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 tend to trend upward 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, between 1983 and 2006, even with dividends included, 64% of stocks underperformed the Russell 3000, a broad-scope market index.

A large influx of short-sellers isn't a condemning factor for any company, but it could be a red flag indicating that something is off. Let's look at three companies that have seen rapid increases in the number of shares sold short and see whether traders are blowing smoke or if their worries have merit.

Company

Short Increase Feb. 28 to March 14

Short Shares as a % of Float

Orange (NYSE: ORAN  )

59.7%

N/A

Hovnanian (NYSE: HOV  )

30.6%

14.9%

Seadrill (NYSE: SDRL  )

22.1%

4.7%

Source: The Wall Street Journal, N/A = not available.

Orange seeing green
Despite the company's big dividend, short-sellers are again beginning to swarm around Orange, the international telecom giant that has seen its shares rise approximately 60% since last summer.

Skeptics' main objection is Orange's lack of top-line growth amid tougher competition in its home country of France. With the emergence of Free Mobile on the lower end of the price spectrum, Orange has had a difficult time competing in France, choosing instead to invest in infrastructure to add value for higher-priced data plan customers. The end result has been lower dividends and profits, as well as a subtle decline in revenue.

However, as a shareholder in Orange myself, I see a bright future and think short-sellers are barking up the wrong tree here.

To begin with, Orange is seeing better-than-expected growth outside of France, which should help stem whatever weakness is derived from tougher competition and unfavorable regulations in its home nation. For the full year of 2013, sales growth in Spain improved 4.4%, while the company's Africa and Middle East segment produced 4.7% growth. Orange also added 1 million new 4G customers, with its contract base growing to nearly 21 million customers.

Second, Orange is cutting costs like a champ, with a total reduction of $1.27 billion in costs throughout the year, most of which came from France. I can't say I'm a huge fan of cost reductions driving bottom-line growth, but it never hurts to make a company's operations more efficient, which can ultimately help boost margins.

Finally, we have Orange's free cash flow, which, though at its weakest point over the past decade, still added up to $1.1 billion. As Orange progresses in emerging markets, reduces its costs, gets past a number of regulatory hurdles in France, and exits noncore markets as it did in the Dominican Republic last year, you can expect its free cash flow to begin moving back to its historical average of between $6 billion and $8 billion. In the meantime, I have no problem collecting close to a 6% yield on a company valued at just 11 times forward earnings.

If you build it, will they come?
Homebuilding is another sector that is quickly coming under the short-selling guillotine, and small cap Hovnanian has been no exception.

The concern pessimists have with the housing industry is that rising interest rates directly related to the winding down of the Federal Reserve's quantitative easing could put buyers on the fence. Between last May and December, when long-term lending rates rose by approximately 125 basis points, the number of weekly loan originations collapsed by roughly 60% and hit a nearly two-decade low, according to the Mortgage Bankers Association. If this reduced interest in getting a mortgage persists, investors alone won't be strong enough to support the housing industry regardless of how constrained builders keep their inventory.

On the other hand, it's been a long time coming, but Hovnanian delivered a respectable $31 million in net income in fiscal 2013 as revenue jumped by double-digits amid soaring home prices. In its latest quarter, Hovnanian also saw the value of its contract backlog increase by 11.4% to $904.4 million.

Which side is right? I personally side with short-sellers on this one.

The first quarter is notoriously weak for Hovnanian, so I wouldn't read too much into its bottom-line loss. Instead, I would point to its 4.2% decrease in home deliveries and the total drop in overall dollar value for its contracts as a warning sign. Buyers are sticking to the sidelines and waiting for even lower lending rates before making a purchase. This "spoiled consumer" threatens to kill what little momentum weaker builders like Hovnanian have gained over the past year, leaving plenty of potential downside for those that aren't as well capitalized -- like Hovnanian.

With Hovnanian carrying more than $1.5 billion in net debt, and its homebuilding margins trailing the sector leaders by a mile, I'd recommend letting the skeptics have this stock.

Drilling the competition
There's something to be said for a deepwater contract drilling servicer like Seadrill that can emerge from practically nowhere, pile on debt via rig purchases, and promise improved efficiencies over its competitors because it will use the newest fleet of rigs in the industry.

For pessimists, the biggest problem at Seadrill is its whopping mountain of debt. Overall, Seadrill sports $1.2 billion in cash and $15.3 billion in debt, which is a terrifyingly high amount considering that a number of deep-sea drilling specialists are having difficulty finding work for all of their rigs at the moment. Competition among contract drillers is fierce, and the concern is that as Seadrill and its rivals introduce new rigs over the coming years to improve their own production efficiency it'll merely weigh down existing demand and harm dayrate charter pricing.

On the other side of the coin are the optimists who view Seaarill to be in the most advantageous position since it'll hold the fleet with the newest vessels. It's likely that oil and gas exploration and production companies are going to choose Seadrill's rigs first since they'll outproduce the older vessels in service from its competitors. This comparative advantage should be enough to help pay down the company's monstrous debt pile.

In addition, Seadrill is paying out an exorbitant dividend to shareholders. Given the weakness in demand in contract drilling at the moment, I'm not wholly certain that Seadrill can maintain its incredibly high payout, but for the time being it's yielding a whopping 11%.

With Seadrill now 27% off its 52-week high, I believe short-sellers have squeezed just about as much as they can out of the company. While its debt level remaind a concern, as does near-term dayrate pricing on deep-sea contracts, Seadrill's newer fleet should give it enough of an advantage that even the introduction of newer rigs won't cause much pressure on pricing in the future. At nine times forward earnings, it looks like a calculated risk investors may want to consider.

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