Herbalife's Shorts -- Hey Bill Ackman! -- May Be Twisting in the Wind Soon

NEW YORK (TheStreet) -- Argus's downgrade of Herbalife's (HLF) is not as bad as you'd think.

Argus, an independent analyst, lowered Herbalife's rating to a hold from a buy following the recently announced Federal Trade Commission investigation into the health supplement, multi-level marketing company.

Argus's retreat from its bull thesis on Herbalife is based, in part, on a negative shift in market sentiment. Argus has a point: The company's headline peril is far from imaginary, but maybe Argus' timing is more "a dollar short and a day late" than clairvoyance. Even Argus states its expected earnings multiple is in single digits.

Also, Herbalife investors don't need the shares to appreciate in order to profit. Friday, before the open, in Real Money Pro, I shared a trading idea and will discuss here how you can profit also.

But first let's examine the landscape.

By now, the market has fully discounted the FTC investigation and the shares have fallen from January highs above $80 to about $50. If you're a shareholder, I'm sorry to remind you that the retracement should not have come as a surprise. Four months ago, near the top of the move I reminded shareholders they "won" in Herbalife Investors Win Battle and should consider taking some profits. Shareholders were reminded to never let a winner turn into a loser.

If hedge fund Pershing Square, managed by Bill Ackman, isn't an example of not becoming greedy when he had the chance to cover his billion-dollar short under $30 only to watch the shares appreciate above $80, I don't know what is.

It's becoming increasingly clear Herbalife isn't going to implode on its own, even with mountains of negative exposure. And why should it? Ackman's presentation is far from convincing. If I can't be convinced, good luck convincing unbiased government regulators.

My bias against Herbalife, Nu Skin Enterprises (NUS), Avon (AVP) and especially Amway stems from the countless number of times I've been approached with an "investment opportunity."

That said, joining one of the above or the many others isn't substantially different from becoming a real estate or insurance salesperson. Real estate and insurance people are normally considered independent contractors who start out losing money and have a small chance of becoming successful.

The most significant income difference I can find between Herbalife, Nu Skin, Avon and real estate/insurance sales is the bigger upside potential with network marketing.

Unless the entire independent contractor model becomes regulated out of existence, it's reasonable to assume the worst-case scenario is reduced revenue and income, and not Ackman's price target of zero. We know what happens when numerically superior, organized and well-funded organizations become politically united. Think of Herbalife, Avon and Nu Skin's marketing network as equivalent to car dealers in the automotive industry.

In New Jersey, car dealers stymied Tesla's (TSLA) efforts to sell cars directly to consumers, bypassing the traditional car dealer model. Think of Ackman as Tesla and the various network marketing independent agents as car dealers.

In a political battlefield, anything is possible. But if you're not factoring in Ackman as the underdog here, you're not considering all the moving parts.

Time is Ackman and the many short-sellers' enemy. Herbalife's short interest is over 20%; meaning, over one out of every five shares traded is borrowed in order to short. Not including borrow costs (fees charged for the privilege of borrowing shares to short), shorts must also pay what's known as "in lieu of" for dividends.

The current dividend yield is 2.4%, and a falling share price means a proportionally higher short carry cost. What does a high carry cost combined with a massive short interest have to do with an FTC investigation? The FTC may come down hard on network marketing companies and the shorts may still lose.

Imagine in a few months that new and stricter rules are put in place in negotiated settlements between government regulators and companies. Also, imagine that, as a result, the market consensus reduces Herbalife's top and bottom lines by 50%. Extreme, maybe, but follow me for a moment.

Herbalife loses the headline risk and the forward earnings multiple shifts from about 8.5 to 17 at the current valuation. The dividend should remain safe with less than a 50% payout. What do you think will happen if the shorts receive what can only be considered a major win from an unbiased observer?

Herbalife's shares will rocket higher from a massive short squeeze. The rocket's fuse becomes lit when the headline risk is removed and new investors are willing to enter chasing value and yield. Anything short of total destruction for Herbalife results in losses for the bears.

I'm comfortable shorting, and the majority of my trades are shorts; however, Herbalife isn't a short candidate for me and, in fact, the headline risk is already fully (and beyond) priced in.

The smart play remains a long position, and in particular a long bias that is short volatility is optimal.

At the time of publication, Weinstein had no positions in securities mentioned.

Follow @RobertWeinstein

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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