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

Do short-sellers have these three stocks pegged? You be the judge!

Jul 14, 2014 at 1:45PM

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.


Short Increase June 13 to June 30

Short Shares as a % of Float

Exelon (NYSE:EXC)



Medtronic (NYSE:MDT)



Rackspace Hosting (NYSE:RAX)



Source: The Wall Street Journal.

Going nuclear
Excepting a small sliver of publicly traded companies, you practically could have thrown a dart at the financial section of the newspaper and hit a winner over the past couple of years. But electric utility Exelon is part of that "sliver."


Source: Exelon

Exelon shares have come under intense pressure because of the company's reliance on nuclear power and its high debt levels. With practically all other forms of energy (coal, natural gas, and alternative energy) running cheaper than nuclear, it's been difficult for investors to justify a more robust price for Exelon.

One piece of the puzzle that Exelon believes will help it move beyond its nuclear reliance is the purchase of Pepco Holdings (NYSE:POM), an electric utility and natural-gas distributor in New Jersey. The deal, which was announced in late April, will dramatically boost the percentage of revenue Exelon garners from its regulated utility business and help remove some of the uncertainty investors have come to expect around earnings time. 

In addition, Exelon is among the cheapest utilities, even following its 20%-plus run higher this year. Whereas the average electric utility is currently trading at 23.3 times trailing 12-month earnings, Exelon is valued at a mere 16 times trailing EPS and just 13.5 times its forward P/E. While some skepticism is warranted given Exelon's $20.6 billion in debt (not including the debt it'll take on when it completes its purchase of Pepco) and its need to spend heavily in order to continue to diversify its holdings away from nuclear energy, the basic need that Exelon provides (i.e., electricity) makes it a particularly intriguing long-term value play at these levels.

In other words, short-sellers could find success from quarter to quarter, but Exelon's long-term outlook continues to look bright.


iPro2 continuous glucose monitoring system, Source: Medtronic.

A taxing purchase
Medtronic has hailed its $42.9 billion cash and stock purchase of Irish-based medical-device maker Covidien (NYSE:COV) as a game changer. The purchase will help expand Medtronic's product portfolio into overseas markets, and also offer greater product depth to allow it to compete on a more level scale with the largest global device company, Johnson & Johnson.

Purchasing Covidien also allows Medtronic to relocate its corporate headquarters from the U.S. to Ireland in a process known as corporate tax inversion. Because the U.S. corporate tax rate peaks at 40% and Ireland's corporate tax rate tops out at 12.5% (and that's before deductions), it's possible that the newly combined company could save hundreds of millions annually in taxes. It's also possible this money could be used to rapidly grow Medtronic through future acquisitions or even pad investors' pockets through a significant boost in its dividend -- as if a 37-year streak of dividend increases hasn't been enough! Also keep in mind that once this deal closes, Medtronic has around $14 billion in cash overseas, to which it could gain instant access and which is no longer subject to tax under U.S. law. 

The big question is, "Does this deal make sense right now?" Over the long run I don't believe there's a question that tax savings, cost synergies, and the company's size will result in better clout, pricing, and product offerings.

Over the near term, however, Medtronic shares may face backlash from traders and existing shareholders. The reason is that U.S. law also states that in cases where a U.S. company moves overseas via corporate tax inversion, and its shareholders will own more than 50% of the new entity, those same shareholders are responsible for the capital gains taxes (which can be as high as 33%) on their shares. The IRS essentially treats the deal as if Medtronic shareholders parted with their shares, even if they haven't. This tax could certainly drive down Medtronic's shares in the near term, especially with investors on the outside looking in potentially keeping their distance. If that's what short-sellers are angling for when they placed their bets, then they might be correct. Over the long run, though, it doesn't appear as if pessimists have much of a case.

A coming buyout?
Whereas Exelon and Medtronic have already made their purchases, the final company drawing the ire of short-sellers this week is a rumored buyout candidate: Rackspace Hosting.

Source: Daniel Iversen, Flickr.

Interest surrounding Rackspace, a provider of cloud-computing services for businesses of all sizes, has been buzzing since it hired Morgan Stanley to evaluate strategic options for the company in May. Earlier this month, TechCrunch cited a report from unconfirmed sources that noted a private-equity buyout of Rackspace could be in the offing. Since this report, where Hewlett-Packard was also mentioned as a potential buyer, HP has denied making any bid for Rackspace.

It's no secret that Rackspace shares have floundered since early 2013, losing more than half their value. Despite topping estimates in its most recent quarter by reporting a 16% rise in revenue to $421 million and a slight dip in net income to $25.4 million from $27 million in the year-ago period, Rackspace is facing tough competition from the likes of Amazon and even IBM, which is throwing the kitchen sink into cloud-product development. Maximizing shareholder value through a buyout could be in shareholders' best interests.

Then again, if no buyout materializes, can Rackspace actually head higher? The company's ability to expand its top line by double digits would go a long way to supporting optimists' thesis. But Rackspace's competition won't disappear anytime soon -- in fact, it's likely to only get worse. With the company valued at 36 times forward earnings, this could mean some possible downside, which would align its long-term growth potential with its profitability prospects.

At the moment I consider Rackspace watchlist-worthy considering its rapid revenue growth potential and possible buyout interest, but I could just as easily see pessimists correctly predicting downside in its share price.

The secret to beating short-sellers rests with high-quality dividends. 
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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 and Johnson & Johnson. It also owns shares of IBM and Medtronic, and recommends Covidien, Exelon, and Rackspace Hosting. 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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