by Amit Kumar
After six quarters of decelerating growth, F5’s product sales had accelerated in the March quarter of 2012. Wall Street expected this reacceleration to be sustained, while Off Wall Street believed that F5 would struggle to meet these expectations and the stock’s valuation multiple would compress as challenges to F5’s growth became more widely understood. F5 stock fell ~30 percent over the next six months from $130 to $90, as Off Wall Street had expected.
F5 Networks Repeat Short in 2013
F5 product sales continued to decelerate in 2012 and grew only 4 percent on a year-over-year basis in the December quarter. F5 management attributed the weakness to temporary macro weakness, and once again expected a recent hardware refresh to reaccelerate growth in product revenues to the high teens by the second half of 2013. Wall Street analysts expected F5’s product revenue growth rates to be in the 20 percent range.
Off Wall Street remained skeptical, as its original short thesis on F5 had not changed materially. Its sources indicated that large-scale cloud providers and private clouds were moving toward a software-driven networking approach in which hardware is treated as a commoditized pool of assets. It issued a new short recommendation after the stock climbed back to $101 in February 2013. F5 stock fell ~30 percent again over the next six months, from $101 to ~$70, as it held onto its bearish position.
Source: Off Wall Street.
Fold When the Story Unfolds with Unexpected Material Developments
Market expectations begin to rise when troubled companies announce turnaround plans and investors buy into the plan. Investors can pay up for the stock in advance of the turnaround if they believe that the company has low leverage and it generates decent cash flow. Management can capitalize on investor enthusiasm by encouraging them to ignore short-term issues and focus on the longer-term turnaround goals. Investors may be inclined to remain hopeful, at least during the first year of a multiyear plan. It may make sense to fold if the stock rises by more than 30 percent, and then revisit the thesis when more clear evidence emerges.
CASE STUDY:
WESTERN UNION (WU)
Western Union fell ~30 percent to $12.73 after they reported third-quarter 2012 revenues that fell 3 percent short of consensus estimates. During the conference call, the Western Union chief executive officer (CEO) played down the competitive pricing atmosphere and blamed the miss on macroeconomic softness and tougher regulatory compliance norms. I began looking at the company when a client asked me if Western Union was a value stock.
Western Union spun off First Data in 2006 and derived 84 percent of its revenues from consumer money transfers through its 485,000 agents. Both send and receive agents were paid percentage commissions on revenue. The agent’s primary business bore the costs of physical infrastructure and staff. Western Union had recently acquired Travelex’s B2B business to boost its business payments solutions. It also tied up with MasterCard to enter the prepaid card business.1
My research indicated that the money transfer industry was highly fragmented. Western Union, the largest player with strong cash flows, faced competition from smaller new rivals such as Xoom,2 and pricing pressure from incumbents such as MoneyGram (MGI) and Ria.3 My analysis of Western Union’s transaction economics (table 10.1) showed signs of structural decline in its unit pricing and profitability. While Western Union had authorized $550 million share buybacks and increased dividend payouts, it was aggressively cutting prices, which could continue the declining trend in profitability. Western Union seemed like a value trap.
I recommended against buying Western Union, but I did not want to recommend shorting it in light of buyback announcements after the stock’s fall. I waited for the short recommendation until the stock rose ~15 percent leading up to the fourth-quarter earnings report in February 2013. The stock traded sideways until the first quarter earnings in May, when Western Union had indicated that its price increases during the quarter were working. It increased guidance and the stock rose 5 percent.
Table 10.1
Western Union transaction economics
Source: Western Union SEC filings.
This new information could undermine my thesis in the short term, and I looked at the impact of price increases on their transaction volumes as well as its competitors’ volumes. MGI and Xoom, Western Union’s rivals, had reported 11 percent and 51 percent increases in their transaction volumes, respectively, during the first quarter of 2013, while Western Union reported a 2 percent volume decline. It seemed like the competition was taking shares from Western Union and I did not fold.
In July, Western Union stock was up 20 percent since my short recommendation and I seemed to be wrong on my value trap thesis. I told my clients that I would wait until second-quarter 2013 earnings results to review my thesis. Xoom and MGI reported earlier than Western Union, posting solid transaction growth of 57 percent and 14 percent, respectively. Later, Western Union reported a 3 percent increase in transactions and its stock closed up 1 percent as the market ignored its decline in unit profitability.
I decided to fold from a risk management point of view for a few reasons. Western Union projected transaction and revenue growth in 2014 and hinted at increasing prices in 2014. The stock was now up ~30 percent and could keep rising on these hopes as Western Union continued to buy back shares. Short interest had doubled to ~9 percent and short squeeze now posed a potential risk.
Fold When Growth Exceeds Expectations Consistently and Revisit When the Business Cycle Begins To Inflect
When companies start to build capacity to fulfill an unexpected jump in market demand, they can get carried away and overbuild capacity. Investors can keeping paying up for the stock as long as the order books and sales beat expectations; however, the multiples begin to rerate downward once there is an inflection in the growth curve. It may be a bad idea to predict when the growth rate decelerates or declines and short a stock on that assumption. It is always better to short when there is clear evidence of an interruption in the growth cycle and emergence of clear catalysts, such as competitive and regulatory threats or slowdown in demand. Shorting in absence of visible catalysts can lead to big losses.
CASE STUDY:
TRINITY INDUSTRIES (TRN)
The U.S. shale oil revolution became apparent in 2011 as Bakken Shale in North Dakota and Montana witnessed a huge pickup in oil production. The sudden boom in oil production was a boon for rail car manufacturers, as crude transportation by rail continued to boom in 2012. Oil refiners began ordering oil tankers alongside rail companies, causing tanker cars to be in tight supply. It seemed to be a déjà vu of buildup in railcar capacity during the ethanol boom in 2005. In the ensuing years, the ethanol bubble burst while railcars had built excess capacity.4
Trinity Industries was the biggest beneficiary, with its railcar manufacturing and railcar leasing group growing more than 30 percent for six quarters in a row. High operating and financial leverage had helped TRN reach all-time-high operating margins. The company decided to enter a joint venture for its railcar leasing business that would help them boost their order book by an additional billion dollars. I began working on the short case for Trinity after their joint venture announcement in May 2013 as their order backlog seemed unsustainable. WTI and Brent crude oil spreads were at an all-time-high of $20 per barrel, making the transportation of crude by rail economically feasible. However, as Bakken oil became more accessible, the spread was also destined to narrow. Railcar leases tend to be short term and were prone to cancellations if the spread narrowed.5
I suspected that railcar manufacturers would face investigations and tighter regulations after a rail car carrying crude oil exploded in Lac-Mégantic, Quebec, turning it into a war zone. Pipelines had always been considered a safer alternative to haul oil; however, new pipeline constructions were delayed and the Keystone pipeline faced environmental hurdles. I published my short thesis in absence of a clear catalyst as I believed that the concerns with railcar manufacturing would eventually surface. I was prove
d wrong for the next two quarters as continued railcar demand from Trinity’s leasing joint venture helped grow its order book.6 I closed my short position in December 2013 after the stock moved up 20 percent, as there were no signs of any regulatory investigations.
Trinity continued to see strong demand in 2014 and the stock rose another 70 percent by June 2014. A Guardrail whistle-blower case, filed in 2012 against Trinity, had just resulted in a mistrial. The whistleblower had accused Trinity of making secret changes to one of its highway guardrail products, which caused them to impale rather than slow vehicles. However, the U.S. Department of Transportation proposed new rules to redress safety risks in July 2014, following a string of fiery train accidents. There was now a visible catalyst, and it seemed a better time to short Trinity.
On October 21, 2014, a federal jury found Trinity guilty in the whistleblower case and ordered Trinity to pay $525 million in damages to the U.S. government. The stock fell 12 percent on the news and was down 33 percent. We covered half of our short position. WTI and Brent crude oil spreads had also narrowed to $2 amid a glut of oil supply, slowing down crude-by-rail demand. Oil prices accelerated their decline in November and December, and Trinity stock fell another 20 percent. We covered our remaining position.
Hot Stocks, High Short Interests: Stay Away from Crowded Shorts
A short squeeze drives up the price of a (typically heavily shorted) stock rapidly when shorts are forced to cover their positions in response to positive news (M&A, analyst upgrades, positive company announcements, regulatory short sale bans, etc.), margin calls, and stop losses. Short squeezes are the single biggest risk for short sellers.
In 2008, Volkswagen (VW) stock soared by almost 5× after Porsche announced that it gained control of an additional 31.5 percent of shares through cash-settled options and it intended to increase its stake in VW from 42.6 percent to 74.1 percent (figure 10.1). Porsche’s announcement led to the speculation that there was less than 6 percent of VW float available, while 12.8 percent of VW shares were sold short, resulting in a panic demand for covering the VW stock and a short squeeze.7
FIGURE 10.1 Volkswagen stock price surges during 2008 short squeeze. Source: Volkswagen AG 2008 Annual Report, Bloomberg.
Short sellers pile into companies whose issues are widely understood in the market. They may be motivated to join already-crowded shorts on pure speculation or when they cannot find other compelling short ideas. However, crowded shorts have low odds of success because market expectations may already be tempered by weak prospects, and any positive news can lift expectations and squeeze out the shorts.
Rising tides during bull markets can also lift troubled boats. On January 5, 2013, a total of 168 stocks in the Russell 1000 index had a short interest of more than 7 percent, while ~70 percent of them rose an average of 38 percent over the next six months. The odds of success in shorting them would have been less than 30 percent.
Growth Stock, Star CEO: Don’t Get in the Way of a Runaway Train!
We have seen many examples of high-growth companies trading at high multiples that can keep expanding. A star CEO, especially a communicative one, can cause the stock price to go up with positive surprises that squeeze short sellers. It is best not to get in the way of such runaway trains; the dangers of shorting based purely on high valuation are quite apparent.
It is the short sellers’ word against the star CEO’s. The market can rightfully vote for the CEO when it is difficult to handicap the company’s growth and there are no immediate threats to the company’s growth. The market can also give short-term bumps a pass when the CEO can promote a good case that the company is on track with its long-term growth targets.
Investors especially reward premium valuation to firms run by successful serial entrepreneurs and follow them closely from venture to venture. Silicon Valley has created several billion-dollar enterprises in recent decades, to the extent that technology and growth seem to be synonymous. In particular, former PayPal employees—popularly known in the media as the “PayPal Mafia”—have built many billion-dollar companies in the past decade alone, including YouTube and LinkedIn.
PayPal filed for an initial public offering (IPO) after the dot-com bust in September 2001. The IPO occurred on February 15, 2002, for a market cap of ~$1.2 billion. PayPal, an online bill payment service, was a natural extension of eBay’s trading platform, as it derived 70 percent of its revenues from eBay.8 eBay announced that it would acquire them for $1.5 billion in July 2002, within four months of the IPO. Many of the millionaire PayPal employees left eBay to join or back successful startups (table 10.2).9
Elon Musk was already a millionaire before serving as the founder and CEO of PayPal from selling Zip2, his first venture, to Compaq computers in 1999.10 He made $150 million from the PayPal sale in 2001 and went on to make successful bold moves. In 2003, he started SpaceX, a risky rocket venture that NASA selected to demonstrate delivery and return of cargo to the International Space Station. SpaceX was later awarded a $1.6 billion contract to fly cargo resupply missions.11
Table 10.2
Prominent PayPal alumni
Musk invested $6.3 million in Tesla Motors, an electric car startup, in 2004, and joined as its chairman, eventually becoming CEO in 2008. He remained a primary funding source for Tesla, ending up with a 65 percent stake at the time of the IPO in June 2010. He also invested $10 million in SolarCity,12 a solar installation startup, in 2006, and joined as its chairman with a ~32 percent stake at the time of IPO in December 2012.
Tesla and SolarCity have been a tale of two heavily shorted stocks since their IPO, and they are constantly featured in media debates about their prospects.13 Short sellers were skeptical about their business model and remained in a tug of war. The turning point came in 2013 when both introduced financing programs that boosted their growth prospects, steamrolling skeptical shorts. Both Tesla and Solarcity now had a viable revenue model backed by financing.
CASE STUDY:
TESLA MOTORS (TSLA)
Tug of war ends badly for shorts
Tesla introduced Roadster, its first electric car model, in 2006, and began production in 2008 for 900 reserved orders. Tesla was saved from death in the 2008 financial crisis by a $50 million investment from Daimler in exchange for a 10 percent stake. Meanwhile, the U.S. Department of Energy (DoE) approved a $465 million loan to Tesla that allowed it to raise its production target from 800 per year in 2008 to 20,000 per year in 2012. Tesla priced two new Roadster models above $100,000 and delivered a total of 1,063 cars before their IPO on June 29, 2010.14
Tesla had also received 2,200 orders by its IPO for its newly announced Model S—a new four-door model eligible for a federal tax credit of $7,500—with prices expected to start at $49,900. Tesla raised $226 million in the IPO, also attracting $50 million from Toyota, and the stock debuted ~40 percent above the IPO price at $23.89. Short sellers expected Tesla to not make profits until it began shipping the Model S in 2012. They believed that Tesla was also underestimating the cost of production and competition from incumbents. In their opinion, Tesla was overestimating the market size based on reports that estimated electric-based markets would grow 6× to 10.6 million in 2015.
Tesla had delivered a total of 2,150 roadsters at the end of 2011 since it first began deliveries in 2008, while it expected to deliver 5,000 Model S vehicles within six months of commencing production in June 2012. Short sellers were skeptical and won the first round when Telsa had production hiccups in September 2012. Tesla also made a follow-on offering of $128 million, in which Musk offered to buy $1 million of shares.
Tesla produced 3,100 Model S cars in 2012, falling shy of its target to produce 5,000 cars. However, it announced soon after that it had reached its production run rate target of 20,000 per year in December 2012. Short sellers had missed the big picture as production uncertainties cleared and paved the way for Tesla to announce additional capacity of 10,000–15,000 per year for the new Model X. Tesla was optimistic about ending its
streak of losses.
Tesla had a banner year in 2013 and its growth continued to be tough to handicap. Musk probably saw it coming when he said in an interview with Fox Business on September 13, 2012: “It was a huge mistake to short Tesla stock and there is a tsunami of hurt coming for those shorting Tesla stock.” Shorts were steamrolled amid a barrage of news that followed, rocketing Tesla stock up more than 4× to $180 (figure 10.2).
The shorts were not ready to give up on Tesla after three Tesla cars were reported to have caught fire. A flurry of media stories followed, while images of these burning Tesla cars were constantly replayed on television. Musk got back in action on controlling the damage as the drivers involved in these accidents posted positive stories. The drivers said they could have been dead in any other car, and Tesla gave them enough warning to pull over and get out before the fire caught on. The stock recovered, but the shorts did not let up.
The next leg of short thesis evolved when Musk announced the plan to build the world’s largest battery factory, with an investment of $5 billion. Tesla announced that it was selling at least $1.6 billion of convertible notes to finance the project and was entering into a partnership with Panasonic, the biggest supplier of lithium-ion cells used in Tesla batteries. Shorts found new ammunition as they pointed out the risks of failure as evident in the recent bankruptcies of battery companies. The other concern was that there was not enough demand for batteries that could provide the economies of scale and bring down the battery cost. The stock fell 30 percent again.