Watching For A Short Squeeze In Bank Of The Ozarks: Earnings Report Monday

| About: Bank of (OZRK)


OZRK appears to be a high-growth, conservatively run, excellently managed bank, trading at a reasonable valuation.

But Muddy Waters has a high-profile short thesis out on the stock.

Insiders are not impressed and are buying.

Earnings report comes out before market opens on Monday.

One method I sometimes use to find trades is to screen for stocks with upcoming earnings reports and high short interest. Then I get the report as soon as it comes out, and if it's positive, I jump in for a quick trade riding the short squeeze. This is actually my best risk-reward setup type of trade, although usually my time horizon is much longer and I invest for much different reasons.

There is only one stock that meets these criteria right now: Bank of the Ozarks (NASDAQ:OZRK), which plans to announce earnings before the bell on Monday, July 11. The story is a little bit more interesting than the usual high-short-interest stock. (And not just because my daughter once asked, while passing a branch of the bank, "What's an ozark?"). In fact, it would require a good bit more research on my part before I felt I fully understood the story. I wanted to put this article out today, however, in case readers wanted to position themselves for a trade before the weekend. (Note that I am not recommending a position either way.)

A Very Well Run Bank … At Least It Looks That Way

On most measures, OZRK is a very well run bank. It has a net interest margin above 5%, and a history of chargeoffs and efficiency ratios well below the industry average. They pursue low credit risk by vetting their borrowers carefully and requiring very high levels of collateral against loans, and they have positioned themselves for a more volatile interest rate environment.

They also have a history of growth on every metric: EPS, dividend, loan book, deposits, you name it. These numbers have driven excellent historical returns.

A Growth Stock Come to Earth

You wish you invested in OZRK some time ago, and then sold late last year. Here is a five-year plot of the stock, versus the S&P 500 and XLF, the financials ETF:

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(Source: Yahoo Finance)

As you can see, since its peak last December it has basically been cut in half. I'm not exactly sure why. Some of it is due to the general downturn in the financial sector, but some of it was probably a valuation collapse: the stock was trading with a P/E over 28 and a P/B around 3.5. There were a few minor expectations misses. And Muddy Waters was putting together its short position.

The Muddy Waters Short Thesis

The reason the short interest in OZRK is so high right now is that at the Sohn Investment Conference in May, famed short seller Carson Block of Muddy Waters unveiled a short thesis against the company. The thesis is complicated to evaluate and it goes beyond (but includes) the claim that Bank of the Ozarks does not reserve adequately against losses. (Another SA author rebuts that part of the claim here.) Block's main thesis, rather, is basically that the bank has a large unfunded liability and no good way to fund it. Let me explain briefly.

Bank of the Ozarks has an unusual business model in that they seek out real estate loans which they plan to fund at very conservative LTVs of around 50%. This means the borrower has to raise a lot of capital before OZRK puts any money into the loans, and this can take a while. Consequently, these phantom loans are not on OZRK's books; you can think of them as a (very large, $6.4B) hidden asset. On the other hand, the loans have closed and they are actual commitments of the bank; when the borrower does come up with their half of the cash, OZRK has to put up their half too. And they do not have $6.4B lying around. In that sense, the unfunded loans are hidden unfunded liabilities.

Historically, the bank has funded their business model by buying other banks and using the deposits to fund loans, and in fact OZRK is in the process of closing two significant acquisitions right now. To be brief about it, Block does not think this is going to solve all of OZRK's difficulties, and he anticipates some dilutive equity raises in the future.

I have presented Block's thesis as fairly as I can, but there is more to it and I am not sure I have everything exactly straight. Do your own due diligence. This Business Insider article is a good place to start, and includes a version of Block's presentation. You may also want to look at the latest Bank of the Ozarks investor presentation, which came out after Block unveiled his thesis and seems designed in certain ways to refute it.

The stock dropped from 38 to 34 during Block's presentation at the conference, but bounced back pretty quickly, and now sits at 35.

Insider Buying

One audience in particular is not impressed with Block's thesis, and that is insiders of the company. Six different insiders decided the stock was on sale, and bought 135K shares with $5M of their own money.

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Current Valuation

I looked at the same 17 banks that Block used to benchmark OZRK for some basic valuation metrics. In that group, OZRK is pricey on P/B at 2.1. But trailing P/Es in the group range from 14 to 24 and OZRK is cheap-ish at 16. The last time it traded there was early 2013. OZRK is the cheapest of the bunch on forward P/E, at 11.4.

The Upshot

So the situation at this point is pretty interesting. We have a well-known and reputable short seller betting strongly against the stock. Short interest is high at 24% of the float, 18 days to cover. We have apparently very solid fundamentals at a decent valuation, and insiders who believe in their company. This is where a more melodramatic writer would say that the battle lines are drawn.

And we have an upcoming earnings report on Monday. This is where the battle might be joined. My own guess right now is that Muddy Waters is not going to win this one.

I will be watching for the earnings report and the market reaction, and may take a position at that time.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in OZRK over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.