Bill Ackman's Herbalife Short Is Subprime Bet 2.0: Street Whispers

Updated to include disclosure of Third Point stake in Herbalife

NEW YORK ( TheStreet) -- After roughly six years of battle, it took the choking off of credit to the subprime mortgage market for hedge funder Bill Ackman to see a multi-billion dollar short bet on bond insurer MBIA ( MBIA) payoff.

Now Ackman, the head of Pershing Square Capital Management, is hoping a roughly $1 billion short bet against multi-level marketing supplements supplier Herbalife ( HLF) will provide a quicker payout.

While Ackman's bet against MBIA, once among the nation's top municipal bond insurers, was vindicated by a souring of mortgage and structured securities the firm guaranteed prior to the financial crisis, his short position in Herbalife follows a similar logic.

Notably, Ackman's accusation that Herbalife's supplements and weight loss products are little more than a pyramid scheme hinges, in the near-term, on a ground level flight from the company by its millions of distributors who are spread across 80-plus countries.

In the financial crisis, an award winning CNBC documentary House of Cards detailed how it was the choking off of funding to key go-go real estate markets, which eventually spelled the demise of the U.S. subprime mortgage market and the trillions in securities tied to it. According to Ackman, a potential flight of Herbalife distributors could, similarly, kink the operations of the supplements seller and cause its downfall after an over 30-year history in the public eye - were the company to be a pyramid scheme.

Without the lubricant of new money, Herbalife might suffer a similar fate to the subprime market and the housing securities MBIA guaranteed, according to Ackman's implied logic. He pegs Herbalife's worth at $0.

On Wednesday, Ackman's bet against Herbalife took a dramatic twist when a late morning filing disclosed that Dan Loeb's Third Point had taken an 8.24% stake in Herbalife.

Third Point's long position means that Ackman has big fight on his hands and very credible doubters, as Herbalife management prepares to publicly defend the company against allegations it is a pyramid scheme. Third Point's stake, which is roughly half the size of Pershing Square's short position, may also shore up confidence in Herbalife and cut against Ackman's quickest way to a potential payout.

Late on Wednesday, The Wall Street Journal reported that the Securities and Exchange Commission has opened an inquiry into Herbalife, citing unnamed sources.

Ackman, who unveiled his bet against Herbalife to CNBC on Dec. 19, subsequently told Bloomberg News that part of his intent in detailing the short trade just ahead of the New Year was to undermine confidence among Herbailife's distributors prior to their 2013 re-up, potentially toppling a pyramid scheme he alleges the Los Angeles-based company orchestrates.

In the same way a credit withdrawal cascaded through the housing market, Ackman's near-term bets on a Herbalife payoff center on a flight of money.

Eventually, a subprime credit crunch that started on the streets of California, Nevada, Florida and Arizona, among others, caused trillions in losses and big returns on short bets for the likes of Ackman, David Einhorn of Greenlight Capital Management, John Paulson of Paulson & Co. and Kyle Bass of Hayman Capital Management. Those trades ultimately paid off when money fled financial markets and exposed the poor fundamental quality of institutions like MBIA and the securities they were involved in.

In multiple public disclosures, Herbalife has forcefully rebutted Ackman's claims. "Herbalife is not an illegal pyramid scheme," the company said in a December statement refuting a Dec. 20 presentation by Ackman of his short thesis.

Herbalife will present a rebuttal to Ackman's claims and an overview of its fast-growing business on Jan. 10 and has hired financial advisor Moelis & Co. and law firm Boies Schiller, as part of its defense.

Wall Street has also provided Herbalife support against Ackman's claims. Herbalife shares have gained back most of their ground since Ackman unveiled his short trade on Dec. 19. Meanwhile investors and analysts see claims that Herbalife is a pyramid scheme as without merit.

Hedge funders Robert Chapman of Chapman Capital and John Hempton of Bronte Capital say that Herbalife's business is legitimate.

Both funds, they say have made bets in favor of Herbalife and against Ackman.

"Despite beguiling and specious reasoning, Ackman will fail to influence/cause a material regulatory response or a HLF distributor exodus," writes Robert Chapman, in a blog post that celebrates a 35% return betting against Ackman.

Hempton of Bronte Capital simply argues Herbalife's earnings and ability to buy back stock can thwart Ackman's bet against the company, even if they are "scumbags," as he writes.

More directly, analysts such as Tim Ramey of D.A. Davidson & Co. simply refute Ackman's allegations that Herbalife could be deemed a pyramid scheme by regulators such as the Federal Trade Commission or the Securities and Exchange Commission.

While Ackman argues 90% of Herbalife's profits come from distributors and not bona fide retail demand, Ramey of D.A. Davidson argues in a January note to clients the majority of Herbalife's earnings come from retail demand, disqualifying it as a pyramid scheme.

In previous research reports, Ramey has discounted Ackman's understanding of Herbalife's retail appeal. Still, the analyst has previously left open the prospect of a distributor exodus. In recent days, Herbalife distributors have expressed confidence in the company to The Wall Street Journal, in on-the-record interviews.

Ultimately, Ackman's accusation that Herbalife is a pyramid scheme isn't likely to be solved in a point-by-point rebuttal of Ackman's 300-plus-age short thesis in the company's Jan. 10 presentation, according to Ramey of D.A. Davidson, who writes in a client note, he expects a more high-level business overview and greater detail on the company's distribution between retail and distributor earnings.

For Ackman's reported billion-dollar short to pay off in the near-term, the question is whether his claims alone can cause a withdrawal of distributor money, which would topple the alleged pyramid scheme.

Such a scenario would be remarkably similar to the U.S. housing market collapse, which helped Ackman collect on his MBIA short.

For more on Ackman's Herbalife short, see why analysts are getting personal.

Also see why MBIA executives are taking money in a case they have to run and why the bond insurers bulls differ on its survival.

-- Written by Antoine Gara in New York

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