PRO Weekly Digest: Inside The Mind Of A Short Seller With The Friendly Bear

| About: Home Capital (HMCBF)

Summary

Unicorns, being patient with a short thesis and the value of short sellers are topics discussed and The Friendly Bear shares a compelling bullish and bearish thesis.

We highlight a noteworthy PRO idea on a broadcaster with a double-digit FCF yield suffering from negative (and largely unwarranted) investor sentiment.

Our idea screen of the week takes a look at opportunities in the large cap space.

Welcome to the latest issue of the PRO Weekly Digest. Every Saturday for Seeking Alpha PRO subscribers and Sunday for all other Seeking Alpha users, we publish highlights from our PRO coverage as well as feature interviews and other notable goings-on with SA PRO. Comment below or email us at pro-editors at seekingalpha.com to let us know what you think. Find past editions here.

Feature interview

The Friendly Bear is an institutional investor focused on short selling. The Friendly Bear primarily looks for companies that are frauds or that have broken or busted business models. The Friendly Bear focuses on outside of the box analysis and concentrates research efforts on management teams that provide poor financial disclosures. While The Friendly Bear does spend time analyzing potential long opportunities, TFB sees short selling as the most intellectually stimulating aspect of the investing business. Notable calls include a bearish thesis on Home Capital (OTCPK:HMCBF), bearish thesis on TrueCar (NASDAQ:TRUE), and bearish thesis on Freshpet (NASDAQ:FRPT), each of which dropped >70% before rebounding. We emailed with The Friendly Bear about multiple battleground stocks including Home Capital, Nutrisystem and Stamps.com.

Seeking Alpha: Where is the bottom for recent unicorn IPOs such as Snap Inc (NYSE:SNAP) and Blue Apron (NYSE:APRN)? Is the IPO window still open for similar companies or does it require much lower valuations? Are there any unicorns you would short if they went public at their current valuations (since many are considering doing so)?

The Friendly Bear: Some truly awful companies with atrocious business models have used the frothy market to go public in the past few years by rebranding themselves as “tech companies”. I don’t advocate shorting a lot of these recent IPOs. That’s a surefire way to bankrupt yourself. Timing matters and these stocks can run against you 50% before you ever make a dime. Right now, my short exposure to recent IPOs is limited. Floats are tight, borrow is limited, and borrow costs are high. For those reasons, I don’t follow SNAP and APRN very closely. I do find APRN rather amusing though. How different is Blue Apron than Omaha Steaks? The former calls itself a tech company and trades on a revenue multiple and the latter is something your grandparents give to their friends as Christmas gifts.

I am short Rocket Internet (listed in Germany) which I think could easily be a zero. Rocket is a holding company that has investment stakes in a bunch of me-too copycat “unicorns”. Their “trophy asset” is a company called Hello Fresh, which in my view is a tier 3 clone of Blue Apron. When your trophy asset is a company that is a copycat of Blue Apron, I don’t think I even need to say anything more about why Rocket is a short.

On the topic of unicorns, in my view, some “unicorns” have real business models. But most do not. In fact, a lot of them are following a very simple and suspect playbook that looks more like Ponzi financing to me.

The first tech bubble involved many companies that did not have revenues. “Ideas” went public and fetched massive valuations – for example, Internet Capital Group (which in some ways was the last bubble’s version of Rocket Internet). The folks who stand to economically benefit from pushing “unicorn” IPOs say this time is different than 1999 because this time the hottest companies have revenues – and in some cases, substantial revenues. But that’s only because the capital markets have been willing to finance massive losses.

What we are effectively seeing now is a bunch of companies out of California and Boston that buy widgets for $1.00, sell them for $0.90, and then say hey look at us! Our revenues are growing at 400% a year! Well whoopdee. If you let me sell things at below their fundamental value, I can generate 400% revenue growth too. But a lot of early stage institutional investors are sitting on piles of cash and are incented to roll the dice with OPM (“other people’s money”).

Companies losing money now and claiming they’ll one day make heroic profits are central to a LOT of narratives in the market right now. Just look at SaaS companies and Netflix. All of these companies are saying wait a few years and we’ll own our market and make money hand over fist. The fact that this “lose money to make money” narrative is so widely pervasive right now is an obvious red flag in my mind. Some of these businesses have been around for over a decade and still don’t make any money now. So how stupid do you have to be to fall for that story? What happens to these companies if investor sentiment changes and they no longer want to stomach losses?

My opinion: don’t buy into the unicorn hype but don’t short them either.

SA: In last week’s PRO Weekly Digest interview with J Capital Research Limited we talked about how you can profit from what everyone “knows” that isn’t true – is your thesis on BofI (NASDAQ:BOFI) an example of this?

TFB: After Trump got elected, the market began to look for ways to play two themes – higher rates, and less regulation. I think that on these two factors, BOFI soared ~50% off its pre-election levels. Given it status as a bank, the allegations surrounding the bank’s behavior, and the high short interest, BOFI quickly turned into a short buster’s dream. However, at the time I argued that the market had it dead wrong for two reasons: 1) higher rates are actually quite bad for BOFI, and 2) the allegations against BOFI were not the type that would magically disappear just because a looser regulator came to town.

It is still too early to tell whether higher rates have hurt BOFI, but as I have alluded to many times – BOFI’s entire deposit franchise grew during a time when competing rates were 0%, allowing BOFI to rapidly build its deposit base from customers searching for yield. I think a substantial chunk of BOFI deposits are brokered or quasi-brokered, leading me to question whether the bank has any real deposit franchise value outside of offering a higher rate during a period of abnormally low rates. So what happens to those deposits as depositors find alternative sources of yield?

On the regulatory front, I’ve been keeping an eye on recent reporting from the NY Post and SIRF Report. Both publications have reported on probes into BOFI led by the Department of Justice and the Department of the Treasury. Given I have written on BOFI extensively for the past couple of years and have documented my many issues with the company, I will not re-litigate those issues here today. I do think, however, that the reporting from these publications does appear to knock down the idea that a “looser regulatory environment” is a “positive” for BOFI. I also note that it took many years after HCG’s initial broker scandal before OSC brought charges against the company. Another reminder of why patience matters in short selling.

We saw what happened at HCG after the OSC brought civil charges (not criminal). There was effectively a bank run. Therefore, one has to sit back and wonder what would happen to a deposit franchise such as BOFI’s if the bank finds itself the subject of civil or criminal charges. I’m not really sure why the bank trades at any premium to book presently in light of these news reports and wonder how a fiduciary justifies owning the stock at these price levels in light of these developments.

SA: Can you talk about how you manage risk on the short side and when to take profits on a short that is significantly in the money – you're short on Home Capital, which dropped 80% in less than a year before the rebound is a perfect case in point?

TFB: Marc Cohodes, who as readers know I admire, has advised the “folks sitting at home” to be very cautious about shorting stocks. I can’t stress this enough: short selling is incredibly risky.

There are many shorts that I have written on that I remain involved in years later. Patience is the most underappreciated quality of good short sellers. At the same time, in the relentless bull market, I think it is wise to not be greedy and take profits when your risk/reward changes. I also think it is important to have conviction in your best ideas. When I put my research out on HCG, the market was not yet talking about the things I called out. The company scrambled to respond to my reports that called out suspect related party transactions in the business. Fast forward a few months, and the OSC brought charges against Home Capital Group. My report ended up being right. I was short well into the run on the bank, but when the borrow cost spiked, I did take some exposure off. The borrow cost was outrageous (100% range) making the risk/reward of the short unfavorable post bank run.

I think there’s a ridiculous view out there that if a short article is written and the stock doesn’t trade down that day then somehow the short report must be wrong. What do people expect? A short seller says there is fraud at a business then the next day the Feds shut the business down? Or the management team comes out and says “yep guys you caught us red handed!”? Short theses can and will take longer than anyone expects to play out. Cohodes came out negative on HCG years ago for context. Regulators move slowly, and in a bull market, investors have been more than willing to give management the benefit of the doubt when allegations of fraud emerge.

That’s the type of myopic and short-sighted thinking that results in leaving lots of money on the table on the short side. As in the case of HCG, it took time for the market and regulators to see the problems at HCG. I was early in reporting the problems at the company. Just because I am early does not mean I won’t eventually be right.

Buffett bailed out HCG. It was not an "investment" as some have claimed. I thought it was interesting that Buffett got quoted in the release. I wonder if he made them give him another 10% of the company just for the kind words because HCG is in my view simply NOT the type of company Buffett has historically aligned himself with. So I don't think retail investors at home should get excited about the HCG equity just because of Buffett. The deal he got was incredible and anyone would have taken it. But if you're analyzing the equity on a standalone basis and Buffett did not invite you into his deal, I'm not sure why you'd have any interest in buying the stock. You're basically gambling your own money and making Warren richer by improving HIS investment. HCG still has lots of woes in front of it, including a Canadian housing bubble that could crash and questions around accounting. Buffett will walk away richer no matter what happens, but that can't be said for new investors into HCG shares.

SA: Can you talk about the mechanics of short-selling as some investors seem to get caught up in the “what” of the trade (stock XYZ is a zero) rather than the “how” (how to execute and manage the trade)?

TFB: Practically speaking, to short a stock you need to first find a broker who is willing to lend you the stock. If you’re using an account with an Interactive Brokers or Fidelity this is pretty straight forward. When you go to sell a stock that you don’t currently own, the broker interface should advise you how many shares are available to short and the rate you will pay to borrow the stock. Assuming there is borrow available, you can then sell the stock in the open market, knowing that you will have an obligation at some point down the road to buy the shares at whatever the prevailing market price is in the future. At that point, you need to monitor the position very closely. If the stock moves against you (i.e. up), then your exposure to the stock grows (if you initially short $100k worth of a stock and it goes up 20%, you are now short $120K worth of stock). If the stock goes down, the short position becomes smaller (in other words, you get to buy the stock back at a lower price than where you sold it). It is an inherently “leveraged” transaction - you have to manage the position closely to make sure you do not end up overextended in a single name.

A lot of investors do not short stocks and I can tell from the comments on Seeking Alpha short reports that a lot of people who read short articles cast moral judgment on short selling. It’s not just on message boards. The NYSE President recently called short sellers “icky”. Given short selling doesn’t advance his listing fees and serves as a “check” on the companies that do list on his exchange, his view shouldn’t surprise anyone.

Short sellers often serve a very valuable purpose. I aim to put out research that brings to light a topic that management teams don’t want to talk about. Management teams are paid in equity and highly incented to sweep negative details under the rug. As seen in the case of HCG, the truth eventually emerges. The OSC brought charges against HCG after the company repeatedly claimed all was well and that its disclosures were appropriate. And if a short report is outright wrong, shareholders can buy more stock and have the last laugh. The way I see it, the only parties that lose out from short reports are management teams that are covering up their bad deeds.

And seriously, who feels bad for CEOs who get paid millions of dollars a year and take advantage of taxpayer funded regulatory regimes? I think they need to put on their big boy pants and learn to peacefully coexist with short sellers. Or better yet, improve and enhance their disclosures so that short sellers don’t emerge!

SA: Nutrisystem (NASDAQ:NTRI) has been a battleground stock for years. You did extensive research to support your thesis - can you walk us through what you think the bulls are missing and the catalysts that will result in a re-rating?

TFB: Nutrisystem just reported yet another blowout quarter. The stock is up almost ~100% this year. It now trades around ~30x earnings. Reflect on that for a moment. Nutrisystem, a company that still relies on celebrities who have not been cool since the 80s and on commercials that would be more fitting for Tae Bo or shake weights is trading at a ~30x multiple. What kind of world do we live in?

This one is a prime example of a stock that is up since I first wrote about it, but which I am very convinced is going to blow up spectacularly in the future. I think the market would be rather silly to assume that my report won’t get traction with the FTC just because the stock is not down since the report. In fact, based on some of the recent reports coming out of The Capitol Forum (research by The Capitol Forum is only available to subscribers) regarding Nutrisystem’s billing and advertising practices, I think there is an even higher likelihood that the FTC takes action on Nutrisystem in the future. I think the stock price and ludicrous valuation can to a large extent be tied back to quantitative investing. I wonder how effective an algorithm can be at distilling and understanding medium-term and difficult to quantify risks in a business rather than just crunching historical and projected financial results.

So what is the market missing? A new CEO came in and this tired and old company magically took off. I think I’ve used this phrase a few times but will keep repeating it because I believe it so strongly. When the numbers seem too good to be true, they probably are.

The current CEO at Nutrisystem LOVES marketing. While she often states analytics as her passion, it’s very obvious from her relentless focus on getting positive press exposure that she understands the value of aggressively marketing. I always do extensive research into the backgrounds of executives I analyze and this CEO is up there in terms of promotional activity. I have been tracking the number of times she gets press stories written about her “turnaround skills”. Just recently, she penned her own op-ed in the Philadelphia Business Journal where she designated herself an expert in turnarounds and then decided to proffer her self-designated expert opinion to the world.

Yet nowhere in any of her many press interviews has she ever talked about the 2013 expiration of the 1993 FTC Consent Decree against Nutrisystem and the massive change in advertising strategy that Nutrisystem employed ever since that decree ended. Given her background was at Readers Digest (a company that went bankrupt soon after she left), it is not clear to me that her work experience prior to Nutrisystem prepared her for the stringent regulations surrounding weight loss marketing. Some people may not know this, but regulating diet advertising is a topic of interest to folks on both sides of the aisle, tempering the odds that a Republican led FTC will give deceptive weight loss advertising a free pass. The industry has a long history of making unsubstantiated claims and ripping people off. I think Nutrisystem’s studies are very suspect. In my report, I lay out in great detail why I think that. I think NTRI’s decision to market a diet called Lean 13 to women who in their own biased studies lost under 12 lbs – on the high end of the range – speaks to how aggressive Nutrisystem is willing to get on the marketing side. I also think their food gross margins at 54% versus Blue Apron’s at only ~31% speaks volumes to the food quality at Nutrisystem.

This business has no real moat and could be replicated by anyone with a kitchen and access to a FedEx or UPS store. The only thing differentiating Nutrisystem is that it is willing to push the envelope on its advertising claims.

I also believe that competitors have taken notice of Nutrisystem’s behavior. Based on my calls with industry contacts, I believe that a competitor may have actually been behind a petition to the FTC asking for an investigation of Nutrisystem for its advertising practices. I raise this to point out that short sellers aren’t the only ones who are likely concerned with Nutrisystem’s advertising practices.

I get why algos would buy a stock like Nutrisystem. Good momentum, good chart, and the good beat and raise story. But if you’re acting as a fiduciary, at 30x earnings I don’t know how you could get comfortable with the risks embedded in this business model that I think haven’t properly been addressed by the management team to date. You may not want to short it, but I really don’t understand how someone could justify owning Nutrisystem at 30x earnings.

SA: Can you walk us through how you used mosaic theory to support your thesis for Stamps.com (NASDAQ:STMP)?

TFB: I think Stamps has questionable disclosures. For the life of me, I can’t understand why investors back companies with such questionable disclosure practices. I think part of it is that they feel that their “edge” is getting differential access to management. I’ve seen this in more than one of my shorts, where chosen longs get access to management whenever they want. But that system relies on trust. It’s sort of like a marriage. If after 10 years of marriage you woke up and found out your husband was cheating on you, don’t you think you’d expect him to “modify his disclosure practices”? I take the view that “once a cheater, always a cheater”.

My mosaic theory is really just my view that Stamps has gotten caught as a cheating lover, with the “affair” being Stamps’ heavy reliance on a questionable reseller program. The company had built strong relationships with its shareholders over the past years that allowed them to get away with questionable disclosure practices. But then the affair got outed. And then the company had to decide how much to tell its “partner” (shareholders) about what it had been up to for the past few years. It must have been a rather awkward moment. Do you rip the Band-Aid off and admit to every instance of cheating and reveal all of the names? Or do you claim it was just one time, and that it didn’t mean anything? And it’s even more complicated for Stamps because there are other constituents involved – namely, the USPS.

The stock has obviously been on a tear. In my experience, nothing gets longs more convicted that they are right than a rising stock price. In fact, I think some of the best long investors got to where they are because they assumed they were right as stock prices went up, and blamed outside forces when stocks went against them. So the longs are naturally reluctant to want to throw their marriage away over just one affair. They want to find ways to stay with Stamps.

But what I think longs are missing is the real bear case. Yes, you just caught your husband in an affair. But what if it’s worse? What if this behavior is a sign of other issues that are under the rug? Are you too blinded by the historical relationship to see it?

When I look at the behavior of management lately, I think it may be worse. To be clear I am not insinuating anything – rather that the mosaic or cockroach theory suggests there could be further problems.

SA: What’s one of your highest conviction ideas right now?

TFB: I’m short Greenhill (NYSE:GHL). The stock has been under pressure, but I think it’s a tired franchise. Their positioning is all wrong. The boutique market has gotten a lot more competitive and Greenhill’s historical focus on mega deals has made it very hard for the company to transition into middle market banking. As a result, transaction volumes are falling apart as balance sheet banks win mega deals and middle market-focused banks retain share of their market. They are also weak in restructuring which I think is likely to pick up over the next few years due to retail bankruptcies. I’ve looked at the compensation levels at Greenhill and think they are also too light. The company also pays an enormous dividend that really only benefits the legacy bankers. While the franchise had historical clout, I think that brand means a lot less today with Bob Greenhill getting along in years and less involved. And I think the dividend is at real risk. These businesses are very reflexive. As the stock price underperforms, the value of compensation packages falls because bankers are paid in high amounts of stock. So I could see this business unraveling in a very ugly way in the next year or two.

SA: One thing that is always interesting is to see what a noted short sellers' long positions are. Do you mind sharing one of your long ideas and what the thesis is?

TFB: I own Intercontinental Exchange (NYSE:ICE). I'm short a number of financials, and I think ICE is not only a nice hedge against the short financials I have, but is also a very high-quality business that will be able to compound earnings for several years. The stock isn't cheap, trading at 19x next year's earnings. But, I think the market does not fully appreciate the earnings growth potential at ICE should rate volatility suddenly increase (i.e. should the Fed surprise to the upside on rates). Volatility in energy prices is also positive for ICE and has driven strong growth recently. Trading volumes have been robust for the past few quarters and I think that can continue. Management is very strong and they have executed well on their cost outs and on the M&A front. If rates normalize, I think ICE could see a big uplift in earnings (30%) that the market is not factoring in currently. Incremental margins in this business are essentially 100% (there's no real incremental cost to processing more volumes). So I think ICE could set up to really surprise investors should we finally see a period of higher volatility in rates. ICE also has a lot of balance sheet flexibility for more M&A or continued buybacks.

SA: When making long investments, how much does your short selling analysis inform your process?

TFB: If you focus on short selling, I think you often have a harder time dreaming the dream and believing management teams. I think as a result you certainly risk missing some of the great narrative driven story stocks that end up being home runs. On the flip side, spending time on the short side forces you to analyze companies in very different ways. I think shorts often do more differentiated research which can help on the long side as well. Shorts are looking for risks that management is not talking about. They're looking for the things that don't impact numbers right now, or may not impact numbers even in the near-term, but that could wreak havoc on financial results down the line (i.e. my thesis on NTRI). So I think that short selling discipline helps you avoid being co-opted by management (I borrowed that line from Jim Chanos).

***

Thanks to The Friendly Bear for the interview. If you'd like to check out or follow their work, you can find the profile here.

PRO idea playing out

Big 5 Sporting Goods (NASDAQ:BGFV) is down ~45% since Livermore Investing called it a short in December 2016 as the industry consolidation would only provide a temporary boost (DKS and other online retailers would eventually capture any BGFV gains) and FCF would drop due to required investments in inventory/capex. Livermore noted that every time the stock has taken off, it was due to a one-time positive impact. The stock’s reaction to seemingly positive 1Q results (beat on top/bottom line with SSS +7.9%) may be a perfect example as the initial 8% gain turned into an 8% loss by the closing bell.

Call from the archive - SPOK

Spok Holdings (NASDAQ:SPOK) is down ~10% since Vince Martin made the contrarian bullish case that it was not a value trap in March 2017. Although the stock dropped following recently released 2Q earnings, management said wireless trends continue to improve (quarterly rate of paging unit erosion slowed to a record low) and software revenue and bookings increased while $12.5M was returned to stockholders in the form of dividends and buybacks. As the original thesis appears to remain intact, and the price target offers ~35% upside, this may be worth another look.

Noteworthy PRO articles

In addition to the Top idea we published this week, we wanted to highlight one of our PRO editors' favorite PRO ideas this week:

SA Editor John Leonard, CFA: Soldier of Fortune makes the contrarian case for Nexstar Media Group (NASDAQ:NXST), as concerns related to OTT offerings and cord cutting trends have been blown out of proportion and created the opportunity to buy a high-quality company at a bargain price with a 18% FCF yield.

PRO Weekly Digest idea playing out

In a previous version of the PRO Weekly Digest, we said that the bullish call by Crudely Midstream on Calumet Specialty Products Partners (NASDAQ:CLMT) was a name to revisit. Since then, the stock is up ~45%. In an update comment, Crudely Midstream said the fuels refining segment (which will determine whether it will be make or break in 2017) outperformed admirably amidst a weak crack spread environment. Crudely Midstream expects Q2 to be even stronger than Q1 and said CLMT has more upside potential.

Notable PRO idea update

When we last checked in on J Mintzmyer’s highest conviction long idea ever on Teekay (NYSE:TK) at the beginning of the month it was “only” up ~25% - now it's up ~80%. In an update comment, Mintzmyer explains how the short thesis has been “decimated” following the announcement of the partnership with Brookfield.

Idea screen of the week

Each week we use the PRO Idea Filter to find potential ideas based on a recent news event. This week, PRO Editor John Leonard, CFA looks at opportunities in the large cap space.

While conventional wisdom says there is greater inefficiency (and therefore opportunity) in the micro/small cap space, this does not mean investors should ignore the large cap space. I ran a screen of PRO long large cap ideas.

Two ideas turned up in this screen that might be of interest (prices as of July 27 close):

TransDigm (NYSE:TDG) by Pricing Power Investing: published on July 5, 2017, up ~5% since publication, author's price target offers an additional 100%+ upside. TDG is the best-in-class operator in the aerospace industry with margins far in excess of peers and the ability to consistently compound FCF at a high rate for years.

Coty (NYSE:COTY) by Chris Karlin: published on March 29, 2017, up ~10% since publication, author's price target offers an additional ~55% upside. The sell off due to disruption around the close of the PG deal and concerns about revenue growth and capital investment presents an attractive entry point as expectations for synergies are largely unchanged while there is a clear path to higher revenue, cash flow and margins.

About the PRO Weekly Digest

PRO members automatically receive the Weekly Digest and other PRO content in their inbox. If you are not a PRO member and would like to be notified of this, click follow at the top of this article to follow the SA PRO Editors account, or click to subscribe to the free newsletter below to receive these in your inbox. You can view all past PRO Weekly Digests here. And if you're interested in SA PRO, check out the details here to sign up or learn more.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.

Additional disclosure: Check with individual articles or authors mentioned for their positions. The Friendly Bear is long ICE and short NTRI, BOFI, STMP, GHL, RKET:GY

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