Ackman Q3 Letter: Corker Resignation Is Bullish For FannieJacob Wolinsky
Ackman Q3 letter to investors first some excerpts on Fannie Herbalife where he blames Icahn for the squeeze and more below.
Fannie Mae (FNMA) / Freddie Mac (FMCC) Since our last quarterly letter, there have been a number of favorable developments in the political and regulatory landscape regarding the GSEs and housing finance reform. These developments include: (1) a Republican National Committee resolution made public on September 13, 2017 that seeks to protect taxpayers by restoring safety and soundness to the GSEs, calls for Fannie and Freddie to be “permitted to rebuild equity capital,” and recognizes that Treasury can generate “an estimated $100 billion in additional cash profits by monetizing its warrants for 79.9% of each company’s common stock;” (2) a September 13, 2017 letter from six Democratic Senators to the Treasury Secretary and FHFA Director “requesting that the GSEs be permitted to build capital” to prevent a future draw on Treasury’s line of credit; (3) testimony from FHFA Director Mel Watt to the House Financial Services Committee on October 3, 2017 in which Director Watt outlined the extensive reforms that have taken place at the GSEs during their nineplus year conservatorship, stated that required minimum capital levels for Fannie and Freddie should be “in the range of 2 to 3 percent,” and hinted at some form of initial capital retention in the coming months; and (4) comments from Treasury Secretary Steve Mnuchin in mid-October that housing finance reform would be the next priority after tax reform, and that Fannie and Freddie would not be in conservatorship by the end of his initial four-year term. All of the above are broadly consistent with the key principles which we have been advocating since the inception of our investment in late 2013.
enator Corker announced in late September that he will not seek re-election in 2018, and will leave the Senate upon expiry of his current term at the end of next year. Senator Corker has been one of the leading voices in Congress on housing finance reform for the last several years, and we believe that he would like to see this issue resolved before his retirement. He and his colleague Senator Warner have suggested that they will soon put forth new bipartisan legislation regarding housing finance reform, for which they should have the support of Secretary Mnuchin after the tax reform initiative concludes. In the meantime, the intrinsic earnings power of both entities continues to increase, driven by growth and improved credit quality in their core single-family guarantee businesses.
We believe that the current share prices do not reflect the significant momentum that continues to build for a bipartisan resolution of their status that would be highly profitable for the government and other shareholders, protect the taxpayer against future bailouts, and ensure that the dream of home ownership remains widely achievable for generations to come.
Herbalife Ltd. (HLF) Short 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.
The Reduction in Herbalife’s Effective Free Float Over time, Herbalife, along with Carl Icahn, has substantially reduced the effective free float of its shares. This has been achieved through Mr. Icahn’s open market purchases of 22.9 million shares, company buybacks in the open market and in a recent tender offer, and as a result of a large forward contract and related hedging transaction that were entered into at the time of the company’s issuance of $1.15 billion of convertible notes in February 2014.
Recently, the effective free float was reduced further because we, together with other short sellers, paid “Take No Action” fees of approximately seven cents per share so that our stock lending counterparties would not tender their shares into Herbalife’s recent tender offer.3 For the last five or so years, we have borrowed shares from the most stable sources of borrow, namely index funds, and other funds that closely track the indices. Because these stock lenders were paid to not tender their shares, the shares purchased in the tender offer came out of the remaining free float of the company, and, as a result, index funds (and other effectively permanent owners) now comprise a substantially greater percentage of the float. The result of all of the above factors is that the effective free float of Herbalife (shares that are actually free to trade) is substantially smaller than current investors in the stock may be aware.
Typically, it becomes more difficult to borrow shares as free float declines; however, in this instance shares remain easy to borrow at low cost because of the large percentage of the float held by index funds who lend their shares. Indices typically adjust their components to account for changes in free float. In the case of Herbalife, however, most of the reductions in effective free float are not evident, and therefore, do not appear to have been accounted for by indices and the index funds that track them.
For example, Herbalife completed its recent 4.6 million share open market purchases through the use of an indirect, until recently undisclosed, wholly-owned subsidiary of the company - HBL Swiss Financing GmbH (“HBL”). After the Herbalife tender offer was completed the share count was reduced, causing HBL’s ownership to exceed 5% of outstanding shares. As a result, HBL was required to file a 13G reporting its Herbalife holdings. The media interpreted this filing as a new investor acquiring a large stake in Herbalife when in fact the purchases represented shares repurchased by Herbalife itself.
While shares held by HBL are reflected as treasury shares under US GAAP and, therefore, reduce the number of common shares used to calculate earnings per share, they remain outstanding on the books and records of the company and create the appearance of a larger free float as reported on Bloomberg and other data services. As a result, index funds likely own more shares than they would if the indices adjusted their free float calculations to account for Herbalife’s effective free float. Once indices, and the index funds that follow them, adjust their free float calculations for these shares, index funds will likely adjust their Herbalife ownership downward.
At the time we disclosed our short position, Herbalife had 108 million common shares4 outstanding. As reported in the third quarter 2017 10Q, shares outstanding as of October 26, 2017 had declined to 87,197,196 million5, as a result of share repurchases net of issuances due to stock option exercises and restricted stock grants since that time. This share count, however, is not an accurate reflection of the effective free float of the company because of a number of factors, some of which we believe are not well understood by most Herbalife shareholders.
The most recently reported shares outstanding do not reflect 14.5 million shares that are effectively no longer outstanding and are or will be removed from the float available for trading as a result of:
(1) a forward contract for 9.9 million shares the company entered into in connection with the issuance of $1.15 billion of convertible notes in early 2014; and
(2) 4.6 million shares purchased by the company in the open market in 2017, but held by HBL in treasury (as described above).
After adjusting for these factors, there are approximately 72.7 million shares of Herbalife outstanding. This does not, however, account for shares withheld from the float as a result of shares held by Mr. Icahn and various index funds, and a so-called “capped call” transaction that was entered into at the time of Herbalife convertible note issuance. We describe each of these factors in greater detail below.
The Forward Contract When the company issued a $1.15 billion convert in February 2014, it used $685.8 million of the proceeds to purchase a forward contract on 9.9 million shares, which expires when the convertible note comes due on August 15, 2019. The convert was not sold to so-called “real money” buyers, but rather to convertible arbitrageurs. The banks that sold Herbalife the 9.9 million share forward contract hedged this sale by purchasing a total return swap on the same number of shares from the buyers of the convertible notes, enabling these convertible arbitrageurs to synthetically hedge the equity conversion feature of the notes. While these shares are considered officially outstanding, we do not consider these shares to be part of the effective free float because they will be purchased by the bank counterparties during the months leading up to the forward contract’s August 2019 expiration date and then delivered to the company.
The Capped Call or Call Spread The company also used $123.8 million of the proceeds of the convert sale to purchase a “capped call” or call spread on 13.3 million shares. The call spread was designed to reduce the dilution of the convertible notes by synthetically increasing their conversion price from $86.28 to $120.79. The call spread was purchased by the company from derivative counterparties who hedge their exposure to the call spread by dynamically holding a certain number of HLF shares – in order to hedge, they must own more at higher prices and less at lower prices. At the current price of $65.03, we estimate that these counterparties are required to hold approximately 4 million shares to hedge the 13.3 million call spreads that they have sold to HLF, reducing the effective free float by this amount.
Icahn and Index Funds Carl Icahn owns 22.9 million shares, which reduces the effective free float to 45.9 million shares. The effective free float is further reduced by shares held by index funds who are effectively permanent holders of the shares unless and until adjustments are made to the indices. Removing Vanguard, Blackrock, State Street and Northern Trust, the well-known index funds, from the float reduces it by an additional 9.9 million shares to 35.9 million shares. This amount excludes other index funds (including Fidelity, which owns 7.8 million shares, a portion of which are likely owned by certain Fidelity index funds) which would reduce the effective free float even further. We summarize the effective free float of Herbalife on the table below:
As a result of the above factors, over the last four years Herbalife has become an extremely closely held company where the company’s largest investors, excluding Mr. Icahn: Capital Group (11.77 million shares), Fidelity (7.84 million shares), Deccan Value Investors (7.82 million shares), and Route One (7.15 million shares), each own large percentages of the 35.9 million effective free float of the company. We view each of these investors as a large overhang on the stock.
Recent Stock Price Volatility The implication of Herbalife’s small effective float is that small purchases or sales have a large impact on the stock price. The recent 16% spike in the stock price in the days after the Herbalife self-tender was completed, and the subsequent large decline and daily volatility thereafter are emblematic of the extremely small float and the difficulty in selling or acquiring shares without a substantial market impact.
When Herbalife announced that it had purchased only 6.7 million shares out of a possible 8.8 million in its recent tender offer, investors viewed it as a bullish sign; they apparently concluded that Herbalife shareholders who did not tender must believe that the stock is worth more than the tender price of $68. We believe that the failure of the tender offer to be fully subscribed is more likely due to the limited effective free float and large amount of shares held by index funds.
We understand that certain arbitrageurs shorted the stock when the tender offer was launched. They expected to cover their short when the offer was completed, anticipating that the stock would decline once
the upward pressure of the tender ended. When the stock rose instead of declining, these investors sought to cover their short positions. In light of the extremely limited float, we believe these purchases drove the stock price up more than 11% in one day, and more on the following days.
As the stock price rose over the course of this year, we believe that Herbalife longs likely believed that increases in the stock price would force Pershing Square to cover its short position. The more the stock price went up, the more likely they believed we would be forced to cover. As we now own the position through put options, this dynamic no longer has any effect. As a result, we believe that Herbalife fundamentals will now play a much larger role in the stock’s trading price.
Over the last few weeks the stock has declined as the upward pressure from short covering abated, the company reported a weak quarter – with below expectations earnings guidance for 2018, and we disclosed the conversion of our short position to puts.
In light of the fact that the four largest holders (excluding Icahn) own 34.6 million shares, representing 50% of actual shares outstanding, (or 75% of the effective free float of the company, net of Icahn’s ownership) it is difficult for even one of these owners to exit without a substantial negative market impact.
While some investors may have held out hope for a going private transaction, this appears unlikely. According to disclosures in the company’s recently filed tender offer documents, the company’s attempts to sell the company to financial buyers have not succeeded. In sum, we believe there is no longer a technical or fundamental case for being long Herbalife shares.
Going forward we intend to substantially limit our comments on Herbalife in light of the reduced capital in the investment and because we believe that further comments from us may distract investors from Herbalife’s deteriorating business fundamentals. In that this may be our last detailed communication on Herbalife, in the appendix to this letter, we provide a detailed description of Herbalife fundamentals from the beginning of our investment to the present for those who are interested in a more in-depth analysis.
Full PDF here - Pershing-Square-3Q17-Investor-Letter-November-2017-PSH