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

Do short-sellers have Solazyme, WellPoint, and McDonald's pegged? You be the judge!

May 5, 2014 at 5:31PM

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 March 31 to April 15

Short Shares as a % of Float

Solazyme (NASDAQ:SZYM)

11.6%

26.8%

WellPoint (NYSE:ANTM)

26.8%

4.7%

McDonald's (NYSE:MCD)

20.7%

1.4%

Source: The Wall Street Journal.

To be, or not to be?
The investing world has been buzzing about biofuels producer Solazyme for years, but it became enthralled when the company announced in January that it had commenced commercial operations in two Iowa facilities for three distinct Tailored oil products being sold throughout the U.S. With production expected to scale to 20,000 metric tons per year within 12-18 months, and to 100,000 metric tons annually in subsequent years, all investors saw were dollar signs. 

Solazyme should also be on the verge of beginning commercial rewewable oils production in Moema, Brazil, another manufacturing facility capable of 100,000 metric tons per year of production.

But is this optimism warranted?

Soladiesel

Source: VOA, Wikimedia Commons.

On paper, Solazyme offers a truly unique technology platform, and the push toward cleaner energy sources is undeniable -- both of which work in the company's long-term favor. However, there are a number of concerns that the typical value investor simply can't ignore.

Consider, for a moment, the argument that my Foolish colleague Maxx Chatsko presented last week that the Brazilian facility may be delayed. A production announcement had been expected in April, but never happened. Delays have been a regular staple of the Solazyme investor diet, so this really shouldn't be all that surprising. But with Solzayme's share price up notably in recent months, these delays do take on increased significance.

Growth prospects certainly aren't an issue, with revenue expected to practically triple in 2014 and 2015 and nearly double in 2016. However, profitability and cash flow are a concern. Wall Street's current projection calls for the company to be ever-so-slightly profitable by 2016 ($0.06 in full-year earnings per share), which is awfully pricey considering the company's $700 million-plus valuation and recent dilutive share offering. In the meantime, I estimate Solazyme will likely burn through about $100 million in cash over the next two years.

While unwavering pessimism may be unwarranted, given Solazyme's top-line growth and proprietary products, I believe short-sellers have more than enough reason to remain slightly skeptical of Solazyme, at least in the interim.

Obamacare or bust
Perhaps no health care company has seen a greater boost from the implementation of Obamacare than health benefits provider WellPoint, which saw its share price surge to triple digits. Prior to the closing of enrollment it was also one of the few insurers to note making money from its Obamacare enrollments, while a number of peers were losing money.

The big question, of course, and the reason skeptics appeared to dive into WellPoint, was whether these enrollments gains would justify the huge run-up in the company's share price or if emotional trading had pushed it too far, too fast. That question was answered last Wednesday when WellPoint delivered considerably stronger than expected first-quarter results.

WellPoint announced that membership increased by 1.3 million members, or 3.6%, from the sequential fourth quarter, with commercial growth of approximately 1.2 million members and Medicaid growth of 121,000 members. The expansion of Medicaid in 26 states worked strongly in WellPoint's favor as it's the largest health-benefits provider to government-sponsored patients. Most important, WellPoint's medical expense ratio (a figure that measures what it brings in via premiums versus what it spends in medical costs) shrank 100 basis points to 82.7%. All told, these figures enabled WellPoint to forecast that its full-year 2014 EPS would come in above $8.40.

The only two concerns I can imagine as an unbiased observer are the recent resignation of Health and Human Services Secretary Kathleen Sebelius and the 280-basis-point rise in the selling, general, and administrative expense ratio to 16.2%. Rising SG&A expenses seem in line with growing membership rates, so that may prove to be of little concern moving forward, but uncertainties surrounding the HHS leadership transition and the November opening for 2015 health insurance enrollment could again cast a cloud over insurers.

Overall, I'm no longer of the opinion that WellPoint is trading at a deep discount, but I don't particularly see much of a case that can be made for short-sellers, either.

Losing its golden luster
Finally we have McDonald's, and only one question comes to mind anytime I reference the Golden Arches these days: "What happened to the innovation?"

Short interest has steadily risen in the wake of another lackluster earnings report. For its latest quarter, McDonald's reported a roughly 1% increase in revenue to $6.7 billion, but worldwide comparable-store sales inched higher by a mere 0.5% -- and you can thank pricing for much of that rise.

Images

The truth of the matter is that McDonald's is being outmaneuvered by a number of its rivals. Recent moves have included peers matching McDonald's interior restaurant redesign to appeal more strongly to families, introducing breakfast items that can be served all day, and delivering organic and natural products for a similar price point as McDonald's. Making matters worse, food costs and potentially labor costs are on the rise, forcing McDonald's to make some tough decisions about its value menu.

On the other hand, we have one of the best-recognized brands in the world. McDonald's spends a small fortune on advertising and partnerships, but it really doesn't need to as its name brand is fairly self-sustaining. What this means for long-term investors is predictable cash flow and a steady dividend. It also gives McDonald's an easy avenue to expand into foreign markets given its easily recognizable logo.

All told, similar to WellPoint, I'm a fan of the company and what it has done in the past, but I'm a bit leery of its future growth prospects given its growing competition and rising cost structure. I'd suggest investors stick to the sidelines and wait for a more attractive entry point than where McDonald's is currently trading.

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Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.

The Motley Fool owns shares of, and recommends McDonald's and WellPoint. It also owns shares of Solazyme. 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.

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