although for the reasons described above, we do not believe that the Company will be able to borrow funds to complete such a transaction.
Since our presentation on Herbalife at the end of last year, we have not learned any facts that are inconsistent with our belief that the Company is a pyramid scheme that engages in unlawful and deceptive marketing practices. In fact, there have been a number of materially positive developments that increase the likelihood of regulatory intervention and the Company's closure.
Numerous state, federal, and international regulators have launched investigations or inquiries into the Company's business practices and products that we believe are ongoing. Many federal,state and local elected officials, consumer protection and community organizations and other advocates have publicly called for the FTC and state regulators to investigate the Company. A number of whistle blowers have contacted us, several in the last few weeks alone, and provided us with information that is confirmatory of our thesis that Herbalife is a pyramid scheme while raising additional concerns that we had not previously identified. Bottom line, we continue to have enormous conviction in our investment thesis.
While we have endured mark-to-market losses on this investment as Herbalife bulls have promoted the stock and downplayed the probability of government intervention, we believe it is only a matter of time before the Company is shut down and prosecuted by regulators.
In order to mitigate the risk of further mark-to-market losses on Herbalife, in recent weeks wehave restructured the position by reducing our short equity position by more than 40% andreplacing it with long-term derivatives, principally over-the-counter put options. Therestructuring of the position preserves our opportunity for profit β if the Company fails within areasonable time frame we will make a similar amount of profit as if we had maintained the entireinitial short position β while mitigating the risk of further substantial mark-to-market losses β because our exposure on the put options is limited to the total premium paid. In restructuring the position, we have also reduced the amount of capital consumed by the investment from 16% to12% of our funds.
We were able to restructure the position cost effectively due to several factors. Over the last 60or so days, the cost to borrow Herbalife shares has declined substantially while the stock pricehas risen. Shortly after we filed a formal complaint with the SEC regarding what we believe to be unlawfully manipulative conduct by other market participants, the cost to borrow Herbalifeshares dropped substantially to the lowest rate since prior to our presentation last December. Inan unrelated recent enforcement action, the SEC confirmed that attempting to engineer a shortsqueeze by removing stock from the available lending base is a form of market manipulation.
Because of the rise of the stock price, the low cost of borrow, and the fact that we are betting onthe failure of the Company, we have been able to purchase long-dated, privately negotiated out-of-the-money put options on terms that offer us an attractive opportunity for profit versus their cost. Furthermore, by substantially reducing the size of our short position as a percentage of theshare float, we minimize the risk of so-called short squeezes or other technical attempts bymarket manipulators to force us to cover our position. In that a substantial component of the bullcase on Herbalife is predicated on forcing us to cover, we think the restructuring of our investment negates this important pillar of the bull case.
The biggest risk of the restructured position is that time begins to be a factor with respect to a portion of our investment. We believe, however, that the long-term nature of the options we ownwill provide sufficient time for us to be rewarded on this portion of our position. In that theoptions are privately negotiated, over-the-counter contracts, we have the ability to extend their terms, if we deem it prudent and attractive to do so in the future.
At yesterday's closing price of $72.84, we believe the potential reward from being short Herbalife is extremely attractive relative to the risk of loss. Using the average analyst s' price target of $77 per share β which assumes that the Company is operating entirely legally β investors have less than 6% upside compared with 100% downside if the Company is determinedto be a pyramid scheme by regulators.
In my career, I have not seen a less attractive risk-reward ratio than a long investment inHerbalife common stock at current levels.
From Bill Ackman's Pershing Square third quarter 2013 investor letter.
The high degree of specificity of Ramey's bullish call has led investors to believe that he is speaking on behalf of th e Company. While September has come and gone without PwC's completion of Herbalife's re -audited financials, bullish investors apparently continue to expect the re-audit to be completed shortly, and a large buyback to be forthcoming.
We are skeptical of Ramey's pronouncements for several reasons. While we do not know the timing of PwC's re - audit of Herbalife's financial statements, we have identified a substantial number of serious issues with Herbalife's accounting, disclosure, and tax policies that we h ave brought to the attention of PwC and the SEC in a series of three letters that we delivered to them in recent weeks, the first of which we shared with you earlier this month. At a minimum, we would not be surprised if the re-audited financials provide further disclosures about the Company which will raise additional questions about its business practices and its previously reported results.
With respect to the supposed $2 billion investment grade bond issue at an interest rate of 4%, we believe it is extremely unlikely that Herbalife will be able to garner an investment grade rating and raise $2 billion, let alone at an interest rate of 4%. As of March 2011, when Moody's withdrew its ratings on Herbalife, the Company was rated Ba1, a junk rating. When the ratings were withdrawn, Herbalife had only $178 million of debt, approximately 0.5 times the then 12 month trailing operating profits, and there was little public scrutiny of the Company's business practices. If Herbalife were able to issue $2 billion of additional debt today, the Company would have $3 billion of total debt, or 4.3 times 12-month trailing operating profits. With more than 16times as much debt, substantially greater scrutiny of the Company's business practices, and a regulatory cloud over the Company, we believe that it would now garner a substantially lower junk rating than that of early 2011.
Furthermore, we question whether a bank would be willing to take on the potential underwriter liability associated with a debt issue for Herbalife. If the Company were later deemed to be a pyramid scheme, an underwriter could find itself liable for the face amount of the entire debtissue, as recoveries to creditors of a pyramid scheme are likely to be de minimis . To earn a 150 basis point fee and risk losing 70 times that amount in a lawsuit is a risk-reward proposition thatwe believe no financial institution would find attractive.
All of the above notwithstanding, if Herbalife could achieve a $2 billion financing, we believe the interest rate would be much higher, and the buyback could only be completed at a price that would be minimally accretive to the Company, factoring in the after-tax cost of debt and the buyback price required to acquire nearly 30% of the outstanding float. When one considers the high degree of leverage that would result from the buyback, we would expect the Company's earnings multiple to compress accordingly. As a result, we believe that such a leveraged recapitalization would generate minimal, if any, shareholder value.
Based on an analysis of comparable situations with our prime brokers, we believe that such a buyback would not require us to cover our position. Furthermore, if a large amount of debt were issued, an Herbalife CDS market would likely develop, presenting us with an even more attractive method to bet against the then highly leveraged Company. We could then choose to add to or replace all or a portion of our existing short position with an even larger notional short position in the debt through the purchase of CDS. We would welcome such an opportunity,although for the reasons described above, we do not believe that the Company will be able to borrow funds to complete such a transaction.
Since our presentation on Herbalife at the end of last year, we have not learned any facts that are inconsistent with our belief that the Company is a pyramid scheme that engages in unlawful and deceptive marketing practices. In fact, there have been a number of materially positive developments that increase the likelihood of regulatory intervention and the Company's closure.
Numerous state, federal, and international regulators have launched investigations or inquiries into the Company's business practices and products that we believe are ongoing. Many federal,state and local elected officials, consumer protection and community organizations and other advocates have publicly called for the FTC and state regulators to investigate the Company. A number of whistle blowers have contacted us, several in the last few weeks alone, and provided us with information that is confirmatory of our thesis that Herbalife is a pyramid scheme while raising additional concerns that we had not previously identified. Bottom line, we continue to have enormous conviction in our investment thesis.
While we have endured mark-to-market losses on this investment as Herbalife bulls have promoted the stock and downplayed the probability of government intervention, we believe it is only a matter of time before the Company is shut down and prosecuted by regulators.
In order to mitigate the risk of further mark-to-market losses on Herbalife, in recent weeks wehave restructured the position by reducing our short equity position by more than 40% andreplacing it with long-term derivatives, principally over-the-counter put options. Therestructuring of the position preserves our opportunity for profit β if the Company fails within areasonable time frame we will make a similar amount of profit as if we had maintained the entireinitial short position β while mitigating the risk of further substantial mark-to-market losses β because our exposure on the put options is limited to the total premium paid. In restructuring the position, we have also reduced the amount of capital consumed by the investment from 16% to12% of our funds.
We were able to restructure the position cost effectively due to several factors. Over the last 60or so days, the cost to borrow Herbalife shares has declined substantially while the stock pricehas risen. Shortly after we filed a formal complaint with the SEC regarding what we believe to be unlawfully manipulative conduct by other market participants, the cost to borrow Herbalifeshares dropped substantially to the lowest rate since prior to our presentation last December. Inan unrelated recent enforcement action, the SEC confirmed that attempting to engineer a shortsqueeze by removing stock from the available lending base is a form of market manipulation.
Because of the rise of the stock price, the low cost of borrow, and the fact that we are betting onthe failure of the Company, we have been able to purchase long-dated, privately negotiated out-of-the-money put options on terms that offer us an attractive opportunity for profit versus their cost. Furthermore, by substantially reducing the size of our short position as a percentage of theshare float, we minimize the risk of so-called short squeezes or other technical attempts bymarket manipulators to force us to cover our position. In that a substantial component of the bullcase on Herbalife is predicated on forcing us to cover, we think the restructuring of our investment negates this important pillar of the bull case.
The biggest risk of the restructured position is that time begins to be a factor with respect to a portion of our investment. We believe, however, that the long-term nature of the options we ownwill provide sufficient time for us to be rewarded on this portion of our position. In that theoptions are privately negotiated, over-the-counter contracts, we have the ability to extend their terms, if we deem it prudent and attractive to do so in the future.
At yesterday's closing price of $72.84, we believe the potential reward from being short Herbalife is extremely attractive relative to the risk of loss. Using the average analyst s' price target of $77 per share β which assumes that the Company is operating entirely legally β investors have less than 6% upside compared with 100% downside if the Company is determinedto be a pyramid scheme by regulators.
In my career, I have not seen a less attractive risk-reward ratio than a long investment inHerbalife common stock at current levels.
From Bill Ackman's Pershing Square third quarter 2013 investor letter.
