The Hedge Funds’ ‘Long The GNC Convertible And Short The Stock’ Bet Has Blown Up (NYSE:GNC)

GNC Holdings, Inc. (GNC) could experience a large short squeeze for two reasons.

Hedge funds have been long GNC’s 1.5% 8/1/2020 Convertible Notes (cusip:36191GAB3) and short its short position since 2017. Currently, there are $159 million (face value) of the convertible notes outstanding and almost 24 million shares of GNC’s short sold short (as of June 15, 2020). After GNC filed bankruptcy, earlier this week, a round lot of the convertible traded at $1.25 per bond (face value is $100).

Let me explain why this is a major catalyst. Let’s say you are a hedge fund analyst for a firm and you were long $30 million (face value) of the convertible at a cost of $0.60 on the dollar. The long side of the trade is an investment of $18 million. Because of the spring maturity, in January 2020, you fully expected that you would get paid par for your bonds, as you thought you owned the fulcrum security. On the short side of the trade, you might have been short 4 million shares of GNC at $5 per share. So, until recently and prior to COVID-19, you thought you would make $12 million on your convertible (the long side of the trade) and worst-case cover your short at $1 per share (and make $16 million on your short less the borrow cost).

Well, if you read GNC’s 8-K associated with its bankruptcy filing, Harbin Pharma has only offered to buy the company for $760 million. Therefore, it is crystal clear that both the convertible and equity are out of the money.

Therefore, suddenly, the hedge fund long $18 million of the convertible own a long position worth $300K (you are down $17.7 million) and you are still short 4 million shares of the stock at $5. So, with GNC closing at $0.66, you are up over $17 million on the short side of your trade ($4.34 per share x 4 million shares). But again, in January 2020, you thought you would make $12 million profit (not an $18 million loss) on your convertible and $16 million on your short position in the equity.

Putting it all together, this fund goes from a nice profit to a mark-to-market loss.

So, with the cost to borrow GNC short at upwards of 75%, why would you keep the short side of the trade on? You need to cash out your short side of the bet to offset your sudden large loss on the long side of the trade. The only problem is you are competing with Robinhood momentum traders to cover.

Harbin offered a $760 million stalking horse bid

Per GNC’s bankruptcy filing press release, GNC said the following:

Additionally, the Company, a significant majority of the Supporting Secured Lenders, and Harbin Pharmaceutical Group Holding Co., Ltd., an affiliate of GNC’s largest shareholder, have also just reached an agreement in principle for the sale of the Company’s business. The term sheet documenting that agreement outlines a $760 million purchase price for the sale transaction, which would be executed through a court-supervised auction process at which higher and better bids may be presented. The sale transaction is subject to mutually acceptable definitive documentation. In support of the proposed sale path, GNC has commenced a comprehensive marketing process for its business. If the sale transaction is timely consummated as outlined, it would be implemented instead of the standalone plan transaction.

This means that for the first time ever, GNC, the business has a ‘for sale’ on it. If you assume that GNC can earn $150 million of normalized EBITDA, then a buyer, with access to cheap debt capital (think a CPG company, Amazon (NASDAQ:AMZN), or a strategic buyer that partners with private equity) could theoretically pay 10X normalized EBITDA. With $850 million of pro-forma net debt and 146 million fully diluted shares (Harbin owns 61 million) at $4 per, a buyer could buy just shy of $1.5 billion and take over GNC. With the 10YR U.S. Treasury at 70 Bps, strong rated CPG companies or Amazon can borrow a 5-year paper at 2% to 3%. At 3% x $1.5 billion interest expense is only $45 million. So, $150 million in EBITDA less $45 million equals $105 million of free cash flow. Even if you assume $25 million to build out GNC’s e-commerce, a new buyer acquires great brands (Total Lean, Beyond Raw, Mega Men, Fish Oil, AMP, etc.) and a superb International Franchise business.

If a strategic buyer were to emerge, as GNC’s board is forced by a bankruptcy court to solicit the highest bid for shareholders (or an equity committee could be formed), this is the second scenario why a short squeeze could occur.

If Hertz Global (HTZ) currently losing tons of money and expected to lose money for the foreseeable future can squeeze from $0.82 to $6, then why couldn’t GNC squeeze?

Finally, GNC’s business should do exceptionally well post-COVID-19, as health and wellness and immunity support will experience high demand.

On June 18th, Franchise Group (FRG) reported its earnings. Per its Q1 2020 earnings transcript, Vitamin Shoppe is experiencing strong demand.

Moving on to the Vitamin Shoppe, the Vitamin Shoppe is an omni-channel specialty retailer and wellness lifestyle company. In the first quarter, the Vitamin Shoppe outperformed our expectations due to customer demand for immunity support health and wellness products as a result of COVID-19. In the month of March, total comps were up 10% and health improve comps for the full quarter to be down less than 1%, with on-line direct-to-consumer revenue up over 12%, and brick-and-mortar comps down less than 3%.

In most states, the Vitamin Shoppe met the guidelines of an essential business, remained predominantly open during the pandemic. Of the 735 Vitamin Shoppe locations, 90 were closed at the peak of the crisis. For the remaining open stores most operated on reduced hours and were impacting as stay-at-home and shelter-in-place orders, which put pressure on in store sales. During this time, we saw a migration to our direct-to-consumer business, which helped offset store comp performance. Direct-to-consumer represented 14% of all sales in 2019 and is currently trending in the low 20s, as a percentage of sales in June after peaking at 34% in April.

Putting it all together, these are two compelling reasons why GNC shares could experience a large short squeeze.

That said, there are risks that the stock could, ultimately, be worthless. If a higher bidder doesn’t emerge, then the bankruptcy judge may accept the Harbin plan. Then again, the consensus seems to believe there will not be a competing/higher bid. What separates GNC from Hertz is post-pandemic, the demand for health and wellness is on the rise whereas the demand for rental cars will likely be subdued for an extended period of time. Therefore, GNC’s normalized earnings power may rebound faster and to a much larger extent than the bears have concluded.

Disclosure: I am/we are long GNC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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