Short Seller Targets Herbalife’s China Operations

Herbalife attacked by short seller over China operations

Short sellers are developing a growing fondness for firms that do big business in China, with word that a prominent US billionaire investor has launched an attack on health products seller Herbalife (NYSE: HLF) over alleged illegal practices in its China operations. The allegations by hedge fund investor William Ackman mark the highest-profile assault to date on a China-related company, and could hint at similar future attacks on multinationals that do big business in China.
This kind of short seller attack has become a regular occurrence against US-listed Chinese companies over the last 2 years, and was a major catalyst in cleaning up a sector that often engages in aggressive and even illegal accounting. Most of those attacks were launched by boutique short sellers that specifically targeted US-listed Chinese companies, with Muddy Waters emerging as the most famous of the attackers.

Ackman is in a much bigger league than those smaller short sellers, and has chosen a much higher-profile target in Herbalife – a global company with a $6.6 billion market value and nearly $5 billion in annual sales. It’s no coincidence that he has targeted Herbalife, as the company is currently under scrutiny in China after word emerged that Beijing was probing one of its chief rivals Nu Skin (NYSE: NUS).  Both companies sell directly to consumers rather than through traditional stores, and are often accused of operating pyramid schemes that encourage aggressive sales tactics.

All that said, let’s take a closer look at Ackman, head of the Pershing Square Capital Management hedge fund, and whether his big bet against Herbalife is likely to succeed. That could determine whether others will launch similar attacks. According to the latest reports, Ackman held a high-profile teleconference attended by more than 300 listeners, in which he detailed several allegedly illegal practices by Herbalife in China. (English article) He specifically said that Herbalife breaks Chinese laws by making recruits pay entry fees, and by letting its distributors recruit new members.

Herbalife responded with its own statement saying it is confident of its business in China, and that Ackman’s presentation reflects his failure to understand the company’s business model. (company statement) Investors seemed to dismiss Ackman’s allegations, at least initially, with Herbalife shares largely unchanged in the latest trading session. Of course it’s worth pointing out that Herbalife shares are down about 25 percent since early January, when word of a Chinese investigation against Nu Skin first emerged and worries surfaced that Herbalife could face a similar probe. (previous post)

The latest share price reaction shows investors aren’t more worried now than they were in early January when word of the Nu Skin investigation emerged and Herbalife shares plunged. Still, Ackman’s specific allegations could prompt Chinese investigators to launch a probe of Herbalife if they haven’t already. I suspect that such a probe is already underway, at least informally, and Herbalife is working closely with investigators to show it is following Chinese laws.

From a broader perspective, Ackman’s assault shows that China is starting to attract the attention of major short sellers who make their money by uncovering negative news about listed companies. Ackman’s attack may have failed in this instance, most likely because concerns about an investigation are already priced into Herbalife’s stock after the January sell-off. But Beijing’s recent fondness for probes of foreign firms, coupled with the growing dependence of many major multinationals on the China market, could easily mean we will see more similar attacks in the future. If that happens, companies with 20 percent or more of their sales in China could become the most likely targets, especially from the retail and technology sectors that are already regular targets of attack by Chinese media and regulators.

Bottom line: Short seller attacks against multinationals that do big business in China could grow in the year ahead, targeting companies that get a fifth or more of their revenue from the market.

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