Playing Short in a Frothy Market

 | May 22, 2013 | 11:00 AM EDT
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Where are the short-sellers in this frothy market? Short interest has always been viewed as a contrary indicator; the higher the short interest, the more pent-up demand for borrowed shares shorts would have to repurchase to unwind their positions.

To parse the data, we need to examine short interest vs. trading volume and vs. the total number of shares outstanding. So, we look at "days to cover," the number of days of average trading volume needed to unwind the entire short position and "percentage of float," the ratio of shares sold short to the amount that are available for trading.

Looking at NYSE short interest data, we see the number one individual stock in "days to cover" has a whopping 94 days' worth of average volume shorted. This stock also lands in the top 20 in "percentage of float" with 34% of shares shorted. This hated stock is Miller Energy Resources (MILL), the common stock cousin to Miller's preferred shares (MILL-C), a Portfolio Guru, LLC shareholding. We're on the other side of market forces here, but therein lies the opportunity.

Why the large short position in Miller common shares? Well, it is a very risky company. Miller Energy owns a platform and nine wells in the Cook Inlet of Alaska and has a foothold in the Mississippian Lime formation in Tennessee. But Miller is primarily a play on Alaskan oil. Miller announced Monday it will commence drilling in a new area in the Cook Inlet, a field that had been drilled in 1964-1965. Taking on previously-exploited fields is indeed risky, but these are the opportunities that exist for resourceful companies like Miller and other Cook Inlet operators, including Apache and Hilcorp.

MILL has 9 million barrels of reserves, and 95% of that is in the form of oil. The value of the company's proved reserves (using the Securities and Exchange Commission's 10-year present value guidelines) is $447 million, quite a premium to MILL's $189mm equity market cap. But MILL's total reserves (including "probable" and "possible") are $1.5 billion. They'll probably never get all that, but if their geologists perform well and oil prices stay near current levels (MILL is hedged at $95/barrel through mid-2014) there is immense value here.

But it is still early days for MILL, and the company produced negative earnings before interest, taxes, depreciation and amortization -- they were cash flow negative -- for the March quarter. From internal cash flow, MILL generated only a tiny fraction of their $30 million in capital expenditures for the last nine months; the rest comes from external financing. This reliance on outside sources of capital explains the negativity regarding the stock's valuation. But as with many other companies, Miller is tapping the robust fixed income markets to finance growth.

Miller recently completed an offering of preferred shares, and the company's willingness to issue these shares at a discount -- 500,000 shares were sold at $22.25, or 89 cents on the dollar -- likely caps MILL-C's price in the near-term. But, with MILL-C we are investing for income, not capital gains, and the 12.2% current yield is appealing.

Is the yield safe? The silver bullet comes from the state of Alaska. Unlike other states, Alaska actually creates jobs via energy exploitation and pays its citizens a dividend every year. For corporations, Alaska allows producers to recover up to 40% of exploration and production expenditures. This is significant in Miller's case, since projected interest costs over the next three years would be covered by the $16.3 million claim submitted to the Alaska Department of Revenue. Miller expects a ruling on its application by July and to recoup the credits in cash by September 15, 2013. Cash flow coverage from state tax rebates -- you betcha!

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