Shorts Are Piling Into These Stocks. Should You Be Worried?

The best thing about the stock market is that you can make money in either direction. Historically, stock indexes have tended to trend up over the long term. But when you look at individual stocks, you'll find plenty that lose money over the long haul. According to hedge-fund institution Blackstar Funds, even with dividends included, between 1983 and 2006, 64% of stocks underperformed the Russell 3000, a broad-scope market index.

A large influx of short-sellers shouldn't be a condemning factor to any company, but it could be a red flag from traders that something may not be as cut-and-dried as it appears. Let's look at three companies that have seen a rapid increase in the amount of shares sold short and see whether traders are blowing smoke, or if their worry has some merit.

Company

Short Increase Dec. 14 to Dec. 31

Short Shares as a % of Float

Trulia (NYSE: TRLA  )

90%

23.3%

Workday (NYSE: WDAY  )

32.7%

13.3%

Cobalt International Energy (NYSE: CIE)

84.9%

5.4%

Source: The Wall Street Journal

Real estate, fictitious valuation
Trulia, a real estate research website that assists prospective home buyers with pricing and neighborhood information, might need to spend some time educating its investors about speculating in its rapidly growing, yet still unprofitable, bottom line.

Growth isn't a problem for Trulia, as the online real estate site reported a 76% rise in total revenue as mobile traffic increased 129%. What is a problem is its current lack of profits, and a lot of looming competition, specifically from Zillow (NASDAQ: Z  ) .

Even with its first quarterly EBITDA profit of $0.3 million, Trulia has yet to turn in a bottom-line profit. That's a concern for a company valued at 10 times sales and better than 130 times next year's earnings. The housing market is improving and lending rates do remain low, which is spurring buyers to make a move and helping Trulia's revenue grow, but what exactly is going to happen in 2015 when rates begin to rise? My guess: a rapid decline in Trulia's revenue.

Also, Trulia and its peer Zillow have very little differentiation between what they offer the user, and the barrier to entry in the sector is low, which makes me question the overall longevity of both business models. Given a weak forecast from Zillow and Trulia in November, I'd just as soon avoid this expensive sector altogether and let the short-sellers have their way.

Can we manage a profit?
One of the biggest keys to being successful in garnering cloud-computing dollars is focusing on an area with currently unmet needs -- and trust me, it isn't as easy as it sounds. Workday, an enterprise-based cloud company focused on human capital management needs, does just this by providing services many of its peers, like Automatic Data Processing or SAP, cannot.

I can't deny that its cloud offerings reduce the need for updates or that they're growing like wildfire in the business sector, but not even in my wildest dreams can I imagine this company supporting a valuation of 36 times trailing-12-month sales figures.

As I opined when I featured Workday as my CAPScall of the Week in October, the company's S-1 prospectus clearly stated that its focus is on expansion and not profits. So while revenue growth is projected to increase by 74% to 83% in the upcoming quarter, profits will remain elusive for what I expect could be at least two or three more years. By then, Workday's competition will have had time to catch up and investors may be left holding a still unprofitable cloud company valued at north of $8 billion. Thanks, but no thanks!

When in doubt, dilute them out
I've long been a skeptic on Cobalt International Energy, which is an oil and gas exploration company drilling for the black gold off the coast of Angola and in the Gulf of Mexico. Over the past year, Cobalt has impressed investors with two significant finds: one announced in December in its North Platte project in the Gulf of Mexico, and one very large find off the coast of Angola that it holds a 60% interest in along with a 40% interest for partner Total (NYSE: TOT  ) .

The question then becomes: Will these finds ever become commercially sustainable drilling platforms for Cobalt (and Total, for that matter)? I believe the answer is yes, but we're still a ways off from having that sustainable revenue become a reality for Cobalt. In the meantime, in order to raise cash for its expected $750 million to $900 million in 2013 capital expenditures, Cobalt issued $1.2 billion in convertible notes (executable at $35.68 per share, thus capping equity gains for shareholders), and issued another 40 million shares last week.

Cobalt's complete disregard for shareholder value is one aspect that's always turned me off from the company and is a factor that has me cheering on short-sellers as they boost their positions. With profits still nothing more than a glimmer in the distance, more pain could in the offing for shareholders.

Foolish roundup
This week we're taking all three companies we've looked at to the woodshed based on valuation and business model sustainability. In Trulia's case, I'm concerned that a housing market shift perpetuated by rising rates will decimate its business. For Workday and Cobalt, it's a matter of showing investors actual bottom-line results.

What's your take on these three stocks? Do the short-sellers have these stocks pegged, or are they blowing smoke? Share your thoughts in the comments section below.

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Read/Post Comments (3) | Recommend This Article (0)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 22, 2013, at 11:58 AM, charlyny wrote:

    the company did not issue new shares, large shareholders sold off a small percentage of their holdings. if you are going to issue reports, lets get the facts right!

  • Report this Comment On January 22, 2013, at 12:27 PM, spartanhill wrote:

    I exactly agree with charlyny. CIE did not issue any new shares, and there was no dilution. The 40 million shares sold were pre-existing shares sold by existing institutional investors such as Goldman Sachs, who reduced their (large) holdings. These were the investors who funded CIE to begin with. Furthermore, after a convertible offering, it is normal for some of the holders of the convertibles to hedge by shorting some shares.

    Mr. Williams should make a little effort to find a few of the basic facts before publishing articles.

  • Report this Comment On January 22, 2013, at 10:48 PM, Nplay1 wrote:

    Trulia's CFO states in a recent CNBC interview that "real estate agents spend $24 billion a year to market themselves" as a foundation statement that Trulia will benefit from this spending.

    He also says in the same interview that "agents spend, on average 10-20% of their commission on marketing."

    I'm not sure how it s possible to arrive at these numbers using obvious well known facts about the real estate market.

    On average, 5,000,000 homes are sold annually at an average of $200,000 each for a total gross market of $1T.

    The average sales commission for sales (buy side and sell side agent and broker) is 5% of the gross sales price.

    Therefore, total commission to all parties is approximately $50B. This represents the total commission pie to be distributed to the agents and their brokers.

    For the Trulia's CFO's statement to be true that agents spend $24b/yr. on marketing, agents would have to spend about 50% of their commission on marketing.

    This of course doesn't jive with his statement early in the interview that agent' spend on average 10%-20% of their commission on marketing, which is a more accurate estimate, but still very broadbrush.

    If in fact agents spend $24b per year on marketing AND this amount equals 10%-20% of the commission, then total commissions would have to be between $120b-$240b per year or 12%-24% of the total real estate market gross sales.

    Either way, the numbers just don't add up to well known industry statistics.

    For disclosure, I am not an investor or short seller or associated with Trulia in any way. Just an intelligent observation to share with others.

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