If investors are worried about a stock's future potential they'll let the market know by shorting its stock. That's why you can usually get some indication on which direction investors are leaning by taking a look at its short interest. Heavy short interest in a stock can sometimes indicate that investors see big problems ahead.
One such company that's hated by investors is Magnum Hunter Resources (NYSE:MHR). As of two months ago, investors had sold short 20% of shares outstanding; however, that has increased to a staggering 32% of shares outstanding as of April 15. With shares down by a third over the past month, it would appear that the shorts are right about this company. Let's drill down into what happened and see what investors can expect.
The cause for the most recent slide in the company's shares occurred after it decided to drop its auditor PricewaterhouseCooper, or PwC. Magnum Hunter cited the reason for the dismissal being due to PwC having "not completed an audit or issued an audit report on the company's consolidated financial statements for the fiscal year ended December 31, 2012." The firm had a short history with Magnum Hunter having only signed on last July 17. The short stint by such a well-known firm did not sit well with investors who have been trained to run for the exits at any hint of problems with accounting.
CEO Gary Evans held a conference call with investors to discuss the change. Without going into too much detail it appears that PwC made several recommendations to the company, which it subsequently addressed, but the overall time frame of the audit continued to drag on. Further, the key point Evans emphasized was that "substantially all adjustments identified to-date with PwC have only been non-cash items." While the company has more than adequately addressed the issues, the bottom line here is that there will be a cloud hanging over the company's shares until investors' fears can be calmed once a full audit report has been issued by the newly hired auditors.
Liquids are drying up
Magnum Hunter had already drawn the ire of investors before the recent issues with the auditors flared up. The company's production had been too gas-heavy while its balance sheet was laden with too much debt. The company had been shifting its production mix toward oil and liquids, and it recently sold most of its Eagle Ford acres to Penn Virginia for around $400 million. The cash from the deal will be used to pay down debt and to help fund the company's 2013 drilling program.
However, in selling the oil-levered Eagle Ford assets, the company transitioned its production mix from 40% natural gas to 60% natural gas. While natural gas prices have been heading higher, oil and liquids still remain the more lucrative markets these days. The company received excellent value for the assets, even though it was a step back in terms of the production mix. Overall the balance sheet is much improved and the company believes it can easily meet its production guidance for the year given its robust drilling inventory.
Shorts, for obvious reasons, have a much shorter-term focus. While that approach can make money for investors, real value is created over the long term. To give you an idea of its potential I'd like to focus on just one of Magnum Hunter's future opportunities.
Magnum Hunter just started drilling its first well in the promising Utica Shale. On the one hand, investors see recent acreage sale announcements by top-tier drillers like Devon Energy (NYSE:DVN) and Chesapeake (NYSE:CHK) as a sign the play will never live up to its lofty potential. Others will point to the success of Gulfport Energy (NASDAQ:GPOR) in hitting the sweet spot, as well as the increase of infrastructure, both of which may indicate that the play is about to blossom. Magnum Hunter has 81,000 acres in what appears to be in the narrow wet-gas portion of the play. If the company's position in the play turns out as it expects, it could create tremendous value for investors.
Foolish bottom line
Sometimes it's better to be lucky than good, and in the case of Magnum Hunter short sellers, those that got in before the company reported a surprise auditor change did very well. However, there is a compelling long-term-growth story around liquids, as the company continues to develop its Bakken acreage as well as its promising position in the Utica. The shorts might have won the first round, but as long as the new auditors don't find anything amiss, Magnum Hunter has the potential to create a lot of long-term value for investors.
Motley Fool contributor Matt DiLallo has no position in any stocks mentioned. The Motley Fool owns shares of Devon Energy and has the following options: Long Jan 2014 $20 Calls on Chesapeake Energy, Long Jan 2014 $30 Calls on Chesapeake Energy, and Short Jan 2014 $15 Puts on Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.