5 Potentially Overpriced Stocks to Consider Short Selling

by: Hedgephone

When screening for short positions, remember that the most important factor in making money from the short side is discovering fraudulent financial statements or companies that are simply never going to grow into their valuations. While shorting potential frauds is a bit more risky in that you could be shorting an undervalued stock if you are wrong (these usually trade for 10X "earnings" or less), shorting stocks that are overvalued is more risky in bull markets because chances are momentum investors will simply send the name higher regardless of the fundamentals. Examples: Netflix (NASDAQ:NFLX), Salesforce.com (NYSE:CRM), and Amazon (NASDAQ:AMZN) -- all three are investments that we wouldn't buy at half their current prices but we can't fight the tape and if anything would be short bear call spreads on these as a market hedge against other technology long positions.

What is questionable about NFLX, CRM, and AMZN is that all three are being touted as disruptive business models with revenue growth but all three are earning most of their cash flows from increasing short-term debt -- usually a sign of, well, accounting irregularities. To be sure, I am bearish on these names because rising payables and receivables are not "owner earnings" but instead simply financial engineering (i.e. making the books look pretty). Green Mountain Coffee (NASDAQ:GMCR) is another name with questionable accounting practices, but shorting the stock in a bull market seems more trouble than it's worth -- I agree with Sam Antar that something doesn't smell right and I think eventually a great short opportunity will arise with the name dropping 50% in a few sessions, but until a bear market erupts, shorting stocks like CRM, NFLX, AMZN and GMCR is an exercise in futility. If you can limit these types of shorts to, say, 20% of your notional holdings and have long positions in great businesses to hedge them against, I say go for it.

For investors looking for a more absolute return, short only approach, I would look toward websites like timothysykes.com, muddywatersresearch.com, and the more old school citronresearch.com, and asensio.com. Citron and Asensio have been around a little longer, but I find Sykes and Muddy Waters to be invaluable research tools in the current environment. All four of these sleuths can help long short investors with their due diligence on short candidates.

These sites conduct in depth due diligence (which is rare) on the short side and investors can research potential "pumps" to short at each of these sites. While we are more of a blog about markets, fundamentals, and bottoms up research on markets, these sites cover in depth fraud analysis on individual issues and all of them have solid track records of success.

Here are some names that I am, well, skeptical of at current prices.

SQNS -- Sequans Communications has exceptional growth and is a leader in the red hot 4G cell phone space, but the company has little to no earnings and a very stretched chart right now. Since Cramer turned bullish on the name, the stock has been on fire, rising from around $9 to $18.50 and falling back to $12 or so per share before rising back to $16.47 or so currently. SQNS trades for a PE ratio of over 600X, which on its face is a bit meaningless, but when combined with a price to book ratio of 20X and the fact that it is cash flow negative right now (and has been for the past six years) makes me more than a bit interested in shorting the name at current levels. We wonder when the lock up period will end and if existing shareholders will be looking for some liquidity -- the stock is up over 100% in the past few months and I will be trying to short this if it hits $18.50 or so for a double top -- a very hard to borrow name, however.

With only 182 employees and a market cap of $450MM this thing looks expensive. I am impressed with the technology solutions and growth but am skeptical of the price after the recent run. While 1st quarter revenue was up more than 145% from last year, sequential revenue was up just 11% over the fourth quarter. The company did earn net income of $1.9MM, so keep an eye on net income trends and also on top line growth -- this conceivably could be a billion dollar concept one day, but for now I would look to short this on intra-day spikes and think it will make a good short in down markets. One thing that is definitely growing at SQNS besides revenue is share count -- diluted share count has been rising by over 25% over the past year, and up to 29MM shares from 26MM shares in just the past quarter. While this is surely a hot stock currently and a tough longer-term short, I do see this high beta name underperforming badly in down markets.

TZOO -- Travelzoo is a name that I have followed over the past year that has blasted short sellers but also momentum buyers over the past few months with the stock rising from just $10 a share to a price of $100 (making a double top with the old 2006 highs) before collapsing back down to $60 or so. Currently, the stock is trading for $76, but the recent quarterly earnings looked terrible as the company actually lost $13MM and the only cash flow the business earned was from increasing short term liabilities. When backing out increases in short term debt, TZOO is essentially a non-profit operation from a cash flow perspective, though we respect the business model and the impressive longer-term top line growth. That said, we think a fair price for the company is around 40X free cash flow (owner's earnings or net income plus depreciation minus cap ex) or around $500MM. This valuation allows for a 30% or so cash flow growth rate, but the current growth in revenue has not generated a commensurate growth rate in cash flows, so we are still skeptical of even a $40 share valuation for this stock. That said, in the short run anything can happen, but over the longer term paying 10X sales and 38X book value for a business that is not very profitable seems, well, reckless and naive to us.

SPRD -- Spreadtrum Communications is the latest Muddy Waters Chinese accounting fraud name to watch for short sellers. Muddy Waters has likely the best track record of calling out accounting fraud among Chinese reverse merger companies in 2010 and 2011. It nailed shares of China MediaExpress (OTCPK:CCME) - along with Citron, which produces research that I highly respect and which got me short the name after "liking" the stock earlier at 4X earnings - and OTC:RINO International as well as Sino Forest over the past year, and recently they announced that they were short shares of Spreadtrum Communications (NASDAQ:SPRD). Since Muddy Waters posted an open letter to SPRD management and announced their short in the stock, shares have spiked a good deal, popping some 100% from the announcement. While the stock looks cheap if there is nothing seedy going on, my money is on the website here, and I think the run up of late is likely a good entry for a new short position for our readers. That said, the website has been relatively mum on the name since its initial article. Like many other Chinese names, the inventories make us more skeptical than the rising earnings make us bullish... That said, SPRD could be a legit company and until we hear more from the website we would be on the sidelines here.

HRBN -- This Citron short is a Chinese electric motor supplier which looks cheap on earnings and cash flow on first glance. That said, anyone following CCME and RINO understand that with Chinese US listed stocks, looks can be very deceiving. HRBN has a full 47% of its float sold short right now, which is a sign that we are not alone in our bearish view on the name to say the least. That said, because there is such a big short on the name a squeeze is always a possibility in an overall bull market.

As Citron puts it:

"It is Citron’s opinion that it is now time for the SEC to halt this (NASDAQ:HRBN) security. The future of Harbin’s stock price is currently propped on the crutch of a purported $24 buyout offer from its Chairman / CEO, which Citron believes is a sham. With time stretching seven months since first proposed, we still have no binding, official takeover bid filed in an 8-K, just a few press releases, and now the boilerplate document of a purported supporting loan that seems half baked, as discussed in the last report."

Citron has been right about 9 out of 10 times since we have followed its research, with most of its short picks falling some 90% or so, and while there is always a chance that HRBN is totally legitimate, I think the short side here makes a good deal of sense from a bottoms up perspective given Citron's track record. Its research on Longtop (NYSE:LFT) was spot on and they also nailed stocks like bidz.com (NASDAQ:BIDZ), which fell from $10 to under $1 and many others.

DEER -- Deer Consumer Products is another stock that Citron believes to be a fictitious reverse merger name duping the SEC. Alfred Little has covered this name in depth on SeekingAlpha and we applaud SA readers outing potential fraudsters -- lord knows the SEC is not going to do the work! Here is a good article on the DEER situation at Zerohedge.

While DEER "looks cheap" it is clear that Chinese reverse stocks are not to be trusted on average because of all of the rampant fraud in the space. Essentially, the report says that DEER products are not actually being sold in the stores that DEER management claims they are sold in -- same story as CCME, as the short thesis is based on the company being nearly 100% fiction.

From Mr. Little's letter to the company:

"In conclusion, the channel checks conclusively shows very low sell-through of DEER’s products,that combined with DEER’s ballooning receivables shows that either 1) DEER is stuffing the channel, which in the medium term this may lead to an accounts receivable write down or asignificant slowdown in orders; or 2) DEER could have fabricated its sales volume to Gome and Suning. Furthermore the channel check confirms that DEER exaggerates its margins, since its products are clearly low-end and low-price."

Disclosure: I am short NFLX, SPRD, CRM. I am long a small position in AMZN put spreads and my shorts on these are made using options spreads.