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Imagine being given the opportunity to short a huge, publicly traded fad that is already showing signs of fatigue. Imagine no longer - that description perfectly fits Heelys (NASDAQ:HLYS).

Less than six months after its December 2006 IPO, investor enthusiasm for HLYS has sufficiently waned to push the stock below its initial offering price of $30 twice, and only recently the stock has recently rallied due to a conveniently timed upgrade from IPO manager Wachovia, which gave the stock an 8% bounce as it tested all-time lows. Aside from the charts, there are also fundamental reasons I am skeptical that HLYS has any upside as a company or stock, which is why I believe it is one of the best short plays in the market today.

Looking at Q4 2006 vs. Q3 2006, revenues experienced a sequential decline, and operating cash flow was negative – a discrepancy that looks to be largely due to a growth in accounts receivable, which suggests Heelys is extended quite generous terms to retailers. heelysAlthough I am hesitant to make an allegation of channel stuffing, I judge companies by operating cash flow, not net income; whether Heelys is just not in a hurry to collect on receivables, or perhaps just being aggressive in recognizing revenues, any company that quadruples sales and grows net income six-fold while having reduced operating cash flow on a year-over-year basis is going to raise red flags on my valuation model.

The fact that all these sales come from the whims of 10 year olds just seems to give Heelys an inherently unstable business model; everyone can name a half-dozen fads that have come and gone in that age group, and Heelys look gimmicky enough to fit in with Pogs, Pokemon, Razor Scooters, Beanie Babies, and those shoes that had flashing lights in the soles, as trendy but transient products that capture the short attention spans of elementary school students for a year or so.

Two final notes from the Wachovia report I am reading:

1. One listed risk is “lawsuits and negative sentiment related to injury,” which I think is one underestimated risk; many stores specifically mention that Heelys are not permitted to be used because the enormous liability created by allowing preteens skate around crowded aisles, and the quickest way to kill this fad would be to get parents opposed to the shoes on safety grounds.

2. Another comment I find interesting is that “sales and earnings growth could begin to naturally decelerate,” which seems to be a hint of recognition to the beginning of the end of the Heelys fad. Right now the five-year growth estimate is an annualized 25%, I see little to no chance that Heelys is in as good a position in 2011 as they are now, and the degree of insider selling that follows the end of the post-IPO lockup period in early June will certainly be interesting to watch.

In short: Heelys is essentially a publicly traded fad catering to elementary school students. The financial health of the company is questionable, the risks that come with a concentrated product are huge for the target market, and the recent jump off the Wachovia upgrade seems like a false rally meant to prop up the sagging stock price, which will soon be under additional pressure as insiders’ holdings enter a market that may already be seeing too much supply and not enough demand.

Although I think Heelys has some legs left as a company – which will give the “Worst IPO Performance of 2007 Award” to Vonage (NYSE:VG) – I still think a short entry here just above $30 could easily return 65% or more, as I value HLYS at around $8.

Disclosure: Author has no position in HLYS

HLYS 4-mo chart

Source: Heelys: Wheel Me into the Short Camp