The market had a tremendous run in 2013 which was a boon for investors. If history is any guide, like past bull markets, this one will prove to have given a massive boost to several companies of dubious quality. Since Wall Street analysts seem to be willing to rate any and everything a buy (why wouldn't they? Tough to garner investment banking fees from a company rated 'sell'), it is up to short selling activists (Citron Research, Muddy Waters, David Einhorn, Bill Ackman, etc) to shed light into the bear case for certain equities. Below I will highlight 3 companies which I believe to be significantly overvalued and have business characteristics which investors will eventually come to find quite undesirable (short sellers will find desirable). My criteria include:
- Unsustainable business model/undeveloped business model - I'll focus on business models which I believe either a) don't add value for customer/potentially mislead customer b) have yet to produce significant revenues/profits c) have been investigated by the FTC/other regulatory body regarding treatment of customers.
- High valuation - selling at > 25x trailing EPS
- Insider selling in past 3 months
Conn's (CONN) looks to be a good short for a number of reasons. First and most importantly, there is a fundamental misunderstanding amongst investors of what Conn's actually does. Investors believe Conn's to be a rapidly growing niche retailer. While Conn's is rapidly growing, it's niche isn't retail. Rather, Conn's is a predatory lender wrapped into a retailer.
The company uses fast talking salespeople to coerce its customers (typically low income people) into not only paying high interest rates to finance their purchases but also into buying expensive product warranties of questionable quality as well as various overpriced insurance policies (if you get hurt and can't work or laid off). The company has been investigated regarding these sales policies in the past and I suspect we will see more investigations in the future given its extremely low customer satisfaction ratings.
Growth has been facilitated by a massive increase in lending to the least credit worthy customers. Conn's has generated negative cash flow over the past couple of years - growth has been facilitated only through increased borrowing. While has allowed the company to post what appears to be impressive earnings growth, I suspect that once all is said and done, we will see that Conn's has earned far less than it estimates (because it is a lender, loan loss allowances are a discretionary accounting entry -we won't know what the company actually earned until loans have been collected).
Historically fast growing lenders tend to dramatically underestimate loan losses leading to significant loan impairments. I expect we will see Conn's do the same. Because of this (and regulatory risk), payday lenders other sub-prime lending businesses usually trade at 6-10x earnings, but at $77/share Conn's is trading at 28x 2013e EPS. I suspect that Conn's true sustainable earnings power is sub $2/share. Applying an 8x P/E multiple gives me a target price of $16/share. Insiders seem to agree that the company is massively overvalued - they've been selling aggressively (over $700 million in sales in past 13 months) since shares broke through $25/share in December of 2012.
Table 1. Monthly summaries of insider stock purchases, sales, and option exercises for Conns Inc.
Lifelock (LOCK) shares performed well in 2013 as the company grew subscribers, revenue, and cash flow. However, it is unclear what Lifelock's service actually does for subscribers. While company marketing implies that Lifelock's product can prevent identity theft (the company used to market its CEO Todd Davis's social security #. This was stolen at least 13 times!), regulators have argued that this isn't so.
In 2009-2010, Lifelock was investigated by the FTC surrounding false marketing claims made by the company - the FTC summarized the case as follows:
"The FTC and 35 states have charged LifeLock with deceptive advertising. According to the lawsuit, LifeLock claimed its service would protect consumers against all forms of identity theft, when, in fact, LifeLock offered only limited protection against only some forms of ID theft."
Lifelock settled in 2010 for $12 million. In addition to the monetary settlement, Lifelock agreed to modify its business practices. Broadly speaking, the company agreed to greatly restrain claims in its marketing. In 2013, a former employee filed a lawsuit against Lifelock claiming that he was wrongfully terminated after questioning whether Lifelock's marketing was in violation of its agreement with the FTC. I've talked to people who have used this service and claim it has not done what it claims - specifically, they were not contacted by Lifelock after applying for credit (one supposed feature of the membership). Such claims appear commonplace.
Selling at 43x 2013e EPS, Lifelock deserves a look from short sellers. Short seller activism could force the FTC to take another look at Lifelock to ensure regulatory compliance. A reduction in marketing activity would likely slow the growth rate of the business, rendering the 43x P/E multiple ridiculous. Insiders have sold $4.5 million over the past 5 months (small in comparison to CONN to be sure).
Organovo (ONVO) sports nearly a $900 million market capitalization despite having less than $1 million in revenue. The stock soared 324% in 2013 as speculators aggressively bid up anything believed to be associated with 3D printing (though Organovo is not a 3D printing stock). Organovo's management has taken advantage of this by doing roadshows targeting retail investors, many of whom I would deem as being less than sophisticated.
SA contributor Richard Pearson did a great job of appraising the company in November. In what I believe to be the surest sign of a bubble, French robot maker Gorge Groupe (OTCPK:GGRGF) saw its shares more than double in a matter of days after announcing that it had acquired a tiny 3D printing company. While it is unlikely that we will see meaningful revenue from this Organovo for the next several years, it is entirely possible that speculator enthusiasm for 3D printing stocks will wane.
When investors come back to their senses, paying $900 million for a business that might generate $5-10 million in revenue in 2017 will again look insane and I expect the share price to decline meaningfully. Insider selling at ONVO has picked up over the past couple of months and I wouldn't be at all surprised to see it continue into 2014. Should the market's mood change, I think we could see ONVO selling at less than $1/share (still a premium to estimated 2014 year end cash balance).
While CONN, LOCK, and ONVO all saw their shares soar in 2013, I'm expecting these shares to dramatically underperform the market over a three year horizon ending in 2016.