Herbalife’s About to Get Squeezed -- and I’m Buying

The noise surrounding Herbalife (NYSE: HLF  ) is intense, but it's all noise, no signal. Herbalife is a legal business that's trading at a ridiculous valuation -- less than eight times this year's earnings -- implying no growth. But we have a ton of value-creating actions -- and management is making many of them -- that could drive the stock higher in the near term. So, my Special Situations portfolio is setting up an aggressive synthetic long on Herbalife that will return massively if Herbalife trades where it should.

Short propaganda
On my first buy recommendation for Herbalife options in May, I was attacked vehemently and incoherently by short investors. I expect more of that now, as shorts attempt to muddy the waters -- doing anything but addressing Herbalife's real fundamentals -- and obscure the immense value in the stock. That virulence and vitriol scare away many investors, keeping the stock price down.

In my first article, I expounded on why Herbalife is not a pyramid scheme, and why it offers a huge opportunity for gain. In fact, I think the stock is worth at least $120 today, given its growth profile and attractive capital allocation policies. Management has done a fabulous job buying back stock when it's cheap, and that will be reflected in the future as this coiled spring shoots skyward.

And now we have a new catalyst in the offing: Management is considering another leveraged recapitalization. The proximate effect of a debt-for-buyback scheme would be to drive shares rapidly higher as the massive short interest -- now at 55% of the float -- has to be covered.

I estimate that Herbalife could borrow $1 billion, and easily afford the 6% interest or thereabouts for a buyback. As management happily noted on the conference call, the company has a modest debt/EBITDA ratio of 1.2, so it could easily afford the increased interest. And note, too, that I thought the real reason for the recent dividend cut was so that the company could have the free cash flow to float more debt. So, I expect another leveraged recap in the near future.

When that happens, the game is nearly over for the shorts. A $1 billion buyback, once completed, would raise short interest to more than 90% of the float. The slightest good news would make the stock soar. For more on Herbalife, follow me on Twitter: @TMFRoyal. And check out my dedicated discussion board.

Will Bill Ackman get burned? Some, but not much. He's already largely exited his common stock position, and his downside is whatever he paid for his options. After his exaggerated presentation in late July -- his supposed "deathblow" to the "Enron-like fraud" at Herbalife -- and then his ridiculous mea culpa a few days later, Ackman no longer has credibility on this stock. I won't be surprised to hear the Ackman salvo is over, and he's cleared out his position and moved on.

Another great sign: Insiders at the highest levels of Herbalife are buying the stock. The CFO, COO, and President each dropped from $555,000 to $600,000 on stock – at prices between $55 and $56 per share – in the wake of the company's earnings release. This is a huge vote of confidence.

Foolish bottom line
My Special Situations portfolio is setting up an aggressive synthetic long to take advantage of this massive mispricing. I'm selling one January 2016 $60 put, and using those funds to buy two January 2016 $80 calls, and six January 2016 $100 calls. For more on Herbalife, follow me on Twitter: @TMFRoyal. And check out my dedicated discussion board.


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