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Pershing Square Closes Short Position in Herbalife Ltd. (HLF); Read Fund’s Detailed Analysis

Bill Ackman’s Pershing Square closed its short stock position in Herbalife Ltd. (NYSE:HLF) and bought options to sell shares of the nutrition company. Ackman is a big critic of Herbalife, calling it a pyramid scheme. Herbalife makes and supplies nutrition supplements, weight management, sports nutrition, and personal-care products. In its Q3 investor letter, Pershing Square comprehensively discussed Herbalife. In this article, we’ll take a look at the fund’s comments about the nutrition company.

During the course of our short position in Herbalife, we have held the investment in various forms, principally a mix of short stock and/or options. Recently we disclosed that we have restructured our short position in Herbalife, and our exposure is now represented entirely by put options. The current market value of the put position is approximately 5% of consolidated fund capital.

We have structured the position in this form so that our exposure to Herbalife is limited, and we are no longer exposed to the risks and costs of borrowing shares. Assuming we do not extend the options beyond their initial term, the maximum potential loss for our current position is its current market value.

The options are privately negotiated, over-the-counter options, which are not traded or reported on any exchange. The options’ expiration dates can be extended upon or before their maturity. Because the options are deep-in-the-money, the amount of time premium reflected in the options’ current market value is a small percentage of the position. As a result, we will lose only a small portion of our current capital invested in Herbalife if the stock stays at the current price until the options expire. If the stock declines substantially, we can make multiples of our current investment. If the stock increases in price, our loss is limited to the current market value of the puts. As such, we believe the investment as currently structured offers a favorable risk-reward ratio.

Over the past several years, a number of events have occurred which would make any short seller optimistic about a short position in Herbalife, namely:

(1) Herbalife’s financial performance has deteriorated significantly;

(2) Despite the company having repurchased ~33% of outstanding shares since we shorted the stock, GAAP and Adjusted EPS are down ~19% and ~16%, respectively, based on management’s guidance for 2017 as compared to Herbalife’s reported 2013 earnings;

(3) The FTC settlement, which took effect on May 25, 2017, appears to be severely impacting the company’s business. US sales for the second and third quarters were down 18% year-over-year, and third quarter sales were down 9% sequentially compared to the second quarter;

(4) The Chinese government recently launched an investigation of multi-level marketing firms which operate in China – a market which represents about 20% of Herbalife’s revenues;

(5) The company has been subject to a tremendous amount of criticism and negative public relations in the media, including from John Oliver (his Herbalife segment, available here, has been viewed 11.6 million times in English and Spanish on YouTube), and in the documentary film Betting on Zero; and

(6) On September 20, 2017, the company and its top distributors were sued in a class action complaint over alleged civil racketeering (RICO) violations.

Despite this deterioration in financial performance, adverse publicity, and negative regulatory and legal developments, Herbalife stock has remained at prices that we believe do not make sense from a fundamental investment point of view. We believe the elevated valuation can largely be explained due to technical factors, namely the stock’s substantially reduced free float, and the market’s perception, up until recently, that we would be forced to cover our (once) large short stock position in the company.

We made the decision to convert our short position to put options because of the reduced free float of the stock, and to eliminate the incentive for market participants to attempt to squeeze us out of the position.

Because we now own the position through the outright ownership of put options, we cannot be squeezed, even if the stock price were to increase substantially, as our exposure is capped at the current market value of the put options.

Copyright: stocking / 123RF Stock Photo

Copyright: stocking / 123RF Stock Photo

You can download a copy of the letter to read the fund’s detailed analysis of Herbalife.

California-based Herbalife Ltd. (NYSE:HLF) is a $6-billion market cap company that sells its products in 95 countries through a network of about 3.2 million independent distributors. The company’s products include protein shakes, protein snacks, nutrition, energy and fitness supplements, and personal care products.

For the third quarter ended September 30, HLF reported net sales of $1.1 billion, down 4% on constant currency basis compared to the same quarter last year. It had net income of $54.5 million, or $0.66 per share, versus $87.7 million, or $1.01 per share, in the same last year’s quarter. The company’s stock has been performing well this year, climbing up to 43% year-to-date.

Meanwhile, Herbalife is a popular stock among the hedge funds tracked by Insider Monkey. According to our database, there were 31 hedge funds with bullish positions in the nutrition company at the end of the second quarter.

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