Short Selling

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Short Selling Page 7

by Amit Kumar


  In July 2008, financial stocks started sinking again, and Freddie Mac and Fannie Mae were the next candidates for bailout. On July 21, the Securities and Exchange Commission placed a one-week ban (later extending it to three weeks) on short selling stocks of seventeen large investment banks, along with Freddie Mac and Fannie Mae. However, financial stocks continued to fall like dominoes, forcing Fannie Mae and Freddie Mac into government conservatorship on September 6, 2008.

  In a sharp contrast to its decision to bail out Bear Stearns, the government decided to let Lehman Brothers file for bankruptcy on September 15, 2008. Standard & Poor downgraded AIG by three notches on the same day after its downgrade warning on September 12, 2008. The AIG downgrade triggered at least $13 billion in additional collateral calls on its CDO transactions, and the stock fell 61 percent on the news to $4.76. Two days later, the Fed announced $85 billion in rescue loans to AIG and the U.S. government took a 79.9 percent stake in exchange for the bailout.

  This was the beginning of unprecedented intervention by the U.S. Treasury to restore confidence in financial markets and thaw the frozen credit markets. Markets did not reach bottom for the next six months until the Fed essentially backed all new debt issuances and provided cover to many mortgage-backed structured products.

  Takeaway

  The collapse in the subprime mortgage market permanently changed the business model of the financial services industry and demand for related securitized products collapsed (figure 3.1). Short analysis can often uncover issues that are not only endemic to one company (AIG in this case) but also pervade in the broader industry or economy.

  FIGURE 3.1 Securitized ABS product issuances. Source: SIFMA.

  CASE STUDY:

  CARPETRIGHT (LSE: CPR)

  The floor covering sector declined with the housing sector after the 2008 financial crisis. Carpetright, the largest U.K. carpet retailer, faced a steep decline in carpet sales, which constituted ~80 percent of their total revenues. Carpetright had navigated the downturn better than its peers, Allied Carpets and Floors 2 Go, which ended up filing for bankruptcy. They enjoyed negative working capital due to their size and scale of operations, paying their suppliers two to three months after making the sale. However, as I researched the stock more, I could see a few traits of a value trap.3

  At £700 per share in June 2012, Carpetright stock seemed to expect the operating profits to return to precrisis levels based on its enterprise value to earnings before interest and tax valuation of 40; however, carpet margins had declined due to an increase in raw material costs (figure 3.2). Monthly mortgage approvals, a key driver for carpet sales, were at half of their precrisis levels (figure 3.3). Carpetright closed more than fifty stores amid these structural challenges in the carpet industry and entered lower margin laminate and bedding markets. They suspended dividend payments and were changing their business model to cope with issues in the core business.

  While Carpetright had only ~£50 million net debt, it had long-term lease agreements on its stores, ranging from 5 to 15 years. Carpetright had annual rental expense commitments of ~£80 million over the next ten years, which amounted to ~£600 million of debt on a capitalized basis. After accounting for these rental commitments, they had a net debt to earnings before interest, taxes, depreciation, amortization, and rent of 5.5. Carpetright’s leverage was not fully apparent on its balance sheet.

  Carpetright’s same-store sales had been declining since 2006, as shown in figure 3.4; however, this decline was masked by growth from the acquisitions of other retailers. The company’s return on invested capital had declined from 56 percent in 2005 to 5 percent in 2011, even though it was still enjoying negative working capital. Carpetright had £26 million in deferred tax liabilities that seemed unlikely to reverse in the absence of sales growth and increases in capital investments. In other words, Carpetright would owe £26 million in taxes if it could not get tax advantage from making capital investments. This could result in a 40 percent loss to shareholder equity.

  FIGURE 3.2 Carpetright stock price and valuation 2002–2012. Source: Carpetright company reports.

  FIGURE 3.3 U.K. macro indicators. Source: BBA, TNS-RI, Nationwide.

  Carpetright seemed like a value trap, and it was no surprise that the stock had short interest of 18 percent. Interestingly, the stock had a small float due to concentrated positions from a few investors. Lord Harris, the founder and CEO, held 20 percent of the stocks; Franklin Templeton bought a 16 percent stake in 2010 between £600 and £700; Olayan, a Saudi investor group, bought a 15 percent stake in 2003 around £600, and Cascade Limited, Bill Gate’s money managers, held 6 percent at an average price between £700 and £800.

  The institutional investors were underwater on their investment and wanted a seasoned executive to take over the CEO role from Lord Harris instead of his son, Martin Harris. They recruited Darren Shapland (who was at the time being considered for the CEO position at the largest U.K. supermarket) to replace Lord Harris in May 2012. I published my short thesis on Carpetright in June 2012.

  How Did Carpetright Play Out?

  The stock lost 10–15 percent of its value a year after I published the report in June 2012. I closed the short position on Carpetright in June 2013.

  Other Examples of Value Traps

  Value traps and good value stock ideas have a few traits in common. Both may appear cheap on certain valuation metrics, such as P/B and P/E. They tend to have past periods of good financial performance. Other less common traits may include significant cash on the balance sheet, high dividend yields, good historic brand, reputable investors and management, and issues with the core business. Basically, value traps may seem like value stocks, only they are not.

  So, what is different? There is no easy answer, but paying attention to downside risks can lead to clues on value traps. These risks can arise from declining profitability in core businesses or diminishing growth prospects. Management can respond to such issues through restructuring or turnaround strategies or by diversifying away from their core business. Stocks of such companies can become potential value traps when management makes an attempt to diversify the business by making overpriced acquisitions, entering a lower margin industry, and launching new products in a highly competitive sector.

  Stocks of speculative companies whose turnaround prospects are overly reliant on management reputation, reversal of a down trend in the industry, or success of a key product are also likely to be value traps. Who would not like to buy stocks for cheap? As stock investors, we are wired to look for signs of hope that can reverse the misfortune of cheap stocks.

  Value traps can pass the smell test of hope but may not offer definitive signs of defensiveness, brand strength, sustainable earnings, and, most important, limited downside. Such companies can stand to lose their relevance when they are met with a structural change in industry, disruptive technology, and a sea change in regulatory or competitive landscape. Let us take a look at a few notable examples.

  Yahoo! reigned as a dominant search engine for five years until 2000 when it was displaced by Google’s disruptive new search engine. Yahoo! unsuccessfully attempted to buy Google in 2002 and has never come close to challenging Google since then. Having failed at its core business, Yahoo! made many unsuccessful acquisitions and missed some key acquisitions, namely Facebook and YouTube.

  In 2006, Pitney Bowes had 80 percent market share in a highly regulated postal meter market in North America. It had 65 percent market share worldwide and its only major competitor was Neopost. Its business is closely tied to postal mail volumes, which had ranged between 200 and 213 billion pieces per year since 2000. Mail volumes plummeted to 177 billion pieces per year in the 2008 recession, marking the beginning of a secular decline in mail volumes.4 In 2010, the Boston Consulting Group (BCG) projected mail volumes to decline to 150 billion pieces over the next ten years. BCG believed that the decline was unlikely to reverse because “First-Class Mail is succumbing to the online diversion of bills, invoic
es, statements, and payments.” Pitney Bowes has struggled to offset a decline in revenue by diversifying to more competitive records management and postal software businesses. Its stock declined more than 50 percent since 2011 and its dividend yield increased from 6 percent in 2011 to 13 percent in 2012 as a result of this decline.

  Chapter 1 discussed the decline in the personal computer (PC) industry as computers started to become commoditized. The woes of the PC industry have been accentuated by a staggering growth in smartphones and tablets since 2006. The secular decline eventually impacted the top two players, HP and Dell, forcing them to acquire software services businesses and diversify away from PCs. Even proven managers such as Michael Dell and Meg Whitman have not been able to fight the tide of secular decline in the PC industry.

  The rise of Internet commerce has led to the demise of many historic icons. Blockbuster suffered from a decline in the DVD rental business and was unable to transition to the new Internet video distribution model. The advertising revenue model for newspapers (McClatchy, Gannett, New York Times, etc.) suffered as news distribution shifted to the Internet.

  Online retailers have much lower distribution costs and are able to offer much lower prices than traditional retailers. Circuit City, Linens ’n Things, and many retailers have gone out of business or filed Chapter 11 in recent years. The surviving brick-and-mortar retailers struggle to defend their business model and play catch-up with their own Internet marketplaces in the wake of continued competition from established online retailers. Retailers such as Best Buy and Bed Bath & Beyond have allowed their stores to become virtual showrooms for their online competitors, such as Amazon and eBay.

  Takeaway

  Disruptive technologies and structural changes in industry growth, competitive landscape, and regulations can virtually destroy the value of a once-successful business, creating potential value traps.

  Broken Growth Stories

  Unlike value traps, growth stocks may be traded at insanely expensive multiples and will keep getting dearer. Shorting growth stories can be no different than playing with fire, as we saw in the cases of Cisco and Questcor in chapter 1. Shorting growth stocks solely based on high valuation is a sure way to go broke. It is important to identify their drivers of growth, threats to these drivers, and most important, near-term threats. In Questcor’s case, we saw that a negative reimbursement policy posed a serious threat to their drug sales; in Cisco’s case in 1999, the threats to the company’s growth were not obvious.

  Companies can find growth from the launch of new products, entry to new markets, and the rise of a new industry or rise in demand. Growing markets, capacity expansion, regulatory changes, and industry consolidation are among many other drivers of company growth. It is usually hard to predict a growth horizon for a company with long growth runways, and the predictions often become hot debate topics in the media.

  However, in some cases, clear signs of threats to a company’s growth may arise from disruptive technologies or overcapacity. In other cases, signs of threat may not be as apparent for hot-selling items. Short sellers rely on scuttlebutt, channel checks, surveys, news reports, sell-side research, and industry experts to read the tea leaves.

  Regulations such as patent protections, subsidies, and fiscal stimulus usually have limited and clear timeframes. Therefore, it is usually easier to point to threats to a company’s growth coming from an expiring regulation or similar impending change.

  Broken growth stories can clearly point out issues with growth and growth drivers, profitability, and near-term negative catalysts. The bear thesis must also determine the market size and limitations to the growth of the overall market. Poor financial characteristics (excess leverage, poor coverage ratios, etc.), cracks in the business model, accounting issues, signs of increasing competition, and insider selling are key elements of a good bear case.

  CASE STUDY:

  SOLAR PANEL MAKERS

  The solar industry had come a long way since Bell Laboratories made the first photovoltaic cell in 1954, with costs coming down from $100+ per watt to ~$4 per watt in 2000. Japanese subsidies in the 1990s had helped double global solar installed capacity to 1,000 megawatts. However, solar costs were far from grid parity with electricity produced from conventional sources, such as coal, and the solar industry’s competitiveness depended heavily on government subsidies.

  The U.S. solar industry could not attract private capital until the enactment of a solar investment tax credit (ITC) in 2006. The cumulative installed capacity in the United States grew from 300 megawatts in 2006 to 800 megawatts in 2008; during the same period, larger subsidies in Germany helped their installed capacity grow from 3,000 megawatts to 6,000 megawatts. Stocks of solar panel makers such as First Solar (FSLR), SunTech Power (STP), and SunPower (SPWR), which supplied these markets, were up 3× to 4× since their initial public offerings (IPOs) by 2008.5

  However, U.S. tax credits were set to expire in 2008, German subsidies were expected to decline after 2008, and there seemed to be a bump in the solar panel growth story. Margins for the panel makers seemed to be under threat from a flood of new competition. In a January 2008 article I published in Seeking Alpha, titled “Bullish on Solar Energy, Bearish on Solar Stocks,” I made my short case for the skyrocketing solar stocks. With $300 million in 2007 sales, First Solar was trading at a P/S of 43 ($225) and other panel makers were trading at similarly high multiples. There were signs of cyclical shorting opportunity in the solar sector.

  While growth in the solar industry seemed threatened by the uncertain future of subsidies in Germany and the United States, margins were also under threat from a glut in production capacity based on data coming from leading solar associations and research firms. Conversion efficiencies of monocrystalline and multicrystalline silicon for STP ranged between 14 and 16 percent, while that of cadmium telluride for FSLR was even lower at ~10 percent. Competitive panels made from polycrystalline silicon provided 2× to 5× conversion efficiencies and were becoming competitive with the drop in silicon prices.

  How Did Solar Stocks Play Out?

  The solar panel growth story seemed broken. Uncertain subsidies, increased competition, margin pressure, and alternative polysilicon panels posed a bump to the growth story. High levels of valuation were the icing on the cake for shorting these stocks. Solar stocks fell between 30 and 90 percent in 2008 as the economy worsened. The ITC did not get extended until late 2008, and panel margins declined amid falling average selling prices.

  Takeaway

  Government subsidies can support fledgling industries in their early stages, and such industries can fail to survive in the absence of subsidies if they fail to create a robust market or generate profitability.

  CASE STUDY:

  LEAP WIRELESS (LEAP) AND METROPCS (PCS)

  Leap Wireless and MetroPCS had raised debt at attractive terms in 2006 to buy spectrum during Federal Communications Commission Auction 36, and each grew their subscriber base by entering new markets. After winning the auction, LEAP entered Chicago and PCS entered Boston and New York; both consequently gained a large number of subscribers from these well-populated markets. LEAP’s subscriber base grew from 2.8 million in 2007 to 3.8 million in 2008, and PCS’s subscriber base grew from ~4 million in 2007 to 5.3 million in 2008. The market liked their growth story. Their stock prices in March 2009 implied $1,200 to $1,500 of enterprise value per subscriber, compared to the top two players that controlled 80 percent of the wireless market—AT&T and Verizon.

  However, LEAP and PCS were prepaid carriers, unlike their postpaid competitors of AT&T, Verizon, and Sprint. Their business model was different because they did not require two-year contracts from their customers like their postpaid competitors did, so they saw a significant churn in their customer bases. Their profit economics were also poor when compared with their peers. Their growth came from entering new markets, which also increased the fixed-cost base from the resulting new cell sites, store costs, salaries, and customer car
e. Due to these high fixed costs, their profitability is highly dependent on stable average revenue per user (ARPU), subscriber growth, and lower churn (table 3.1).

  The return on invested capital to acquire a new wireless customer in the new markets was much lower than in existing markets due to the capital expenditure to build out the new network. LEAP would typically need 6–8 months to break even on acquiring a customer in its existing markets, but twice as long (20+ months) in new markets. To be profitable, LEAP would need to increase its current penetration from 5.7 percent to 9 percent in the wireless markets.

  Easy growth for both carriers seemed to near its end as they were expected to complete their rollout by 2010; they would need to challenge the larger carriers to increase their penetration and keep growing. This was difficult for many reasons, primarily because they could not impose long-term contracts on their customers. The other growth option for them would be to acquire additional spectra after they had covered their target population in the new markets in 2010.

  Table 3.1

  Profit per subscriber and break-even analysis

  Source: LEAP and PCS annual and quarterly reports, Artham Capital Partners LLC.

  There was more to a bear thesis on their growth and profitability. Their grip on the prepaid market was under threat from signs of new competition. Sprint, the third largest carrier, which was still reeling from the poor execution of its recent acquisition of Nextel, had announced that it would enter the prepaid market with cheaper price plans. LEAP and PCS had already cut prices in 2008 to stay competitive in the prepaid market, and new competition meant even lower ARPU. There seemed to be a bump in their growth story.

 

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