Short Thoughts

As many of my readers know that I am short some stocks that I have written about on HypeZero:

With the market trending up the last couple of months, both Pandora and SHOS have skyrocketed costing me some money. However, Orchard has really tanked which has helped my short portfolio pretty much break even. Not bad in this market. 

I am keeping all three shorts as nothing fundamentally has changed from a business perspective at any of these three companies.

Because the market has gone up quite a bit, I am looking to add to my short portfolio. Here are some companies that have caught my eye as possible short candidates:

Zillow/Trulia

I have written that Zillow is better than Trulia based on sheer numbers. However, as I read more about this industry and these companies a couple of things concern me:

  • When I search for real estate in my area, I don’t use Zillow/Trulia because their information does not come from MLS so it is sometimes inaccurate or outdated. I use the realtor site run by Move Inc (MOVE).
  • I don’t see much of a difference between Move’s business plan and that of Zillow or Trulia. In fact, Move has better data.
  • Move has been around for a while and they have been struggling growing annual revenue past $200 million. Zillow is half the size at only $116 million in annual revenue, but worth 4+ times as much. As Zillow gets to Move’s size it will have similar growth problems.    
  • Sales and Marketing expenses are going up at a faster rate than revenue. If the market is so big and these companies have such a small percentage of the market size, why is it so hard to grow revenue? In 2012, Zillow revenue grew over 75+%, but sales and marketing grew over 100%. 2013 forecast calls for 45% revenue growth and 70% growth in sales and marketing expenses.
  • Both companies are trying to enter other markets by acquiring companies at premium prices. This is a big hint that the current business model does not justify the current valuation.
  • Zillow is barely profitable and Trulia is not profitable.

One thing that these companies have going for themselves is that the housing industry is bouncing back. This could result in real estate agents increasing their advertising spending on sites like Zillow. 

Moneygram (MGI)

I wrote that Wester Union is a value trap a couple of months back. Moneygram is Western Union’s biggest competitor, but it is smaller and does not enjoy Wester Union’s premium pricing. A couple of things concern me about this industry:

  • They charge the poorest people high prices to transfer small amount of money. Every year fees per transaction keep going down and there is constant pricing pressure. They need to increase the number of transactions per year just to keep revenue and profits from going down. Western Union, a huge cash cow, has been making $1 billion in profits for over 8 years.
  • Wester Union is performing price cuts across certain corridors and this should have an impact on Moneygram in 2013. 
  • New competitors (Xoom) and the wide adoption of smart phones will impact this industry in the future.

Monster/Dice

LinkedIn (LNKD) is hitting on all cylinders and the by-product of this that sites like Monster (MWW) and Dice (DHX) are hurting. Monster is at a 52 week low and I think Dice, a career website for technology professionals may be next. Even though the technology market is hot, Dice is barely growing revenue and profits. 

I will do more research on these companies before I short any of them.

Disclosure: I am short Pandora, Sears Hometown and Orchard Supply 

Year end review

Happy new year! I took some time to disconnect over the last two weeks and enjoy the holidays. For the first post of 2013, I thought it might be a good to review all the picks from the last 3 months to see how I fared.

AIG (AIG)

AIG is still one of my top picks. It is up about only $2 from the price I paid for the stock. However, I feel it still has significant upside. Mainly all the arguments I made previously still apply:

  • It trades at half of book value.
  • The government completely sold AIG shares at the end of 2012. It now only holds warrants in the company.
  • AIG sold its stake in AIA. It also has agreed to sell a majority of its stake in ILFC.
  • The company can now focus on its core insurance operations and improve its return on assets.

Dean Foods (DF)

I sold Dean at a little bit of a loss. I still think Fresh Diary Direct segment is undervalued. However, the volatility of Whitewave was too much for me to take. I think the best way to play Dean is to wait for them to distribute the Whitewave shares and buy it before the distribution date if the current prices remain as they are.

General Motors (GM)

GM is one of my biggest winners. It is up nearly 50% for me. The government sold off 200 million shares of its stake in the company to GM recently. This should have a positive impact on EPS. If the economy improves in US and Europe and vehicle sales return to a normalized state, earnings could easily be over $5 over the coming years. Also, it is slowly removing the overhang of the pension liabilities. This could also be a big boon.

With the stock to almost $30, I might cut my position in half and book some profit. The auto industry is very capital-intensive and very competitive.

Orchard Supply Hardware (OSH) & Sears Hometown & Outlet (SHOS)

I have written a lot about these two Sears spin offs and I am short both. As I mentioned in my previous articles, I am convinced Orchard will go under. So far, it has been a very profitable short for me. I am not 100% convinced on Sears Hometown, so I only have a small short position there. Both of these plays are a bit risky, since they are cheap on a revenue multiple basis. Sears Outlet is a wild card for SHOS. If it can grow that successfully, the stock may have upside. I have no faith in the Sears Hometown business as it has had negative same store sale numbers for years. I know a lot fellow financial bloggers are long SHOS and I am open on seeing their analysis. So far, I have been wrong as SHOS. It has bounced nicely from $30 to $35 recently.

Xerox (XRX)

I bought Xerox around $6.50. The stock is around $7.20 today. Nothing fundamentally has changed about the company since I wrote the bullish case. It still trades at a significant discount to FCF and has increased its dividend. I still think there is significant upside.

Genie Energy (GNE)

Genie was a quick arbitrage trade on its offer to exchange common shares for prefered shares. I booked little less than a 10% profit on the trade. I still think there may be an opportunity on this type of trade in Genie in the future. Nobody will exchange the common for the preferred as the common is trading higher than the preferred.

Pandora (P)

I have a small short position in Pandora. So far, it has not been a good trade as the stock has shot up from $8 to $10. I continue to believe that this company will not exist in the future. It really has no barriers to entry, no competitive advantage, and is not profitable. Obviously, a lot of Pandoras profitability depends on the outcome of the Internet Radio Fairness Act. However, there is no doubt that there will be more competitors in this space in the future. I will keep this short position.

Susser Holdings (SUSS)

Susser is up about a $1 from what I bought it at. It may take some time for this stock to go up. However, it should be able to expand a lot faster after the spin-off of SUSP. I have a small position and will keep that position.

Others

I also missed out in some of my other bullish calls such as Facebook, Lumos Networks, Nacco Industries and Einsteins. I wrote a bearish case on Western Union, but the stock has been up since then. I still believe in the bearish case. I believe that Western Unions biggest competitor Moneygram will have a tough 2013 due to Western Unions price cuts. I will be looking to short in 2013.

DIsclosure: I own or am short most of the positions

Pandora By The Numbers

Internet Radio Fairness Act

In my last article, I gave a general idea of why I initiated a small short position in Pandora (P). I argued the only way the stock has a chance of going up is if there is new legislation that significantly lowers music royalty rates.

This legislation is the “Internet Radio Fairness Act”, or IRFA. In fact, Pandora CEO is currently arguing on Capitol Hill that the royalty fees that it pays as a percentage of revenue (50+%) are unfair compared to what satellite radio (8%) and radio stations (0%) pay. Pandora wants Washington to cut royalty rates by more than 80%. On the other side, musicians are arguing that they do not make much as is.

I don’t understand why Washington has to get involved and if a company (Pandora) cannot make money based on the current royalty structure why is it still in business. Comparing royalty rates as a percentage of revenue is meaningless. For example, if Pandora gets higher advertising revenue, then the royalty rates a percentage of revenue go down. Maybe it needs to play more advertisements. Maybe it needs a new business model.

I don’t expect that the bill will get passed in its current state. However, if it does, the following table lists trailing 4 quarter earnings if there is a drastic 85% cut in royalty rates (35% tax rate).

  Jan 2012 April 2012 July 2012 October 2012
Earnings $21 Million $18 Million $29 Million $37 Million
Earnings Per Share .13/share .11/share .18/share .22/share

By my rough calculations, Pandora would have trailing 12 months earnings of .64/share or over $100 million and its stock price would more than double. On the other hand, it would also bring new competition into the now more profitable industry.  

Growth

There is no doubt that Pandora has experienced tremendous growth to the number of users and more importantly to listener hours. The growth is mostly due to the growth in smart phones. Users tend to listen more on phones, then on computers. 

However, this growth will slow considerably. Pandora had 62.4 million active users in the month of November. That is about 20% of the total US population. Also, the smart phone market is pretty mature in the US. See figure below. 

US Smart Phone MarketSource: Business Insider 

Monthly listener hours (in billions) numbers prove growth is slowing significantly. 

  Feb Mar Apr May Jun Jul Aug Sep Oct Nov
Listener Hours .975 1 1..06 1.1 1.08 1.12 1.16 1.15 1.25 1.27
Growth(Y/Y) 101% 88% 87% 87% 77% 76% 70% 67% 65% 58%

One thing to note is that listening on the phone per hour is less profitable than on computers for Pandora due to lower advertisement revenues.

Conclusion

I only have a small short position in Pandora because of the current legislation risk. But I feel there are many things working against Pandora and expect that eventually the price of the stock will go down. Another way that I am thinking of playing Pandora is selling December naked calls as they are priced pretty high due to the stock’s volatility. 

Disclosure: I am short Pandora. 

Shorting Pandora

Pandora LogoPandora (P) is an internet radio service. “The company allows listeners to create up to 100 personalized stations to access unlimited hours of free music and comedy, as well as offers a paid subscription service to listeners.” Most of their revenue comes from advertisements that are run between songs. 

Yesterday, the company announced quarterly results that beat market expectations, but provided lowered fourth quarter guidance. The company blamed soft guidance on advertisers being cautious with spending due to macroeconomic concerns such as the fiscal cliff.

Due to weak guidance, the stock is down around 18% to $7.80 today. 

I have wanted to short Pandora for a long time, but never got around to doing it. But, finally I initiated a small short position today at $7.79. Here are the reasons for the short: 

Profitability

Even with huge subscriber growth, Pandora is having a hard time just breaking even. The reason is that Pandora has to pay royalties for every song a user listens to. So, as advertising revenue increases as more users join Pandora, so does the “content acquisition” cost.

In fact, it gets worse. The royalty rates are going to increase every year under the “Pureplay Settlement” with SoundExchange, which has set predetermined prices every year until 2015. 

Pandora has been lobbying in Washington to lower these rates to boost profitability. However, I don’t think anything will materialize and even if something does, it will be a long time away.

Competition

There is plenty of competition in this space. The biggest ones are Spotify, Apple, and Amazon. Spotify has a very similar service to Pandora except

  • Spotify has integration with Facebook which allows users to share songs with friends.
  • Spotify is free on personal computers. You can listen to any song in their library for free.

There has been a rumbling that Apple may enter the interent radio space. It seems a natural fit for Apple and Amazon as they already provide music content.

Also, there is nothing holding users from using other services beside maybe personalized stations that have been created on Pandora.

Conclusion

I am confident that Pandora will continue to go lower. The only thing that could save it is if it negotiates better rates for content acquisition.

Disclosure: I am short Pandora.

Don’t Short Sears Hometown… Yet!

Eddie Lampert of ESL Investments the major holder of SearsSears Holding’s (SHLD) latest spin-off, Sears Hometown and Outlet (SHOS), starts to trade tomorrow. Based on the subscription rights price, it is expected to trade in the high 20s. I originally wrote an article back in September advising investors to stay away from SHOS.

 

However, avoiding does not necessarily mean shorting it. In the short term, SHOS could go higher because:

  • It is profitable.
  • It is cheap by a lot of valuation measures. 
  • It earned $1.80 in the first half of this year. It will trade at less than 10 times this years earnings. A lot of value investors will be fooled by these numbers.
  • There are still 60 company owned stores. Let me explain.
As I mentioned in my original article, SHOS profitability rose due to huge margin improvements. Part of that margin improvement was due to the conversion of company owned stores to franchisee operated stores. The franchisee operated stores have to pay an initial franchisee fee of $25,000 and also have lower occupancy costs.
 
Here is the numbers breakdown for Hometown and Hardware Stores and Home Appliance Showrooms for last 2 quarters:
 
Hometown and Hardware stores and Home Appliance Showrooms
 Figure 1: Number of Hometown and Hardware Stores and Home Appliance Showrooms
 
 The company owned stores went down from 85 to 60 in the last quarter, while the franchisee operated stores went up from 86 to 104. The 941 independently owned and operated stores are all Sears Hometown stores and are not available to be converted to franchisee stores. However, the good news for SHOS is that there are still 60 company owned Hardware Stores and Home Appliance Showrooms which are available to be converted. This will at least keep margins flat in the near term.
 
However, what happens when there are no more stores left to convert? Margins will slide as the negative business fundamentals catch up with the company!
 
My advice is to avoid SHOS in the near term because there are catalysts that will drive the share price higher. However, with every quarterly report watch the number of company owned stores. When it reaches close to 0, think about shorting this stock!
 
Disclosure: I do now own SHLD or SHOS. I am short OSH.

Troubling Times at Orchard Supply Hardware

As Sears Holding (SHLD), a HypeZero recommendation, spins off Sears Hometown and Outlet Stores, let’s look at the state of the company that it spun off less than a year ago, Orchard Supply Hardware Stores Corporation (OSH).

Background

Orchard owns and operates 88 home improvement stores in California. The company was spun off Sears on December 30, 2011. For every 22.141777 shares of Sears Holdings, investors received one share of the Class A Common Stock and Preferred Stock. The Class A Common Stock trades under the symbol OSH on NASDAQ. The Preferred Stock trades under the symbol OSHSP on OTCQB.

Competition

Orchard is a small fish in an ocean full of sharks. Its main competitors are Home Depot, Lowe’s, Ace Hardware and True Value. It also competes with discount retailers such as WalMart, Target and Costco in some of their product lines. To get an idea of its size, Orchard’s fiscal 2011 revenue was $660 million and Home Depot’s fiscal 2012 revenue was over $70 billion. Home Depot’s stores are more than twice the size of Orchard’s stores and produce almost four times the revenue. The larger competitor stores give their consumers more variety and better pricing.

Performance

While Home Depot’s revenue, profits and comparable store sales have been increasing since 2009, Orchard’s have been going down year after year. In the first two quarter of this year, all three went down again, and the company is no longer profitable. As a result, there has been liquidity concerns. The company is running low on cash and is struggling to maintain compliance with certain covenants that would allow it to borrow money. Non-compliance could mean that certain debt that is maturing in the future would be due now. And a default in one agreement could mean a default in other agreements.

Because of the deteriorating results, the company would not have been in compliance with the leverage ratio covenant on July 28, 2012 had they not completed a six-store sale and leaseback transaction. The company is pursuing all measures to alleviate the liquidity problems. The next measurement date to see if it meets all its covenants is October 27, 2012. It is a bit of a coincidence that investors have to exercise the subscription rights on Sears Hometown and Outlet Stores offering before October 8, 2012 (right before the measurement date).

It only gets tougher for Orchard from here. The first two quarters are seasonally the best for business.

Insiders

The biggest holder of Orchard, ESL Investments (Eddie Lampert), has been selling its stake in OSH. ESL Investments decreased their holdings by almost 23% in their latest quarterly filing at the end of June. Fairholme Capital Management has also decreased its stake.

One thing to note is that Lampert has been buying up the Preferred Stock at around $1.60/share. The Preferred Stock has no voting power, no conversion rights, and no dividend. However, it has to be redeemed for $4.16 in case of 3 events: before a dividend on the common shares (not going to happen), before any repurchases of the common shares (not going to happen), or in the event of a company liquidation (maybe this will happen). Nobody is sure of Lampert’s motives because in the event of a liquidation, there might not be anything left for the Preferred Stock holders after the debtors take their cut.

Whatever the reason is, the future does not look bright for Orchard. With their poor performance, liquidation problems and their business in a highly competitive industry, it is hard for us to see Orchard turning itself around.

Disclosure: I am short OSH.