Herbalife Scores a Hat Trick Against Bill Ackman

NEW YORK (TheStreet) -- Herbalife (HLF) delivered a hat trick against Bill Ackman's Pershing Square hedge fund on Monday. The network marketing company reported a significant beat on the top and bottom lines, raised guidance, and canceled its dividend in order to increase buybacks. The company stuck it to short sellers Monday:

  • First quarter worldwide volume growth of 9% compared to the prior year period.
  • Adjusted EPS of $1.50 increased 18% as compared to the same period in the prior year. Reported EPS of $0.74 primarily reflects a foreign exchange loss for Venezuela and other items.
  • Raised FY14 adjusted diluted EPS guidance to a range of $6.10 to $6.30.
  • Generated $191 million in operating cash flow in first quarter 2014.
  • Board of Directors takes steps to accelerate cash returns to shareholders, terminates dividend and determines to utilize cash instead to repurchase stock during the second quarter.

For short sellers, it was a worst case earnings report scenario come true. The company reported first-quarter non-GAAP record earnings of $1.50 per share versus the consensus estimate of $1.30 per share.

Revenue was 12% higher than the comparable period last year at $1.3 billion compared to $1.26 billion estimated. At the same time, product inventory level fell from $351 million to $325 million. Short sellers hoping the company would have trouble moving inventory has their hopes crushed quickly.

A beat and a raise. Jim Cramer writes about why a "beat and a raise" is incredibly bullish for a stock in his new book, Get Rich Carefully. Granted, Herbalife is a unique situation that requires an even more careful analysis to determine if it's appropriate for your portfolio, but the theory is the same.

The real kick in the pants for short sellers, particularly shorts that own put options, is the suspension of dividend payments. Unsurprisingly, suspending the dividend appears to be tailor made to put a hurt on Bill Ackman and Pershing Square. If you're not an options trader, you can be forgiven for not understanding the dynamics behind the decision, but I will explain why this is devastating for put owners and beneficial for call owners.

In order to avoid a short squeeze, Ackman reportedly covered a large proportion of his short position and bought put options to create what's known as a synthetic short. Because put options give the owner the right (but not the obligation) to sell (or put) a stock to the seller at a set price over a set period of time, they have an inverse relationship with the stock price.

In other words, with all else being equal, when the stock price increases, put options fall in price. By purchasing put options, Ackman is able to profit if shares in Herbalife fall soon enough. Part of the premium paid for an option is the time premium. Because options have an expiration date, each day they become worth a little less which means time is working against Ackman.

Options also have another component that is highly relevant with Herbalife's decision to suspend the dividend. Because stocks are expected to decline an amount equal to a dividend payment on the ex-dividend date, put options are equally more expensive, and call options are equally cheaper than a given stock without a dividend.

Because Herbalife paid an expected $1.20 per year dividend, leap option (a leap is an option with an expiration at least a year into the future) on at the money is expected to cost about $1.20 more than a non-dividend paying Herbalife. In reality, it's a little more complicated than that, but this works for a back-of-the-envelope review.

What you need to know is that if you own put options with expiration beyond the next expected ex-dividend date, they just fell in value. The more expected ex-dividend dates from now until the option expiration date means the more that the options fell in value.

Because options are priced and paid for at the time of purchase, there's no mulligan, or do-overs, or refunds based on changes in dividend policy. If your name is Bill Ackman and you own hundreds of millions of dollars' worth of put options, your portfolio just declined in value, even if the share price remains the same.

For stock short sellers, the news is decidedly more favorable, at least up to a point. Short sellers pay what's known as "in lieu of" to the buyers of the short sales. If you're short, these payments add up quickly, especially with high yield stocks. No longer having to pay in lieu of payments helps short sellers maintain their position.

That's why I believe suspending dividend payments is a surgical strike against Ackman. Shorting Herbalife isn't a favorable waiting game for put option buyers who need the price to fall far and quickly.

Herbalife just made that objective more difficult to obtain and Ackman suffered a loss even if the stock doesn't appreciate.

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

Follow @RobertWeinstein

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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