Active investor Bill Ackman‘s quest to be Herbalife’s undoing may have just been dealt a serious blow. The company revealed on Monday that it had been circling a go-private deal last week, which triggered a run on its shares even though a deal did not ultimately happen. But what may actually end up in in an Herbalife short squeeze is the company’s announcement that it will buy back its shares via a “modified Dutch auction.”

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herbalife short Herbalife short squeeze
By Herbalife International of America, Inc. (http://www.herbalife.com) [CC BY-SA 4.0], via Wikimedia Commons

Herbalife short squeeze agead? Company announces Dutch auction

Herbalife plans to begin the self-tender Dutch auction on $600 million worth of its shares priced between $60 and $68 each. The company's stock surged on Monday as a result and then continued to climb on Tuesday, peaking at $69.69 a share.

Shareholders who tender their Herbalife shares in the auction will receive a "contingent value right," which allows for a second payment in cash if the company ends up being acquired at a higher price within the next two years. In order to keep the auction from reducing only the tradable float, the company's board, executive directors and activist investor Carl Icahn—who has opposed Bill Ackman over Herbalife for years—agreed that they won't tender their shares in the auction.

According to data from financial analytics firm S3 Partners, there are 93.6 million outstanding shares, and insiders own 27.02 million shares. Icahn himself owns 22.87 million Herbalife shares. Based on these numbers, the float that will be eligible to be tendered in the auction stands at 66.94 million shares. It's generally expected that the Dutch auction will be fully tendered, which will slash the float by 8.82 million to 10 million shares, cutting it to between 56.94 million and 58.11 million shares.

Herbalife short squeeze could be in play as short interest rises

According to S3 Partners' Ihor Dusaniwsky, Herbalife short interest has climbed 28% year to date. Short interest has fallen mostly quarter to date, but he has observed an uptick in short selling within the last week.

He notes that Ackman's Pershing Square had an estimated $988.38 million short stake in Herbalife, based on the firm's January annual report, which indicated that the position was about 9% of its assets under management. That amounts to about 18.6 million shares, based on Herbalife's $53.13 per-share price on Jan. 26. It's very unlikely that Ackman covered his position because this is one battle he's been fighting for several years now.

Dusaniwsky also reports that total Herbalife short interest hasn't fallen below last year's average levels, which seems to confirm this.  He estimates Pershing's two-day loss on from the mini Herbalife short squeeze at about $115 million and its year-to-date loss at $419 million, while the position turned a profit of about $160 million last year.

Is Herbalife trying to put the squeeze on Ackman?

He adds that Herbalife's planned share repurchases could squeeze Bill Ackman out of some of his short position. There are already 24 million Herbalife shares being sold short with about 7 million left available to borrow, according to S3's data. The Dutch auction probably won't result in a tender of all the shares that are in stock lending programs and being actively out on loan to short-sellers.

However, he believes that some of the shares that are out on loan or in margin accounts will be tendered in the auction, resulting in "a significant decrease in stock loan availability and numerous street-wide recalls." Because Ackman's firm consists of 75% of the total Herbalife short interest, most of the recalls will be sent his way. And if the auction is fully tendered, he estimates that Ackman will see 3 million to 5 million stock loan recalls.

But that's not the only problem the activist investor will probably face. The auction will dramatically increase the cost to borrow Herbalife shares, which will undoubtedly raise the question of whether the company decided to deal some damage to Ackman after years of grief. Depending on how many shares are recalled, he estimates that borrow fees could climb to as high as 40% meaning a  gigantic Herbalife short squeeze could be ahead.

To put this into perspective, he says Ackman is paying about $63,000 in daily financing fees to borrow his Herbalife shares, but if borrow rates climb to the 10% to 40% level he predicts, those daily fees will climb to between $300,000 and $1.2 million. So not only might Ackman have to cover some of his Herbalife short position because of share recalls, he might have to cover another chunk of his position "due to prohibitively expensive borrow costs," says Dusaniwsky.