by Amit Kumar
These scheduled company events are critical catalysts for short sellers as they digest new information and look for important cues that can impact their short thesis. When a stock has high short interest (heavily shorted), even minor positive news at such events can force a mass exit of short sellers and a massive surge in the stock price.
Some industry sectors release important metrics more frequently, on a weekly or monthly basis. Retailers and automakers announce sales-related data on a monthly basis. Companies can also announce postlaunch sales numbers after important product launches. These data releases are closely watched catalysts that impact stock prices.
Company Events: M&A That Kicks Issues Down the Road
M&A can be a core part of the business model for large companies, such as Johnson & Johnson, Google, and VF Corporation; their corporate development teams constantly hunt for targets that can bring synergy and growth. However, companies can run into integration issues when they make transformative or large acquisitions, especially when they do not have good M&A history. In general, M&A announcements merit close examination when they appear to mask slowing growth and significant business issues.
CASE STUDY:
HMS HOLDINGS (HMSY)
HMS Holdings verifies Medicaid benefit eligibility and audits health care claims to ensure proper payment for services provided by hospitals and other health care entities. State Medicaid programs accounted for 70 percent of its revenues. HMS shares were up about 27 percent after the Supreme Court upheld the Affordable Care Act in June 2012. Bulls saw the ruling as a boon for HMS because it stood to benefit from increased Medicaid spending.
HMS had acquired Health Data Insights (HDI) for $368 million in December 2011. HMS’s slowing core growth was overshadowed by significant new revenues from HDI’s recovery audit contractors (RACs) service, and Wall Street was willing to ignore the slowing growth. Research and discussions with industry sources suggested that Medicare RAC revenue could slow down or even decline.
Hospitals had responded aggressively to Medicare RAC audits by appealing an increasing number of denials, especially from HMS, and were winning their appeals and recovering lost revenues. They took their complaints about aggressive RACs to Congress and to the courts to attempt to change or clarify Medicare regulations to preclude incorrect payments due to vague reimbursement rules.
Wall Street was overly optimistic about revenue growth from HMS’s rollout of Medicaid RACs. Its research suggested that improper payments to fee-for-service providers accounted for only half of the errors in Medicaid payments as compared with nearly all of the Medicare payment errors. Medicaid RAC programs were also likely to be much less profitable than the Medicare RAC programs because contingency fees were capped at 12.5 percent.
HMS lowered its revenue and earnings guidance on October 4, 2012, amid ongoing issues with its Medicaid program. HMS shares fell approximately 14 percent on the news. Three weeks later, HMS reported third-quarter earnings that missed Wall Street’s expectations of revenue and earnings on higher operating costs, causing HMS stock to plunge approximately 24 percent below the target price of $23.
Source: Off Wall Street.
Company Events: Expensive Acquisitions
The acquiring company can rely on cash, stock, debt, or a combination to finance an M&A transaction. The nature of financing provides critical insight into management’s view of their own stock valuation. In general, management does not use company stock to make acquisitions if they believe that their stock is undervalued. In such a case, it would make more sense for them to use cash or cheap debt (or a combination of cash and debt) to finance the transaction.
Conversely, management can make liberal use of their stocks to make acquisitions if they believe that their stock is overvalued. All stock M&A deals tend to pick up during the peak bull market cycles. The technology boom of the 1990s probably saw the largest share of such transactions. The two largest and most notable transactions were the $183 billion all-share merger of Vodafone AirTouch and Mannesmann and the $111 billion share and debt merger of AOL and Time Warner. Both transactions failed and have become the subject of business school case studies.
CASE STUDY:
FACEBOOK (FB)
Facebook had raised approximately $1.5 billion over its seven years as a private company from a host of small and large investors, such as Peter Theil, Microsoft, Goldman Sachs, and Digital Sky Technologies. As Facebook decided to reincarnate as a public company, it reported a cash balance of $3.8 billion and, more importantly, cash flow from operations of $1.5 billion in 2011.
Facebook offered 484 million shares in a rollercoaster IPO at $38 per share, raising a total of $18.4 billion; however, approximately $7 billion went to the Facebook coffers, and the rest went to selling stockholders in Facebook. Facebook’s cash balance as of May 18, 2012 stood at approximately $11 billion. Facebook’ stock was cut to half in its first year as a public company; however, its cash balance was nearly unchanged during this period. During this period, Facebook spent approximately $1 billion on buying servers, storage, and building data centers, while it spent $500 million on buying other companies and patents, including $300 million toward the $1 billion cash and stock acquisition of Instagram in September 2012.
Facebook regained its lost love with Wall Street when it announced that it had made $881 million from news feed advertising revenues in the quarter ending September 2013—$576 million more than the previous quarter. Wall Street was awed by this announcement, and it declared that Facebook was now a mobile company. Shortly after this quarterly report, Facebook was speculated to have offered $3 billion in cash for Snapchat; however, Snapchat turned it down.
Facebook was now trading well above its IPO price by this time. The company made a secondary offering of 27 million shares at $55 per share on December 19, 2013, raising approximately an additional $1.5 billion. Companies usually make secondary offerings when they are strapped for cash or when they want to capitalize on market euphoria or high stock prices. It was too early to tell if Facebook wanted to capitalize on high stock prices.
After the secondary offering, Facebook had raised about $10 billion of outside capital since its inception as a private company. Facebook generated more than $4 billion in cash flows from operations in 2013; its biggest annual use of cash so far had been approximately $2 billion on hardware and data centers, followed by approximately $1.5 billion on research and development. Facebook’s cash balance at the end of 2013 stayed unchanged at approximately $11 billion, and they really did not seem to need cash. The reason behind their secondary offering was not very clear.
Within two months of the secondary offering, Facebook announced that it would buy WhatsApp on February 19, 2014, for $19 billion ($4 billion in cash, $12 billion in stock, and $3 billion in restricted stock units). The deal produced sticker shock, and it clearly came at the expense of existing shareholders. With 450 million users at a fee of $1 per year of service, WhatsApp was probably generating $300–400 million in cash revenues. Although the $4 billion cash portion of the deal would dent Facebook’s cash war chest, it did not create a hole or impair its ability to make further deals. However, it was a different question whether the $15 billion stock dilution would result in outsized returns for Facebook shareholders. Facebook was treating its stock like paper, creating a tactical shorting opportunity. Facebook stock fell more than 20 percent over the next month, chipping off nearly $38 billion from the market cap—twice the size of the WhatsApp acquisition.
Facebook successfully renovated its business model with mobile advertising revenues, its foray into television advertising, and video advertisements (although the market is largely controlled by YouTube for now). However, the Instagram and WhatsApp acquisitions signal Facebook’s strategy to overspend on acquisitions for user experience innovation. Although Facebook has so far been clever in preserving cash in these transactions, its willingness to buy them at any cost signals that Facebook may overpay for future acquisitions. Why is it imp
ortant to pay attention to the cost of these transactions? Let us compare Facebook’s business model with that of Google for some perspective on current Facebook valuation.
There are nearly 2 billion desktops connected to the Internet, compared with a smartphone installed base of 1.7 billion. Google has 80 percent market share in desktop advertising, with an adjusted revenue of $55 billion, whereas Facebook generates nearly $12 billion on an annualized basis. Neither of the companies are available in China. At Facebook’s market cap of $200 billion in July 2014, the market believes that Facebook is the Google of mobile advertising. Why?
If we assume that mobile advertising grows more than four times in next four years to $48 billion, the mobile advertising market would become nearly as big as the desktop advertising market. Assume that Facebook captures the entire market in these four years compared to Google, which took seven years to grow from $12 billion to $48 billion. At this point, if Facebook gets a slightly higher multiple of 6× EV/sales versus 5.5× for Google, it will be worth $288 billion—or 48 percent higher—at $112 per share. If we discount the share price back by four years, stock is worth approximately $76 per share, where it is currently trading.
Is Facebook stock priced for perfection? Is there room for speed bumps on Facebook’s growth trajectory—for poor acquisitions or expensive acquisitions? Only time will tell.
Macroeconomic Events: Federal Reserve Meetings, Crude Oil Inventory, and More
The Federal Reserve System (the “Fed” or central bank) gets an early look into economic data from its twelve regional banks and responds to data trends through monetary policies of targeting interest rates and money supply. Press releases from periodic Fed meetings provide a glimpse into the state of the economy and the Fed’s policy stance. Fiscal policies and trade balances have a direct impact on economic cycles as well.
In addition, other agencies release periodic data to take the pulse of the economy. These leading, coincident, and lagging indicators can have an impact on the overall market or specific industry sectors. For example, a buildup in oil and natural gas inventory can lead to a sell-off in oil stocks; conversely, a decline in inventory can lead to a sell-off in airlines, refineries, and utilities. The most closely watched indicators include unemployment claims and rate, gross domestic product, Michigan consumer sentiment, crude oil inventory, Case-Shiller index, producer price index (PPI), and consumer price index (CPI).
Economic data and policies have a direct impact on the prices of financial assets as well, and the impact is especially pronounced during economic turbulence. Steep market corrections during the financial crisis of 2008, the technology bust of 2000, the Asian crisis of 1997, the savings and loan crisis of the early 1990s, the crash of 1987, the energy crises in 1973 and 1979, the Great Depression of the 1930s, and the banking panic of 1907 are the most prominent in the history of U.S. stock markets.
It is nearly impossible to predict events that trigger a mass exodus from financial assets, such as the Lehman bankruptcy, a Russian default, or a Middle East crisis. However, investors gauge market fear leading up to the crises and during each crisis through several risk indicators, such as the Treasury–Eurodollar spread (figure 1.4), Chicago Board Options Exchange Market Volatility Index, Credit Default Swap Index, Sovereign Credit Default Swap, Term Structure, and Treasury auctions.
Bear markets may seem like a short seller’s paradise; however, short sale restrictions, regulations, and vicious bear market rallies can complicate shorting. Modeling economic downturns to find shorts is a different game than modeling company financials and is beyond the scope of this book. I have discussed the common characteristics of past crises, the impact of monetary policies, and key economic indicators (in chapter 5), which can signal a tightening credit cycle or recession. Analysts can pick clues from such indicators to identify companies whose business models are more vulnerable to tightening cycles and recession and focus their analysis on related industry sectors.
FIGURE 1.4 TED Spread vs. S&P 500 negative correlation during 2008 financial crisis. Source: Federal Reserve, S&P Dow Jones Indices.
Recap
• There are three broad short categories: (1) structural shorts with a one- to two-year outlook, (2) tactical shorts with a one-week to one-quarter outlook, and (3) pair trades.
• Structural shorts are longer-term shorts on companies with structural issues with their business or business model. Tactical shorts focus on shorter-term issues and rely on scuttlebutt, surveys, and channel checks.
• Shorting expensive stocks based only on valuation is dangerous.
• There are seven key aspects to analyze in fundamental research: industry, product, financial statements analysis and valuation, customers, management team and incentives, business cycle, and risks.
• When sourcing short ideas, look for signs of business model issues (issues with key client, product, etc.), unsustainable operating or financial leverage, value traps, financial statement issues, and tactical issues.
• Key catalysts that can drive stocks down include investigations, investor announcements, loss of key client or product, product issues, industry slowdown, accounting issues, company events, and macroeconomic issues.
2
Leveraged Businesses
The Upside and Downside
The pound of flesh which I demand of him is dearly bought. ’Tis mine and I will have it.
—SHYLOCK, MERCHANT OF VENICE
THIS SCENE FROM SHAKESPEARE’S classic Merchant of Venice is a crude analogy to demands from creditors when companies breach their credit agreements, especially when companies become insolvent. Creditors are ahead of stockholders in the queue to stake a claim when a company fails on its indenture (loan contract). In the event of a liquidation sale, shareholders may end up getting nothing and creditors can claim everything. The downside for shareholders of heavily indebted companies can be disastrous; they need to pay careful attention to indentures and whether the debtor company can continue to meet the demands of their credit agreement.
Common Reasons that Companies Borrow
Companies borrow money to finance assets, for short-term working capital (payment to vendors, employees, etc.), or for investment in long-term fixed assets (plants, real estate, etc.). The related debt is reported on balance sheets.
In some cases, companies enter into commitments or contracts that might require payments over a long period of time (e.g., 10-year rent contract) or assume the liabilities (implicit or explicit) for special-purpose entities related to their businesses. While such commitments or contracts are similar to borrowed money, companies may not be obligated to report them as debt on their balance sheet.
Creditors Versus Shareholders
Creditors and shareholders reside on the liabilities side of the balance sheet. Creditors mostly have the first right to companies’ assets and get preference over stockholders in the event of restructuring, bankruptcy, or liquidation. In other words, when companies are forced to sell assets during liquidation or bankruptcy, they must repay their creditors before shareholders.
If the company has nothing left after repaying the creditors, its shareholders will be wiped out; that is, the share price goes to zero. The priority of repayment among creditors is typically in the following order: senior secured creditors (lienholders on company assets), unsecured creditors, junior creditors, preferred stockholders, suppliers, employees, and common shareholders.
Creditors and shareholders effectively own and control company assets, and their ownership stake appears on the liabilities side of the balance sheet. Because the balance sheet must always balance, a decline in the value of an asset must be offset by an increase in the value of other assets or a decrease in shareholder equity.
However, if the value of overall assets declines and the company faces declining profits or losses, the company may be forced to take a range of corrective steps such as cutting dividends or raising additional capital in the form of debt, stock, or preferred investme
nts. Such actions dilute the existing shareholder value, which may even be wiped out in the extreme event of bankruptcy or liquidation.
Table 2.1
Eastman Kodak’s balance sheet (December 30, 2011)
Source: Eastman Kodak SEC filings, 2011 annual report.
Let us take a look at Eastman Kodak’s balance sheet before they filed for bankruptcy on January 19, 2012. In table 2.1, we find that Kodak’s total liabilities ($3.288 billion + $1.363 billion + $2.15 billion) were more than total assets ($4.678 billion), implying negative equity. Equity would have continued to suffer if Kodak had continued to post losses or dispose assets for a loss.1
Takeaway
Companies borrow to finance assets, working capital, and expansion plans. Creditors are ahead of shareholders to get repaid during distress. Shareholders can get wiped out in the event of a bankruptcy.
Financial Leverage Versus Operating Leverage
Financial leverage, or gearing, measures the degree of indebtedness of a company resulting from interest-bearing loans. The most common leverage ratios are debt to equity; debt to earnings before interest, taxes, depreciation, and amortization (EBITDA); and earnings before interest (EBIT) to interest. Companies report short-term and long-term liabilities on their balance sheets. These liabilities can arise from borrowing needs (as mentioned previously) or from other liabilities such as pension liabilities, unpaid claims, and so on.