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.
Richard Pearson is an activist investor in U.S. and Chinese stocks. He was previously an investment banker in New York, Hong Kong and London focused on Equity Capital Markets. Notable calls include a bearish thesis on ForceField Energy (NASDAQ:FNRG) and bearish thesis on Keryx Biopharmaceuticals (NASDAQ:KERX). We emailed with Richard about his unconventional (but successful) process for finding short ideas, what causes (and how to profit from) a death spiral financing and why he currently stays away from shorting Chinese equities.
Seeking Alpha: You recently pu blished a very compelling long idea on Dillards (NYSE:DDS) can you walk us through how this was a mathematical trade?
Richard Pearson: With Dillard’s, the Dillard family and the company 401(k) plan own more than 50% of the outstanding shares. The family owns non-trading class B shares, which give them voting control, so they can control what the company does. The family is causing the company to use company money to aggressively buy back shares from the public float. It doesn’t matter what metric you use (cash flow, asset values, etc), as the share count decreases, the value per share increases.
The company has already bought back over 80% of the outstanding float over the years. And the company continues to use nearly 100% of free cash flow to buy more and more shares. At the end of this process, there will be no more shares outstanding. At this time, the Dillard family will end up owning the real estate. Various people have debated the value of this real estate. Some say it is worth as much as $6 billion.
Others say that it is worth only $1 billion because mall space is no longer worth what it used to be. I really don’t care about that number. It is irrelevant. The Dillard family is causing the company to use company money to buy back all of the stock. At the end of this process, they will own real estate worth $1-6 billion without having spent any of their own money.
It is quite brilliant, yet simple. In the meantime, Dillard’s the company refuses to correspond with investors or engage with activists who are trying to “maximize” shareholder value . This should come as no surprise. The last thing that the Dillard family would want to do is raise the share price. It would just make it that much tougher to buy back all of the stock.
The stock is currently very easy to short. When bad earnings affect Dillard’s or any of the department store competitors, the stock price takes a dive. But when shorts try to cover, they quickly find that there are not enough sellers and then the share price quickly spikes. On July 10th, retail stocks across the board took a big dive simply because of Amazon (NASDAQ:AMZN) hosting its Prime Day. Dillard’s fell to $54 on very high volume.
It was clear that this was heavy short selling. When the short interest numbers were released shortly thereafter, it showed that short interest had risen to 70% of float. The stock quickly went to over $80 as shorts scrambled to get out. On August 10th, Dillard’s reported disappointing earnings. This should come as no surprise. Of course, the nu mbers are bad. The stock took a dive back down to around $57.
But this is a math trade. As the share count continues to dwindle, the value per share will continue to increase, regardless of earnings. And there is no chance of bankruptcy. Dillard’s has strong cash flow and little debt. What will send this much higher is also that as the float continues to shrink, there are fewer and fewer shares available for the huge short interest to cover. Short interest now stands at 7.9 million shares.
SA: Can you talk about how for some of your best trades, the short thesis was so compelling without even caring what the company did?
RP: There are many instances (both long and short) where I literally don’t care what a company does. Dillard’s is one example. It doesn’t really matter what clunky business the company is in. Over 3-12 months, as the share count dwindles, the share price is forced to rise. As the float becomes less than the short interest, the supply and demand also pushes the share price up regardless of its business performance. But it may take a few months.
On the short side, when I wrote about Biolase (NASDAQ:BIOL), the company was out of cash, was in violation of its debt covenants and issuing lots of equity was its only way to raise money. As soon as it missed earnings, it became clear that it would have to raise a big chunk of equity. The problem is that when the market knows that the company is going to raise equity, the share price falls.
As the share price falls, it requires the company to issue an even greater number of shares to raise the same amount of money. And then the share price falls even more. This was a classic death spiral situation and it didn’t matter at all what business the company was in. When I wrote about Biolase, its stock was at $3. It is now at 50 cents.
SA: As a follow up, generally speaking what are the biggest red flags you look for in a short idea?
RP: I look at my shorts much differently than most other people. The “normal” way to find a good long idea is to start with a sector that has promise and then drill down to which company has the best prospects within that sector.
I do my analysis in reverse. When I come across the first evidence of problems, I start looking at the backgrounds of management and of their 3rd party service providers (accounting firms, law firms and IR firms). When I see that a company uses 3rd parties with a history of problems, then I am 100% confident that the stock has problems, regardless of what industry it purports to be in.
Think of it this way, if you were a legitimate small company, would you ever select an accounting firm whose past 20 clients had been delisted due to fraud? Of course not. It becomes a situation of natural selection. The only companies who select such an accountant are ones who have problems. This is something that 99% of investors miss because they get so sucked in by a slick investment story in the latest hot sector.
SA: How has the Chinese equity market evolved over the past few years, especially as it relates to the number and type of short opportunities there? What specif ic factors do you look for?
RP: I try to never say never… but following my short trade on YRD in February, I may never short another Chinese stock again. I lost piles of money by being short various Chinese ADRs over the past few years. Despite varying indications of problems, I saw these stocks often rise by 100-500% within a year. Examples included YY Inc. (NASDAQ:YY), Vipshop (NYSE:VIPS), Ali Baba (NYSE:BABA), Baidu (NASDAQ:BIDU) and others.
If a tree falls in the woods and no one is around to hear it, the answer is “no it does not make a sound.” Likewise, if a Chinese company has problems but there is never a day of reckoning, then it doesn’t matter that you were “right” about the problems.
In 2011, I lost a pile of money by being short Harbin Electric. I had done enough work to be convinced that it was a fraud and that its supposed buyout offer from China Development Bank was a sham. But the buyout went through at $22 and I lost my shirt. Five yea rs later, Harbin Electric defaulted on its loans to CDB. Duh. Of course they did. The problems I had found were 100% valid. But being right about that does nothing to get my money back.
There are still a few fraudulent Chinese reverse mergers laying around, but they are few and far between and they have already traded down so low that they are not worth shorting.
SA: Whats one of your highest conviction ideas right now?
RP: On the long side, both Dillard’s and Hertz (NYSE:HTZ) will be up by at least 100% in the next 12 months. I am long both. I don’t really care much about what they do up or down in the interim,
On the short side, I am short American Renal (NYSE:ARA). It wrote about it at $18. It is now at $14. It will go deep into single digits as soon as we see any selling from private equity firm Center Bridge, which owns more than 50%. ARA has deep business problems. But because Center Bridge owns so much, there isn’t much natural selling pressure in the meantime.
Thanks to Richard for the interview. If you’d like to check out or follow his work, you can find the profile here.
PRO idea playing out
Cardtronics (NASDAQ:CATM) is down ~50% since Hayden Cole presented a bearish and contrarian case in October 2016, primarily that its aggressive roll-up strategy was masking the lack of organic growth opportunities while there were a number of catalysts including declining revenue/EBITDA due to the loss of the key 7-Eleven contract, secular decline in ATM usage and high leverage. The reaction to earnings last week (similar to BGFV that we highlighted in a recent PRO Weekly Digest) may be a confirming sign of how negative the market is on the roll-up strategy as the stock initially rose ~10% after beating on the top/bottom line; however, the stock closed the day down ~15%.
Call from the archive – DFIN
Donnelley Financial Solutions (NYSE:DFIN) is down ~5% since ACM Research Team shared their bullish thesis in April 2017. Although revenue/earnings decreased in the mrq (up against a challenging comp), management reaffirmed guidance for 2017 and noted that it expe cts to end the year within the targeted leverage range while the overhang from the RRD stake is gone. As the original price target calls for ~40% upside, this thesis may be worth revisiting.
PRO Weekly Digest idea playing out
Anavex Life Sciences (OTCQX:AVXL) is down ~40% since Amit Ghate said it would trade substantially lower in an interview with the PRO Weekly Digest in June (see his update comment).
Noteworthy PRO articles
We wanted to highlight a few of our PRO editors’ favorite PRO ideas this week:
SA Editor Jeffrey Fischer, CFA: Following abandonment of their nuclear plant under construction, SCANA Corp. (NYSE:SCG) seems to believe that South Carolina will allow them to redeem the costs from consumers. Investors appear impervious to potential negative regulatory developments, says CashFlow Hunter.
SA Editor John Leonard, CFA: Tomer Cohen, CFA presents a compelling relative value thesis on Mexco Energy (NYSEMKT:MXC) as it trades at a significant discount to peers on a proved reserves and per barrel basis while wells in Martin County and reserves in the Haynesville Shale provide additional upside. There is limited explo ration risk and a significantly lower G&A burden than peers while the CEO owns almost half of the shares providing significant skin in the game.
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 how to avoid dead money deep value ideas.
One way to avoid dead money type deep value plays is to look for companies taking a proactive approach to realizing value (e.g. selling assets). I ran a screen of PRO long Deep Value ideas with the Divestiture Investment Opportunity tag.
One idea turned up in this screen that might be of interest (prices as of August 10 close):
TT Electronics (OTC:TTGPF) by Simeon Rusanov: Published on July 25, 2017, ~unchanged since publication, author’s price target offers ~35% upside. The significant transformation is now complete following the recent sale of the TS&C division, which should improve margins and the balance sheet while it is poised to benefit from numerous macro/tech tailwinds. Upside driven by re-rating more in line with peers and improved fundamentals.
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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. Richard Pearson is long DDS.
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