Beware of the obvious short squeezes: they rarely pan out, even if you believe the stock isn't a short and you just want to invest in the darned thing.
Last night the companies behind two heavily shorted stocks, Herbalife (HLF) and Square (SQ) , reported better-than-expected quarters. When you see the short interest of both at elevated levels -- Herbalife at 31% of the float and Square at 19% -- you can tell that there could be some fireworks.
Both are deserving of some degree of fireworks, but are they bottle rockets or genuine screamers launched in crescendo fashion?
Herbalife's numbers were certainly better and it's now predicting $4.50 to $4.80 for the year. Given that the company's model gives it pretty good visibility, I would bet that it would be closer to the high end.
Now, we know that the reason why there will be short covering isn't the EPS: it's that the company's business didn't fall apart despite the FTC's strong actions taken against it, actions that noted short-seller Bill Ackman said leave the company basically dead. Instead, Michael Johnson, the CEO whom Bill Ackman must personally loathe, said on the call he embraced the changes and they would be good for business.
That's right, good for business. Now, I say "loathe" because I am sure Ackman will only double up on his negativity instead of declaring victory that he helped clean up some of Herbalife's practices, so to speak, which had clearly resulted in some harm to sellers. He will do so, I believe, to prove that the FTC-mandated changes are bad for business.
That's why if you are going to play the short game you have to come back to the fundamentals. What would you pay for $4.80 in earnings power from a company that is hardly Bristol-Myers (BMY) ? It's hard; that would be good growth off of a depressed number that represents about 20% growth. I struggle again, as I have done in the past, trying to figure out what the normalized earnings power is here. When that's the case, it sure can't get a market multiple.
In the end, it is a supplements business. So what does the biggest supplements business, GNC Holdings (GNC) , trade for? About a 7 multiple. Sure it's tainted, but Herbalife isn't? Obviously if you give it that multiple, the stock deserves to trade appreciably lower.
So, let's, for the sake of argument, double the darned PE of GNC: you get $67.
That's what I think people will pay. Which means that you are dealing with a stock that could be fairly valued. So now you literally are just playing the squeeze. Which means you are betting either that Ackman will cover, or that Herbalife will go private again.
I think both are unlikely. So what are you really buying? A supplements company that trades off of points. That's not enough to take the stock dramatically higher until it can demonstrate sustained earnings power, and for that we will just have to wait and see.
Square? Here's a really hard to value stock, but a company that had been dogged by credit risk. After last night's call I got comfort that there are enough buyers of their 14% notes based on the actual sales coming out of small businesses that you have to severally discount that risk. That means you are dealing with a high-growth loss-making company in the incredibly competitive payments space.
What's that worth? I would argue more than it was yesterday. But how much more, given the tough firmament it finds itself in? Not much more than the huge gain it showed last night. Here's one where the ultimate target might be its all-time high of $15. But you are dealing with a riskier environment for small to medium sized retailers -- the core customer -- than you were in March when it hit that high. My take? If you like it, wait for the hoopla to die down.
I think that will represent a better opportunity.