Linn Energy's Queen Gertrude Moment

Linn Energy (Nasdaq:LINE) is the biggest oil-and-gas production Master Limited Partnership (MLP) in the US. The market cap is a little over $7 billion and there is a little over $7 billion in debt.

Like many MLPs it raises a lot of money and it pays big, fat and increasing dividends.

I have a number of listed companies including Linn Energy on "Ponzi watch" because they could potentially be Ponzis attracting capital with large and increasing dividends in an ultimately unsustainable spiral.

There are two things that make Linn Energy stand out. One is the voraciousness with which it raises money and the innovative ways it chooses to do so. In 2009 it raised $292 million. In 2010 it raised $844 million in equity and borrowed over $1.1 billion net. In 2011 it raised a further $679 million and borrowed another $1.2 billion. In 2012 until September it raised another $761 million and borrowed over $2.8 billion net. (Source cash flow statements from the last 10-K and 10-Q.) The company is the most innovative money-raiser in the MLP space having made a parallel structure (Linn Co - NASDAQ:LNCO) to appeal to institutional investors.

The second thing which makes Linn Energy stand out is their strange hedging policy. Linn Energy buys in-the-money puts. It also appears to have entered in-the-money-swaps on gas it intends to sell.

It sells the gas and collects money on its puts and its swaps. The proceeds when the puts and swaps are exercised is considered as distributable income. This is bizarre - so bizarre that I could scarcely believe it was real.

It was as if I owned a Microsoft Share with a market price of $28. And for $12.90 I purchased a $40 January 2014 put for it. [This contract is real - it can be purchased.].

Then come January I exercised the put, sold my Microsoft Share for $40 and declared a big capital gain. I told my clients all about the capital gain and told them they could spend it. I even gave it to them  in distributions. And I told them to ignore the $12.90 I paid for the put which I had amortized away. After all the put premium disappears in depreciation and amortization - and amortization is a non-cash expenses.

If a mutual fund did this I would call it fraud. But just as the water goes down the bath hole differently in the Southern Hemisphere what is fraud in a mutual fund is acceptable in a very large MLP. Much to my disbelief Linn Energy seem to do precisely this.

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Recently some anonymous short seller argued that Linn Energy's accounts were fake because they were doing precisely what I said they were doing above. Barrons recently made similar points.

Whatever - the short seller said (according to the MLP) that the MLP purchased "deep in the money" puts. This led to an amazing 8-K released by Linn Energy - an 8-K leaves me thinking of almost nothing except Queen Gertrude in Hamlet saying "methinks the lady doth protest too much".

This blog post repeats the whole press release with annotations. The original is in italics.

LINN’s Hedging Strategy and Response To Inaccurate Statements

Made By An Anonymous Short Seller

“Since our IPO, hedging our oil and natural gas production has always been an important strategy for the company and our investors. Our hedge strategy has served LINN and our investors well through a variety of commodity price cycles,” said Mark E. Ellis, Chairman, President and Chief Executive Officer. “Hedging will continue to be an integral part of LINN’s strategy.”

Below is an overview of the company’s hedging strategy and the company’s comments related to inaccurate statements made by an anonymous short seller.

Hedging Rationale

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Reduce commodity price risk

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Lock in acquisition margins

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Lock in margins on organic drilling (capital investment)

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Provide stability and growth in distributions

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Preserve ability to make acquisitions during down markets

Hedging Strategy

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Hedge up to 100% of expected production for 4-6 years

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Continually maintain a 4-6 year hedge book

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Use approximately 70% swaps (fixed price contracts) and 30% puts (floor contracts with unlimited upside)

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Typically budget up to 10% of the cost of an acquisition for put expenditures

This last line is an admission that they buy puts and capitalize them. They also own gas swaps (ie forwards) which are a long way out of the money. Do they also budget cost for buying those? I would like to know.

Fact #1 – LINN is confident in the validity and accuracy of its audited financial statements.

Well they would say that wouldn't they? However there is no allegation I am aware of that the P&L or the balance sheet is incorrectly stated. The allegation is that EBITDA (which is not a GAAP concept) is overstated and they are paying unsustainable distributions.

Indeed the idea that they are paying unsustainable dividends is supported by their audited accounting statements. Linn Energy made an audited GAAP loss of $298 million during 2009. It paid $303 million in distributions. It made an audited GAAP loss of $114 million in 2010 and paid $366 million in distributions. In 2011 it made a (rare) profit of  $438 million and paid $466 million in distributions. (Source: the last 10-K).

The last 10-Q reveals the situation has worsened: Linn Energy made a loss of 199 million in nine months - but it made 430 million loss in the last quarter. And it paid distributions of 426 million.

The pattern is increasing losses and increasing distributions - something that would be a standard feature in a Ponzi.

As a short seller I am relatively confident in the accuracy of Linn Energy's audited accounts. Far more confident than I am in their definition of distributable EBITDA.

Fact #2 – LINN generates sufficient cash flow to cover its distributions.

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Since the company’s IPO in 2006, LINN has paid its distribution for 27 straight quarters. These distributions were paid in CASH.

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Amortization of puts is a non-cash expense and should not be deducted from EBITDA (hence the definition of EBITDA; earnings before interest, taxes, depreciation and AMORTIZATION).

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LINN considers the cost of puts as a “capital” investment and views it as an additional cost of an acquisition (hence the target to spend up to 10% of the cost of an acquisition on puts). No one disputes that “depreciation” of oil and natural gas assets should be excluded from EBITDA or distributable cash flow because it is a “capital” expense, and the company views puts the same way.

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When LINN purchases puts, the company pays 100% of the cost in upfront cash and capitalizes them as an asset on the balance sheet.

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The cost of LINN’s puts is deducted from Net Income over time. Net Income is not a cash metric.

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What does flow through to Distributable Cash Flow per Unit is the cost of debt and equity securities (interest and distributions) that were needed to purchase both the oil and natural gas assets and the puts. This is a CASH expense.

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Anonymous short sellers are improperly mixing the definitions of cash flow and non-cash flow metrics (Net Income vs. Cash Flow).

This is a straight admission of the short-case against Linn Energy. Linn Energy buy puts. They pay money for these. They do not consider amortization of those puts an expense that should be deducted from their "distributable amount". They admit it should be deducted from the GAAP income.

This is an absolute analogue of me buying $40 puts on Microsoft and considering the gain when I deliver my Microsoft shares to be distributable. [Of course my GAAP accounts will tell the truth. Linn Energy's GAAP accounts also tell something approximating the truth. The truth is that Linn Energy is a loss making enterprise.]

Fact #3 – LINN does not always buy “in the money” puts.

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Most of the company’s hedge positions consist of swaps (approximately 70%), which are entered into on “market” terms.

Now here is where the company completely loses me. All this legerdemain is alright because most of it is done through swaps on "market" terms. The give-away is that the word "market" is in inverted commas. You see this is a definition of "market" that I am not normally familiar with...

In particular the company swaps seem to be at the same price or higher than the company puts. And the puts are purchased "in the money". Moreover they invest money in their swaps so the swaps are purchased in the money.

You can see this in the last 10-K. In 2012 the price of their gas swaps is $5.85 (a fair way in the money). The price of their puts is $5.83. There is not much difference. There is not much difference in the out years except that for 2014 the price of their swaps is $5.69 and the price of their puts is only $5. In some years it seems the company "invests" just as much in their swaps as in their puts.

So they use swaps to fudge their distributable amount too.

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The remaining balance of the hedge position consists of puts, the majority of which were purchased BELOW the market.

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Out of 40+ hedging transactions over the last 10 years, only 7 were purchased “in the money.”

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Some of the confusion arises due to the fact that certain investors do not know the difference between the prompt price (today’s price) and the 4, 5 or 6 year average market price.

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For example, if the spot price for natural gas is $2.00 per Mcf but the 5 year average is $4.50 and LINN purchases a $5.00 put, that could hardly be considered “deeply in the money” when compared to the 5 year average market price.

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When making decisions regarding spending money for puts, LINN focuses on achieving the best value for its money.

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Additional confusion arises when some investors look at the price levels for the company’s hedge positions. This is largely due to the fact that most of LINN’s hedges were executed when prices were higher.

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Obviously this is the reason the company hedged in the first place. LINN wanted to insulate the company from just such an event.

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LINN has never and will never purchase deeply in the money puts to manipulate its cash flow stream.

I am just going to call BS on this. The company is claiming that it purchased substantial numbers of below market hedges. I want to point out the average price of gas sold after hedging in 2009, 2010 and 2011 was $8.57, $8,22 and $8.20 respectively. It is an awful long time since the natural gas prices - even forward natural gas prices - let alone say five year strip natural gas prices were that high. There is simply no way that these prices were obtained except by purchasing substantially in-the-money positions with large amounts of cash.

The last sentence - that LINN has never and will never purchase deeply in the money puts to manipulate its cash flow stream is a real Queen Gertrude moment as will be discussed below.

Fact #4 – LINN does not restructure its hedge book to manipulate earnings.

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On rare occasions, LINN has restructured its hedge book.

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One example was in 2008, when oil soared to $150 and LINN’s put strikes were approximately $70. At the time, that hardly felt like adequate protection. LINN paid a nominal sum to raise the strike prices for 2009 and 2010 to $120 and $110, respectively. First, both transactions were well BELOW the market, and second, oil later that year declined to a low of roughly $35.

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Two other examples came in July 2009 and September 2011:

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Both instances involved a precipitous decline in prices in the “long” part of LINN’s book (i.e. in years 4-6).

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LINN realized gains of approximately $75 million by unwinding these positions. The company’s intent is always to leave the value in the hedge book instead of taking the cash. Therefore the company used the proceeds to raise hedge prices in near term years by a nominal amount.

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Shortly thereafter, LINN rehedged the outer years again.

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Bottom line is this is extremely rare and the magnitude of the trades is immaterial.

I agree LINN does not restructure its hedge book to manipulate earnings. The hedges are accounted for properly on a GAAP basis. What this does do is change its measure of EBITDA. In every instance they have reduced the price received in out years (reducing the EBITDA in out years) and increased the price received (and hence their measure of EBITDA) in the near-years. What they are doing is manipluating their dodgy definition of EBITDA and hence distributable cash flow.

They do this to continue to fake-up their distributable income and hence allow them to pretend to have a sustainable dividend.

They say the trades are immaterial - however the last 10-K contains this amazing section:

In September 2011, the Company canceled its oil and natural gas swaps for the year 2016 and used the realized gains of approximately $27 million to increase prices on its existing oil and natural gas swaps for the year 2012.  In September 2011, the Company also paid premiums of approximately $33 million to increase prices on its existing oil puts for the years 2012 and 2013.  In addition, during the fourth quarter of 2011, the Company paid premiums of approximately $52 million for put options and approximately $22 million to increase prices on its existing oil puts for 2012 and 2013.

Lets count that out. The company used 27 million of gains (taken out of 2016 hedges) just to increased their estimated distributable income in 2012. But that was not enough. So they paid $33 million to increase the price of their oil puts for 2012 and and 2013. They also paid 52 million for more put options and 22 million to increase prices on oil puts for 2012 and 2013. Funnily enough all this legerdermain is additional to the ones disclosed above in the press release.

This is beginning to look (a) material and (b) like a pattern.

The company says that it has never and will never purchase deeply in the money puts to manipulate its cash flow stream. That was the Queen Gertrude moment - after all they have a pattern of paying to make options and swaps more in the money to manipulate their cash flow stream.

Fact #5 – During 2012 LINN purchased $583 million of puts for the following reasons:

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During 2012, LINN completed approximately $3 billion of acquisitions. Consistent with its hedging strategy to reduce commodity price volatility and lock in margins associated with the acquisitions, LINN purchased approximately $320 million of puts (again roughly 10%).

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The remainder of the $583 million spent during 2012 was used to add puts for 2013 through 2017 for volumes that were not yet hedged.

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As a reminder, this $583 million cost has a true finance cost (interest and distributions). The puts were purchased with cash. The potential benefit may not be realized for years to come. However, the cost is reflected now in LINN’s distributable cash flow per unit.

I have read this several times. All it means (I think) is that they paid out $583 million in cash which they will receive back when they sell gas and oil in the out years. That cash (which was borrowed as far as I can tell) will wind up being counted as distributable cash flow and be distributed. In a round about way then the company is borrowing to pay distributions.

Fact #6 – LINN’s publicly stated Adjusted EBITDA is the same that the company provides to its lenders.

Bluntly: Linn Energy uses the same misleading definition of EBITDA with the people it borrows from as it does with the unit holders. Does this make the lenders nervous? Should it make the lenders nervous?

Fact #7 – LINN’s taxable income is low relative to its cash flow.

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The company’s taxable income due to non-cash deductions is relatively low compared to cash flow. So is every other oil and gas company.

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LINN does not pay distributions with net income; the company pays them with cash flow and clearly has sufficient cash flow to do so.

I agree Linn's taxable income is very low relative to its cash flow. This company makes GAAP losses. It also - as far as I can tell makes tax losses - there is no taxable income.

Linn Energy however has raised its distributable cash flow with its strategy of buying in-the-money hedges. They just don't think that is faking EBITDA. I report: you decide.

Fact #8 – LINN only cancels out of the money hedge positions to comply with lender covenants.

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On two occasions the company cancelled hedge positions, which happened to be out of the money at the time, to comply with its bank covenants when selling assets.

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LINN also cancelled interest rate hedges when issuing long-term fixed rate bonds, again to comply with its covenants.

This is maybe the most extraordinary admission I have ever seen from a richly valued company. This company has has rejigged its hedging to comply with its covenants. Which covenants? Is it necessary to use this convoluted and unusual definition of EBITDA to comply with covenants? How do lenders feel about this? Do lenders even know they are being fed an unusual definition of EBITDA?

Fact #9 – LINN does not issue debt and equity securities to pay its distribution.

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Since the company’s inception, LINN has issued approximately $12 billion of debt and equity securities:

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$10 billion to finance acquisitions

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$1 billion to finance puts (roughly 10% of the cost of the acquisitions)

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$1 billion primarily to repay higher cost debt

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Since its IPO, LINN has paid $2.4 billion in distributions. The only way that would be possible is by earning a sufficient amount of cash to pay the distribution, which LINN clearly did.

I agree the company does not raise money to pay distributions. Linn borrows money to buy things including put options and other derivatives. The money paid for these derivatives turns to cash as the company sells gas and oil at inflated prices. It is then distributed to unit holders.

Unit holders and debt holders would not countenance raising money to pay distributions. That is the essence of Ponzi.

So a really strange and opaque derivative maneuver gets inserted in the process. Then they sell equity and debt securities to buy derivatives that turn to cash. Then they distribute that cash. Whether interposing the strange derivative maneuver is sufficient to remove the whiff of Ponzi I cannot tell. I report: you decide.

As for the statement the only way that paying $2.4 billion in distributions would be possible if they earned the money - well I just present the GAAP accounts. All they have earned is losses. This company clearly has a different definition of "earnings".

Other Information:

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In evaluating this issue, LINN has identified other publicly traded partnerships that purchase derivatives, and all of these companies account for derivatives the same way LINN does.

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In fact, LINN has yet to identify any publicly traded partnerships that account for it differently.

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LINN’s hedge policy strictly prohibits any speculative trading or manipulation in the hedge book. The company adheres strictly to this hedge policy.

The GAAP accounting is correct. I have said this above. What is unusual is the definition (non GAAP) of distributable amount. I have yet to see any other partnership that estimates its distributable amount in this way - but hey - there are always other things to short as well.

So there.

That Queen Gertrude does protest too much. And she is so transparent.





John

Another day - another strange Gulfport Energy related party transaction

I woke up this morning to the news that Gulfport Energy (NASDAQ:GPOR) is buying another 22 thousand net acres in the Utica Shale from Windsor Ohio - an affiliate of Wexford Capital. The price is about $10 thousand an acre. This is funded by a large equity raise.

This is very similar to a transaction in December 2012 where 37 thousand acres were purchased from Windsor Ohio for $372 million. That was also funded by an equity raise. The 8K describing that transaction contained the following disclosure:

Mike Liddell, Gulfport’s Chairman of the Board, is the operating member of Windsor Ohio. All distributions made by Windsor Ohio are first paid to the Wexford members in accordance with their respective ownership interests in Windsor Ohio until they have received amounts equal to their respective capital contributions. Thereafter, distributions are made 90% to the Wexford members in accordance with their respective ownership interests and 10% to Mr. Liddell. Upon closing of the Acquisition, Mr. Liddell received approximately $2.9 million in distributions from Windsor Ohio corresponding to his 10% interest described above.

It is an open question as to how much money from this equity raise will find its way into Mr Liddell's pocket. The Gulfport Energy press releases do not broach this question.

However - on a cursory look - it appears that the Windsor Ohio members have already received back their capital contributions and on a literal reading of the above quoted 8K a full ten percent of the money paid for this acreage will flow personally to the Chairman of Gulfport Energy.

$22,000,000 is not a bad pay day. I know it is a guess - but hey - Gulfport do not disclose this detail in their press release. Nor is it disclosed in their prospectus for the offering. I telephoned Paul K. Heerwagen IV (the IR officer and contact on the press releases) and asked him the question directly. He hung up on me and did not answer return calls.

But dear Gulfport shareholders - you should have no discomfort: the press release assures us that "the transaction was approved by a special committee of Gulfport’s Board of Directors."





John

Disclosure: short Gulfport.

Comment on the false New York Post story about the law enforcement investigation against Hebalife

About twenty four hours ago I was alerted to a story in the New York Post by Michelle Celarier asserting that Herbalife was the subject of an enforcement action. To quote:

The Los Angeles-based distributor of nutritional products is the subject of a law enforcement investigation, The Post has learned. 

The existence of the probe emerged after the Federal Trade Commission, responding to a Freedom of Information Act request by The Post, released 192 complaints filed against Herbalife over the past seven years. 

The FTC redacted some sections, saying it didn’t have to divulge “information obtained by the commission in a law enforcement investigation, whether through compulsory process, or voluntarily ...”

This story was false. But lets go to the original source - the information released by the Federal Trade Commission (FTC).

The key document - the source of the New York Post story - was on page 719 of 720. Here it is the key bit - a photograph:

To quote directly:

We have located 717 pages of responsive records. I am granting partial access to, and am enclosing copies of, the accessible records. Fifteen pages, and portions of other pages, are subject to two of the nine exemptions to the FOIA's disclosure requirements, as disclosed below. 

I am withholding 15 responsive pages which are exempt from disclosure under the FOIA Exemption 3, 5 U.S.C 552(b)(3), because they are exempt from disclosure by another statute. Specifically, Section 21(f) of the FTC Act provides that information obtained by the Commission in a law enforcement investigation, whether through compulsory process, or voluntarily in lieu of such process, is exempt from disclosure...

The FTC found 717 pages of responsive records. It withheld 15 pages because they were exempt from disclosure because they were found pursuant to a law enforcement investigation.

On this flimsy evidence and no more the New York Post concluded that Herbalife was itself subject to a law enforcement investigation.

The text says nothing of the sort.

Indeed the text proves comprehensively that Herbalife is not subject to a law enforcement investigation.

The way you see that is obvious. When the government asks for documents using a subpoena or the threat of subpoena how many documents do you think you supply? The usual story is truck-loads. Fifteen hundred pages of documents would be typical in a very minor case. Fifteen thousand pages would be more typical. 15 truck loads is not unknown. Discovery is very expensive.

The fact there were only 15 pages of documents gives you the answer you need. These documents may have been found subject to a law enforcement investigation but the law enforcement investigation was not against Herbalife and fifteen pages of documents came out as a by-product.

This was obvious enough to anyone who thought about it - and I purchased the stock for the bounce.

Michelle Celarier - the New York Post journalist - made an amateur mistake driven by simple failure at reading comprehension.

We all make those. Lord knows I have made mistakes. (And when I make them my clients lose money...)

But that is not how Michelle Celarier sees it. She blames the FTC language for her mistake rather than herself. Panicked investors, now wearing an unnecessary loss, might not be feeling quite so charitable towards Michelle and the Post - which I hasten to add is in many other respects a surprisingly fine paper.

John

Notes on visiting an Herbalife nutrition club in Queens

I visited a Herbalife nutrition club in Queens. There is plenty wrong with this company – but this is not a post about the things that are wrong with the company (most of those I will leave for other people to think about). This is simply a post about what I observed and the implications for Bill Ackman's Herbalife thesis.

(a). There are a lot of Herbalife nutrition clubs in Queens. This is an Hispanic area and within the US Herbalife is mainly an Hispanic phenomenon. If you use Google satellite navigation on your phone you will find lots Herbalife clubs (dozens are listed around Corona Queens) though some of the ones you try to locate will not be there any more (suggesting they have either moved or closed).

(b). I was told the best time to visit a nutrition club was between 7 AM and 9 AM so I dutifully arrived at about 7.15. The club was empty. I was told to go with a Spanish speaker because the clubs were pretty close to mono-lingual Spanish. The club was not signposted from the street and coloured paper made opaque the windows so a passer by would not know what was in there.

(c). I was served “all three” meaning an aloe drink, a diet suppressing tea and the protein shake.

(d). This was the first time I had drunk a protein shake. I can tell you they suck - so does the tea for that matter. This stuff tastes unbelievably bad. It is flat-out-gross. I sent an email (with the trusty smart-phone) to a friend in Asia explaining where I was and told him how gross it was. He puzzled: he asked if I was a virgin. He explained that when he was a competitive lightweight rower (he rowed for an Ivy League university) he used to live on protein shakes as he had to keep his weight within the limits. And he exercised extensively on them. Exercise and protein shakes is a well-worn and proven weight loss combination. But they do taste gross. [I have been informed that Herbalife taste slightly better than some protein shakes at the cost of adding some sugars – also I have been informed the texture is much improved by blending in a banana or even a mango....]

(e). There were no visitors prior to 8 AM. By 8 AM I was going to sell my entire Herbalife long and give up on the position. My Spanish translator talked to the guy running the place and he told us roughly how many visitors he got a day and told us the time they came in – and that it really started by about 8 AM.

(f). The translator was correct. The visitors started around 8 and in the next 75 minutes over twenty came in. They came in roughly to his schedule suggesting that they were regulars. They spoke in Spanish and he spoke to them as friends. Most of them were either no longer obese or in the transition from being morbidly obese to (merely) rectangular shaped.

(j). The key product: the proprietor/distributor greeted the visitors as friends and offered moral support as they drank the tea and the shake.

(k). There was a series of before and after photos on the wall. They were impressive – many of the customers – and the husband and wife team that ran the club – had gone from balloon shaped to roughly rectangular. [I gather before and after photos are impressive at other weight-loss groups such as Weight Watchers - however in this case there were a lot of impressive photos for a very small club.]

(l). The husband and wife who ran the shop had been Herbalife customers for about five and a half years and had been running the club for about eighteen months. They were true believers in the product – extolling its virtues and also repeating mostly in Spanish but also in Spanglish the benefits of the Herbalife system. [In their case they also also extolled the virtue of replacing the fat-and-cheeze laden meals that were non Herbalife with something more nutritious and the virtue of some exercise even if it was just walking further.]

(k). The benefits of the Herbalife program in the wife's case were real. The wife had gone from a three insulin shot per day diabetic to a half insulin shot per day diabetic. [Statistically this should add over 15 years to her life expectancy.] Her prior body was balloon shaped.

(l). On the wall was a list of the seventy odd people who regularly attend this Herbalife club. There was a list of gold stars against the names with weight-loss and Herbalife consumption targets on them. Clearly the gold stars were part of the reward system. This looked a little like primary school.

(m). We asked if he had any “downline”. He explained to us that every one of his core customers was also a distributor – and they were a distributor to get the 25 percent discount on stuff they took home.

Observations

This club was not a club selling diet drinks (but it clearly did that). It was a club selling the social support group necessary to drink diet drinks. These diet drinks work (especially when combined with a modicum of exercise). What happens though is that normal people do not have the will-power to maintain a diet drink and exercise regime. My friend in Singapore did – but then he rowed competitively and people into rowing are austere driven people (think all those 4 AM starts).

But I am a fairly disciplined person and - without social support I could not drink these shakes.

In the richer-parts of our society we have a solution to diet-and-exercise will-power problem. We hire a personal trainer (usually someone cheerful, younger and good looking) and they cajole us into weight-loss. This is a “for-hire” personal support group.

But Herbalife is another valid mechanism of getting personal support – and it clearly worked on the customers I saw. Personally I find it very difficult not to endorse a product that reduced to one sixth a person's insulin injection requirement. If Bill Ackman thinks America would be better off without Herbalife he could politely explain that at the woman's funeral.

I will - in the interest of fairness - include the main negative observation: the man who ran this shop covered his rent (we worked that out) but he was cheerful man working hard (80 plus hours a week) and making an amount that was less than minimum wage. I gather than many (possibly a majority) of Herbalife clubs do not cover rent (consistent with the observation that there are lot of Herbalife clubs in Google maps that no longer seem to exist). Minimum wage appears to be the upside.

This showed both the benefit and problems with multi-level marketing. The benefit is that it allows a company (in this case Herbalife) to get deep into a community and that is a necessary part of the product – the product they are selling is community support for weight loss and they can't do that without getting into the community. The problem is that the company actively recruits distributors to the point that it is impossible for the distributors to be good businesses. Indeed as the rewards to many people in the chain are on recruitment (and you can't make it up the chain without a substantial “down-line”) it is likely that recruitment will continue until the distributors make nothing (or less than nothing when convinced to sign up by hard-sell rather than rational argument).

There were so many Herbalife clubs around Queens that I suspect on average the Herbalife shops make something near nothing or less than nothing. The profile of a Ferrari driving Herbalife distributor that Mr Ackman presented was – at least compared to what I saw – ludicrous.

I wrote once about income distribution in the US by working out how cheap my laundry was in Brooklyn and working out that it was being done in a sweat-shop with illegal Chinese workers paid under minimum wage. [I got a lot of flack for that post from my libertarian readers.] The Herbalife distributor I met (who may also have been an illegal) had a better life than those illegal sweat-shop workers. He did not earn much more money – but his job was community based and he interacted as a friend with a great many customers. That I think was personally satisfying and he clearly was happy with his lot. And the product saved his wife's life which trumps most things.

Herbalife as exploitative in a Marxist sense

Herbalife is clearly an exploitative system in the Marxist sense. The head-honcho is paid well over $70 million derived from a vast network of people earning minimum wage or less. Dan Loeb (who now controls 8 percent of Herbalife) is someone who often attacks excessive salaries for senior executives. This could become quite amusing.

Some comments on Bill Ackman's thesis

It was striking how totally Bill Ackman's thesis fell apart from observing for just a few hours in a nutrition club.

The best way of analysing Herbalife that I can find is as alcoholics anonymous for fat (and very often Hispanic) people. I joke: “my name is Jose and I am fat”.

Herbalife works in the same way as alcoholics anonymous – by supplying (and in this case selling) a support group to help you kick the “fat addiction”.

Like Alcoholics Anonymous it has millions of members and looks – at least externally – a bit like a cult.

Herbalife like Alcoholics Anonymous has millions of members because it works. It does not work because one nutrition powder is better than another (indeed some nutritionists argue soy based powders are inferior). Herbalife works because of the support group.

AA is probably the single most effective way devised by humanity to cure alcoholics. It is far more effective than any drug developed by pharmaceutical companies and if a drug were devised as effective as and as free of side effects as AA then it would be worth tens of billions of dollars. Even then AA probably fails a majority of times. Herbalife is among the more successful ways of curing morbid obesity (but even then it probably fails a majority of times). [I shudder to think what a weight-loss drug as effective as the Herbalife support system would be worth though - considerably more than Herbalife's market cap.]

The biggest difference that I can see between AA and Herbalife is that Herbalife is (emphatically) a for-profit institution (and possibly quite an exploitative for profit institution) whereas AA is just a club.

Lets run through Ackman's presentation by section

Ackman on Herbalife as a commodity

From Page 21 to 26 of the presentation Bill Ackman “demonstrates” that Herbalife's products are not unique – and from that he argues that they do not maintain their price position by being a “proprietary product”. He compares the product to GNC and other brands and notes the price per serve or the price per calorie is higher.

This is a complete misunderstanding of Herbalife's product. GNC and other brands are sold as commodities. Herbalife is sold with a community support mechanism.

In Central Park anyone can go and have a run. It is free. It costs you $20 an hour if you exercise with a personal trainer. Comparing the price of Herbalife (sold through a network) to the GNC (sold without a network) is like comparing the cost of a run through the park without and with a personal trainer.

Bill Ackman has just missed the point.

Ackman on Herbalife's lack of advertising

From pages 27 to 31 Bill Ackman notes the lack of advertising expense on Herbalife (which he argues is very little) and says that they cannot maintain their price premium that way.

This is of course garbage. Herbalife has the best advertising possible – word of mouth. People will pay huge sums to Facebook for the hope of getting someone to “like” a product online and hence endorse it to their friends. Herbalife has far more powerful advertising support than that – it is deep in the community.

Alcoholics Anonymous has 2 million members and I have never seen an advertisement for the product. However like you I have heard of AA. Brand recognition for community based products is (naturally) very high. I suspect almost every reader of my blog has heard of Alcoholics Anonymous without ever seeing an advertisement.

That said Herbalife does sponsor one of the biggest football teams in the world (Barcelona). It also sponors LA Galaxy but nobody cares about them!

Bill Ackman on Herbalife's research and development

From page 35 to 50 Bill Ackman tells us all about Herbalife's (very thin) research and development program.

He is of course right that relative to its claims Herbalife has a very thin research and development program. So what: Alcoholics Anonymous – relevant to its claims – has a very thin research and development program. And yet it is known to work for a lot of people and the results are well known.

There is plenty of research that says social cues are important in whether you take drugs or not, whether you drink. And social cues are important as to whether you stay fat or not.

You don't need a lot of research to tell you that.

As Bob Dylan says: you don't need a weatherman to tell which way the wind blows.

The main Bill Ackman mistake

Page 164 of the Bill Ackman presentation lays out the key criteria for determining whether Herbalife is illegal. Here is the slide:

I will quote this as it is the core criteria for determining whether Bill Ackman is right:

The critical question for the FTC is whether the revenues that primarily support the commissions paid to all participants are generated from purchases of goods and services that are not simply incidental to the purchase of the right to participate in a money-making venture.

Bill Ackman spends most of his presentation arguing that Herbalife's product is the business opportunity. He argues for instance that most the product is sold to "distributors". This was clearly true in the Herbalife club I visited. Almost every customer was also a distributor. They however were clearly customers - they came in - they paid their money - they drank their shake. They look like customers because they were customers.

Bill Ackman calls these distributors victims of a false "business opportunity". Facts on the ground: they are customers.

That fact is very inconvenient for Bill Ackman because if they are customers then Herbalife is legal and Ackman's thesis falls apart totally.

Bill Ackman's logic as to why these distributors could not be customers is disarmingly simple - and amazingly erroneous. Bill Ackman argued that it was illogical for someone to sign up as Herbalife distributor for the 25 percent discount because even with a 25 percent discount the product was more expensive than commodity product available from GNC and other suppliers. [My Spanish translator came back to me with an errata on this point: he says that some of his downstream were considering the business opportunity - but the majority were distributors without any plans at all on the business opportunity.]

That is true. But it misses the point.

Remember those gold stars and the support group. If you buy weight loss shakes from GNC you do not get the gold stars. Buy the product from GNC and you are not part of this Latino self-help group. By not understanding Herbalife as a social support group for weight loss and by analysing the product as a commodity Bill Ackman has failed to observe what globally would add up to millions of customers. Real customers. The customers that make Herbalife legal.

What this story is really about

Herbalife is a company which combines a lot of good (think the life-saved diabetic above) with some pretty ugly features.

But this is not really a story about Herbalife - Herbalife will survive globally. Like all multi-level marketing schemes it will have its ups and downs. There will be all sorts of problems (such as tax compliance throughout the scheme, cash handling, perhaps even using Herbalife accounts to launder money).

What this has (deservedly) become is the story about how Bill Ackman can be so wrong. He spent (by his own admission) a year and a half analysing this company and his thesis can be falsified by visiting a few clubs in his home city. Bill Ackman's thesis is the most easily falsified bear-thesis I have seen from a major hedge fund ever.

You have to wonder how this happened. So I am going to tell you: 

Bill Ackman a Harvard educated (magna cum laude) billionaire New York hedge fund manager bet over a billion dollars on a short position (imperilling his fund and his reputation) without checking the facts.

And he did not check the facts because he was so rigid with a misplaced silver spoon that he could not stoop to sit on a subway for thirty minutes and talk with poor people for ninety minutes.



John

Bill Ackman either lacks imagination or has a touching faith in government

There is a wonderful Bloomberg story today about the more-to-come in the Bill Ackman vs Herbalife saga.

There is however one quote in the article which exposes the flaw in Bill Ackman's position:

“We can’t imagine how the SEC or the Federal Trade Commission or any other relevant regulator will ignore what we have said.” 

Either Bill Ackman lacks imagination or has a touching faith in government or both.

In the comments people might put a list of things you might think that Government could never possibly ignore but do. I will start with climate change. There are plenty of others: the range of government failures covers the whole political and policy spectrum.





John

Ackman's Herbalife thesis: someone from the government will help poor people and billionaire hedge fund managers...

I was just on CNBC talking about Herbalife. Nervous as they come and was propped the wrong way by the sound guy (and hence never looked at Herb Greenberg who interviewed me).

But here is the quick summary.

I agreed with Bill Ackman that Herbalife is mostly about ripping off distributors and people at the end of the chain. The product is more than twice as expensive as competitor shakes. I called Herbalife "scumbags".

But they are highly cash flow positive scumbags and they will use the cash flow to buy back shares. Over the past five years the share count has gone from 140 million to 108 million and will fall further.

They are scumbags then - but they are scumbags working for stock market investors.

That I pointed out was similar to tobacco companies. Tobacco companies kill 5 million people globally per year - 400 thousand of them in the USA. Is anyone stupid enough to think the government would close them? That has been a bad short thesis for decades!

Bill Ackman is shorting a profitable company - and his argument is that they run an illegal pyramid scheme. By implication his argument that the government is going to somehow close them down.

That is a really truly awful short thesis - the short thesis that Government is going to come and help poor people and a billionaire hedge fund manager! Normally neither group is high on the agenda!

---

I said that I had reported many frauds to the SEC. Sometimes the SEC acted. Mostly it did not. When it acted it was often after the stock had gone to zero.

If my thesis was the government was going to help me then I got it wrong!

Bill Ackman has that one wrong!

---

I did not state other important parts of the argument.

(a). Being wrong on crowded shorts is very dangerous indeed. Herbalife is a crowded short - the short is however mostly one person - Bill Ackman - who has a massive position.

(b). The nutrition clubs have some merit. I once shared house with a lesbian Avon lady. She sold a couple of hundred thousand dollars worth of make-up a year. Her shtick was simple. She visited women stuck in outer-suburbia - the land of the 3 hours of daily commute. Their husbands were away from them for 11 hours a day and they were very stuck. She would play with them - putting makeup on them like 14 year old girls put makeup on each other. She would tell them they were beautiful and be supportive. This was multi-level marketing as decentralized support mechanism and it worked.

The nutrition clubs are like that. Fat men turn up and share a shake with other fat men and support each other to lose weight. It is sort of a Hispanic obese person's version of alcoholics anonymous. Mostly Hispanic anyway - as it started in the Hispanic community. Guys turn up and they say something like "My name is Jose and I am fat". It works.

The Manhattan version of support for weight loss is a highly priced gymnasium with a personal trainer to push you to remove the pounds. But it is blindingly arrogant to believe that that is the only valid sort of support group for weight loss.

---

I also did not say what I think Herbalife's strategy should be. They are going to offer a defence. I think it should be bland - simply a statement of profits and maybe the merit of the system.

Anything to allow Herbalife to buy back more stock. Herbalife has a lot of capacity to buy back stock as it is very cash flow positive. The more stock they buy back the better for remaining shareholders.

I might wind up a remaining shareholder. So I hope they buy a huge quantity of stock back - and the easiest way to do that is to do that when the stock is cheap - that is right now.

---

As per usual on this blog I could be wrong. The government might just decide to help a billionaire hedge fund manager out and save Bill Ackman from his oversized position.

That however is something I am willing to bet against.




John

Madeleine Albright and Herbalife

Presented without comment.

Hewlett Packard Pension Fund - a final post

I have written three posts on HPs pension fund. I also wrote to HP outlining several of my main concerns.

HP filed a 10K and gave me a detailed response to other concerns. They also hired external audit people to check.

First observation: A good proportion of the gains were from total return swaps on very long US government bonds. I thought that unlikely - but many of my blog readers (correctly) guessed it.

Second observation: All my other concerns appear groundless. (I am not going to bother detailing them as they were groundless.)

I was wrong. It happens a lot unfortunately.

Kudos to HP on transparency

I have written many letters to companies before - most to very dodgy companies. I have never received a response as transparent as HP. Kudos to them.

As for Gretchen Tai. Her asset management looks pretty good.



John

Bill Ackman enters the city of Stalingrad

A few days ago I wrote a post describing shorting multi-level marketing schemes as akin to the Battle of Stalingrad.

Little did I know that Bill Ackman was shorting well over a billion dollars in Herbalife stock. [If you need the figure you can back work it out from comments in this BBC interview.]

Ackman has publicly said his target for the stock is zero - and the size of his position (huge both with respect to the company and his fund) and the ferocity of his attack means that his only honourable out is the total collapse of Herbalife.

Moreover Ackman is a very wealthy man controlling funds considerably larger than Herbalife's resources. He has said he can't be bought off. The only way Herbalife is going to get rid of him is by totally defeating him.

This is the hedge-fund equivalent of Stalingrad. Someone is going to lose big. And the victor will be so bloodied that the word victory will sound hollow...

For a short-seller who is as risk-averse as me watching this is pure hedge-fund porn.







John

PS. I am utterly convinced by everything in Bill Ackman's presentation except the final conclusion - that Herbalife's stock will collapse. I took a long position on Christmas Eve. I suspect that Herbalife is so profitable and so powerful they will see Mr Ackman's attack off - and the easiest way to do that is to buy back stock (and make the stock go up). Mr Ackman has given them the incentive to return their huge (but tainted) profits to shareholders (and I plan to be a recipient shareholder).

PPS. Ten years ago Ackman's old fund (Gotham Partners) wrote a defence of a multilevel marketing scheme called Pre-Paid Legal Services. They were long (which turned out OK in the end). The PDF document was called: "A Recommendation for Pre-Paid Legal Services, Inc". If anyone has a copy of the original PDF I would appreciate it. These days the report is only remembered because Gotham wrote the bullish report and sold stock into the subsequent rise. Elliot Spitzer investigated (an investigation that went nowhere).

J

Fushi Copperweld: A Christmas present from the China Development Bank and Abax Captial to arb funds

For the record: I lost on this one. See SEC filing...


Fushi Copperweld - a small cap Chinese stock specializing in bimetallic wire - is going private - purchased by "Green Dynasty" - a vehicle funded by Abax Capital and China Development Bank. The deal was supposed to close in the week of 11 December 2012 according to a press release filed with the SEC.

It never closed.

The following Monday (before market) Fushi released an update regarding the merger. The press release has so far not been filed with the SEC. To quote: "[b]ased on information provided by Green Dynasty, the Company anticipates closing of the transaction by or on Monday, December 24, 2012."

If the deal closes it will be a nice Christmas present from the Chinese to various arb funds because this deal has had a fat spread for much of its existence.

History of this transaction

This transaction has history. It was first proposed by the chairman in November 2010 at $11.50 - but later withdrawn. The Chairman came back with a $9.25 offer and revised that offer to $9.50 which was accepted.

The stock is not without controversy. Muddy Waters (of Sino Forest fame) has alleged Fushi is a fraud. Bronte was short a small amount well before the Muddy Waters announcement (and shorted the original $11.50 offer) because the accounts were a little unusual. This was a stock on which we won-some, we lost some.

Even if the company is a fraud that does not mean the deal will not close. There were credible allegations of fraud against Harbin Electric and the accounts were decidedly funky - but the deal did close and many shorts (including Bronte) received a nastier than usual flogging.

Moreover Harbin was taken private by Abax Capital backed by China Development Bank. The same combination taking Fushi private. That I am short again (and in this time in quantity) indicates that I am some kind of masochistic sucker for punishment.

Why fraudulent Chinese companies were taken private

There is a theory as to why some Chinese companies with fraudulent accounts were taken private. About a decade ago you could not buy industrial land around Shanghai and other cities unless you had a business to put on that land.

So people invented fictional businesses to buy real land.

Later they reverse merged those fictional businesses into the US and sold shares in the fictional businesses. In some cases the land appreciated enough to make the stock worthwhile even though the accounts are fictional. I know this to be true in at least one case (a case on which I lost money). I am not sure whether it is true of Harbin but Harbin Electric did own lots of land.

There is another reason why Chinese companies are taken private. And that is the operation was originally the children of Chinese elites ripping off Western stock markets (by selling fraudulent stocks). When that no longer worked they had no shame. Now they ripped off Chinese banks by getting them to finance LBOs. I know of at least one fraud run by a child of a central committee member that received a bid from a well connected Chinese private equity fund.

Back to Fushi Copperweld. 

The Fushi Copperweld saga is long running. Now it is a simple question of whether the deal will close and today is the day of truth.

It is likely to close. It is not over until the fat-lady sings - but she is clearing her throat.

But imagine it does not close. Then it will likely be because the fraud allegations are substantially correct and the stock should eventually trade at pennies. There will be a few arb funds with some 'splaining to do. (See this disclosure from Centaurus Capital for an example.)

Boiler plate

When examining situations like this its best to read the boiler plate.

The boiler plate in various disclosures has changed recently.

A press release dated 28 June 2012 and filed with the SEC says categorically:

There is no financing condition to completion of the merger. Mr. Fu and Abax have secured fully committed debt financing from China Development Bank Corporation Hong Kong Branch to finance the transaction.

The press release of 11 December 2012 says that the deal will close "this week" (a week now well and truly past). However it introduces a new paragraph into the boiler-plate forward looking statements.

A number of the matters discussed herein that are not historical or current facts deal with potential future circumstances and developments, in particular, whether and when the transactions contemplated by the Merger Agreement will be consummated. The discussion of such matters is qualified by the inherent risks and uncertainties surrounding future expectations generally and also may materially differ from actual future experience involving any one or more of such matters. Such risks and uncertainties include: any conditions imposed on the parties in connection with consummation of the transactions described herein; satisfaction of various other conditions to the closing of the transactions described herein; and the risks that are described from time to time in the Company's reports filed with the SEC.

The press release of 17 December 2012 - the one not filed with the SEC - but which postpones closing until 24 December says:

"As previously announced, on December 11, 2012, the Company's stockholders approved the Merger Agreement.  Green Dynasty has advised the Company that it is in the process of effecting the satisfaction of all conditions to draw all necessary funds pursuant to the facility agreement with the China Development Bank in order to consummate the proposed merger.  Based on information provided by Green Dynasty, the Company anticipates closing of the transaction by or on Monday, December 24, 2012."

"Effecting the satisfaction of all conditions necessary to draw all necessary funds" is a somewhat weaker statement than "there is no financing condition to completion of the merger".

All I can say for the arb funds involved. This better close. Or you are holding a very weak hand indeed.

But then I have never seen a deal fail so near the line. It should close and by close of business today the stock will have disappeared and shareholders will be entitled to receive $9.50 per share from the clearing corporation. And I will have lost a few pennies on my short (just in time for Christmas).

Whatever happens - I hope you all have a merry and safe Christmas (or festive season if Christmas is not your thing).




John

PS. After market now. So far the fat lady has not sung...


PPS: On Friday - just before closing - the market got a little jittery about this. Check out the one-day chart. Someone panicked. (I was shorting earlier in the week.)