Friday, October 18, 2013

The Herbalife Short Thesis Is The Pony In The Pile

I have to admit that I've had something gnawing inside of me. A couple days ago in a post about the prospect of Herbalife's massive share repurchase program I said something I shouldn't have. I used an equine analogy to sideways infer that Bill Ackman and Dan Loeb were 'waspy'. I was WAY out of line when I said this because they are both Jewish. Now that is not to say that it would preclude them from participating in 'waspy sports' like dressage although lawn bowling would probably have been a better choice, however having recognized this fact, I hereby withdraw my waspy commentary and instead would like to point out that Dan Loeb loves beating Ackman at an expensive non-denominational sport like dressage. Turns out that some of the greatest riders in US history are part of the tribe (Robert Dover & Edith Master).

I have also been reconsidering my stance on Herbalife's share buyback I talked about in that same post. I like to bury my head in the problem and not in my burro.

So let me explain why I'm reconsidering the situation. In that post I surmised that after having carefully re-read the Q2 transcript, that:

"a clean audit was not necessary for Herbalife to re-commence share buybacks; having a new auditor on board was the contingency they wanted fulfilled before they resumed their pre-authorized share buyback. That means that they will have unequivocally undertaken a minimum of $50M in buybacks this quarter with a minimum of $50M in the next quarter, regardless of having audited financials in hand."

But, retrospectively I realize there is a flaw in my rationale. D'oh!

You see, John DeSimone referenced the prior day's guidance(released Jul 29) in the passage I was referring to when he said that the company will resume its buyback program.

Again for your pleasure I have pasted the same passage below for you too to read again carefully:

John DeSimone (CFO) :"Finally, I will address on share buyback program. Over the last couple of years, our guidance normally included $50 million of share repurchased per quarter. This indicated our intention to at least execute a portion of our buyback program on a routine basis even though in many quarters we significantly exceeded that amount.   Last quarter, we did not include any repurchase in our guidance for Q2 as a result of KPMG’s forced resignation.   We wanted to wait until we had new auditors on-board, which would provide us better visibility into the timing of securing re-audited statements. With (Peter Mussey)[sic. should be PwC, gotta love transcripts] on-board and our confidence in having re-audited statements by year-end, our guidance provided yesterday included the assumption that the company will resume its buyback program."

My conclusion was that they were unequivocally in the market buying $50M in shares, but I actually estimated that they had purchased more than $300M worth in Q3. I am now unequivocally equivocating.

This is my flaw: if DeSimone was referring to the buyback within the context of full year guidance Herbalife wouldn't have had to purchase 1₵* worth of shares. If Herbalife will be relying on repurchase to meet or beat guidance, what DeSimone was saying could still be true so long as it happens before the end of the year.

*Note to all of you that probably haven't seen the ₵ symbol in a while, the definition of 1₵ is 1/100 of $1.00**(aka those pieces of paper @drunkstepmother throws at strippers). 
** Note to Bill Ackman, the definition of $1 (you've probably forgotten what a single looks like) is 1/100 of $100, which is what I imagine you typically expense for your lunch***. (It is also 1/105 of John Hempton's price target for Herbalife )
***Note to Carl Icahn, the definition of Bill Ackman's lunch is that thing you ate on CNBC.

This has some important ramifications we have to consider, if it turns out my equivocations have some insight.

  1. Herbalife has not repurchased a single share in Q3.
  2. If Herbalife had not repurchased a single share in Q3, demand for shares came from elsewhere. 
  3. If Herbalife had not repurchased a single share in Q3, they are going to achieve their numbers through growth alone.
  4. Ackman covered, for reasons other than Herbalife forcing his hand.
  5. If Herbalife had not repurchased a single share in Q3, they still have a $787M authorization that they can use to swallow huge chunks of shares at any moment.
I can't help but be impressed with Herbalife if they are able to beat earnings through growth alone, in the face of all the difficulty and negative publicity that Ackman has tried to create for them. If you think that possibility is far fetched you have to look no further than their last quarter to see the same thing. In Q2 2013 even if you ignore the benefit to EPS provided by audit/legal costs they beat by 23₵. By my estimates, Herbalife should be able to beat Q3 guidance by 5-14₵, just through growth alone.  

So if Herbalife crushes it yet again without having modified the public float, what does that say for investors once Herbalife does implement their buyback? If they were only to use their current authorization they could push one button on their smoothie maker and pull ~10M shares out of the float. Again, hearkening back to Mr. Dunn's reference to "having leverage" I think Herbalife will go well beyond their current authorization and will issue debt.

I know, I know, Bill says it is unlikely that Herbalife could issue investment grade debt based upon the last rating Moody's published in March 2011 of Ba1. Ackman conveniently ignores that just six months prior to Moody's last debt rating for Herbalife, they upgraded Herbalife's rating to Ba1 from Ba2. Why ever would they do such a thing? Their reasons are pretty clear in the Ratings Rationale they lay out for us:

"The upgrade in the Probability of Default rating to Ba1 from Ba2 acknowledges Herbalife's continued strong operating performance and its improved sales leader retention rate. As Herbalife's probability of default continues to decline, asset recovery rates in the event of default have become less clear. Thus, Moody's is applying its standard 50% family recovery rate to Herbalife instead of the previously used 65% rate.
Herbalife's Ba1 Corporate Family Rating reflects its very strong credit metrics, healthy liquidity profile, conservative capital structure, significant geographic diversification with sales in 73 countries, and the stable sales performance of its core meal-replacement products. These positive attributes are offset by the company's modest scale, sales concentration in a relatively narrow product segment -- meal replacement shakes and nutritional supplements -- and its small market share in the broader packaged food market. The rating also acknowledges the ongoing challenges of the multi-level selling model, particularly the high turnover of the sales representatives."
Keep in mind this rating is on a secured facility in a 2010 credit environment when, Herbalife was operating in 73 countries and revenues were around $2.5Billion. Today 5yr yields are down over 100bps, Herbalife is in 88 countries and has over $4Billion in revenues. Herbalife's 2011 revolver terms had a five year maturity with floating rates fixed to 1-month LIBOR, BAC prime & FFR that bears interest in today's environment at 4.75%. I wonder what sort of terms they could get today?
Maybe it will turn out to be mental masturbation on my part, but to try and answer this, I looked at a prime example of another direct seller, Primerica. In July 2012, Moody's gave the company a Baa2 rating on a senior unsecured $375M 10-yr (4.75% coupon). Just a few months earlier in March, Moody's Primerica disclosure stated they seemed to be rather concerned about Primerica's counterparty credit risk:

"In April 2010, Citigroup Inc., Primerica's former parent, conducted an IPO of Primerica. This IPO, and an additional secondary offering in April 2011, reduced Citigroup's ownership of Primerica to about 23%. As part of this IPO restructuring, PLIC ceded 80%-90% of its pre-2010 in-force business to a captive reinsurer that is now owned by Citigroup. As a result, Primerica is exposed to significant counterparty credit risk, although certain provisions in the reinsurance agreement help to mitigate some of this risk."

Granted, it isn't an absolutely perfect example because their product base is so different, but they face a lot of the same potential risks in implementing and managing their business models. Where I think Herbalife stands out from many other direct sellers is in their daily consumption model, which engages consumers and helps drive sales, which is a characteristic you do not see with other direct sellers. After purchasing that term policy does a Primerica customer talk to their agent everyday about their mortality? Does a Tupperware buyer call their Host or Consultant every time their lime Wonderlier "burps"? Daily consumption is such a strong part of Herbalife's growth that in their latest 10Q that it is the first thing they attribute their increase in net sales to.

Although their consumers are different, all it takes is a cursory comparison of Herbalife's and Primerica's counterparty risk, source of revenues, customer bases, free cash flow, growth rates, revenues, and leverage ratios to determine that any jackass would buy Herbalife debt before they would buy Primerica's. Which brings me to the point that if Primerica can get an investment grade rating on their 10yr unsecured debt, why exactly does Ackman think that Herbalife can't get at least that or better??? I think what Ackman was really thinking was that he is rightfully terrified that Herbalife can and will issue debt on top of their current repurchase program because he knows they are in a much stronger position to do so than other direct sales companies like Primerica. Maybe the folks at Pershing Square stopped making conclusions they would have to retrospectively back in to and started asking ratings agencies to see what Herbalife debt would actually get rated at instead of telling them what it would get rated at. And the beauty of Herbalife issuing debt to repurchase shares is that it is entirely unnecessary. Herbie generates so much cash and has such a concentrated shareholder base they could easily pull the rug out from under the float without having to go to the bankers. A debt financed buyback would be catastrophic for the shorts, to say the least. 

Behind that salt and pepper swagger and those cold, dead cerulean eyes, Ackman knows all this, which is probably why he covered part of his short (I mean "restructured" his exposure). He may paint himself as the smartest, most majestically benevolent stallion in the stable, but he brays like a jackass and is coming up lame.

It may very well turn out that I am a jackass myself for reading too deeply into Duane Stanford's article on Jeff Dunn or John DeSimone's commentary on the Q2 call. It may be that I am wrong in my previous assumptions that Herbalife has been in the market buying back $300M in shares. Ask yourself this though, if I am wrong and they haven't been in the market this quarter and still have $787M burning a hole in Michael Johnson's spandex, is that better or worse for shareholders and is it better or worse for the short-sighted?  If Herbalife adds to their current $787M buyback authorization and issues investment grade debt to engineer a smaller float is that better or worse for shareholders? These scenarios are all decidedly very good for shareholders. All you have to do is look at Herbalife's shareholder base to recognize that the bookrunners probably would only have to walk to place a $1-2B offering; a few of those buyers would probably be happy to stand across from Ackman at the CDS table after the placement too.

Buyback aside, let's get back to why I really wrote this: I deeply regret insulting the sensibilities of Jews and Anglo-Saxon Protestants alike by inferring that Bill Ackman was a wasp on horseback, particularly because his short thesis may turn out to be a pony in a pile of manure.

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