Does This Number Mean Bad News for These 3 Stocks?

Bigger isn't always better -- at least when it comes to this number. Find out why this figure could spell trouble for three household stocks.

Aug 17, 2014 at 8:00PM

The stock market may have swooned a bit since the beginning of August, as it has on a number of occasions over the past couple of years, but it's been ages since we've witnessed a sizable correction in either the Dow Jones Industrial Average or S&P 500.

There's a good reason for that: The U.S. economy is improving. Manufacturing and factory order data have been expanding at a brisk pace, the unemployment rate is down 38% from its October 2009 high of 10%, consumer confidence is near a multiyear high, and housing has seen a strong rebound, with home prices in the 20 largest U.S. cities averaging a double-digit increase year-over-year.

Images

Source: Hobvias Sudoneighm via Flickr.

But not all investors are on board. In fact, incredible amounts of short interest are building in the stock of some huge household names, which could portend a drop on the horizon. Just as investors buy shares and make money if they rise above their purchase price, short-sellers borrow money on margin and bet against a stock's share price, making money if it goes down and losing money if it rises.

Let's have a look at three companies that, according to the latest data from The Wall Street Journal, have the greatest number of shares currently held short and determine whether this reflects something damning about their future prospects or is just a bunch of hot air.

(NASDAQ:SIRI)

The bull thesis for shareholders all along has been that satellite radio offers users more customization by genre and the ability to avoid nearly all commercials, something that's impossible to do with traditional radio stations today. Therefore convenience and personalization should drive results, allowing Sirius XM to grow at an exceptional pace relative to traditional radio broadcasters and pay down its high levels of debt.

What we've actually seen is Sirius XM's debt situation heading in the opposite direction and the company's growth prospects slowing.

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2014 subscriber total estimated. Source: Sirius XM. 

In the second quarter, Sirius XM reported that its subscriber growth increased to a record 26.3 million, but that this was up just 5% from the year-ago period. Furthermore, the company's long-term debt rose by more than $1 billion thanks to a $1.5 billion bond offering it priced in May, which comes due in 2024. The satellite radio provider seems more focused on "returning capital" to shareholders through share buybacks -- which can have a positive effect on EPS by reducing the number of shares outstanding -- than on addressing the real issues, including its slowing subscriber growth and high debt levels. 

Sirius XM investors should consider that the online radio space is beginning to get awfully crowded -- and that some of the company's would-be competitors have far deeper pockets.

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Source: Sirius XM. 

I personally don't doubt Sirius' ability to stay profitable at this point, but like many short-sellers, I question whether or not a forward P/E of more than 30 is warranted with a subscription growth rate that has slowed to the single digits.

AT&T (NYSE:T): 196,919,776 shares held short (3.8% of float)
On the other hand, the nearly 197 million shares currently held short in AT&T stock are a bit of a head-scratcher.

From the standpoint of a skeptic, I see only two reasons to bet against AT&T here.

Att Woman Smartphone

Source: AT&T.

First, AT&T is a highly defensive play: It's not volatile, it pays a healthy dividend (with a current yield of more than 5%), and it offers a basic service that most people can't live without. Long story short, it's a basic-needs company. The problem with basic-needs stocks and other defensive names is that they usually underperform when the economy is rapidly expanding. Investors will cycle out of defensive stocks as their appetite for riskier investments matures, which is what some current short-sellers might be betting on.

The other possibility here is that pessimists recognize AT&T is playing catch-up to Verizon (NYSE:VZ) in the rollout of its 4G LTE network. For the time being, Verizon has far more U.S. cities covered with its next-generation networks than AT&T, and this is forcing AT&T to spend on infrastructure upgrades. This excess spending has the potential to hurt its profit and send its share price lower.

AT&T's second-quarter results were mixed at best, with revenue rising 1.6% to $32.6 billion as wireless revenue trudged higher by 3.7%. Adjusted EPS, however, fell to $0.68 from $0.71 in the year-ago period.

Att Picture

Source: AT&T.

Yet there were also a number of positives, including the best postpaid churn rates in more than four years, signaling that consumers are satisfied with AT&T and sticking with the company. Brand loyalty is extremely difficult to come by in the wireless sector, but as Brand Keys noted earlier this year, AT&T Wireless sits at the top of the list in terms of keeping customers loyal.

Moving forward, there are a number of questions left to be answered, such as how smoothly its merger with DIRECTV will go and exactly how much it'll need to spend in order to give Verizon a run for its money. What I can say is this: AT&T is a cash flow machine with a premium dividend, and that's not the type of business model I would advise betting against.

Frontier Communications (NASDAQ:FTR): 176,393,899 shares held short (17.7% of float)
Lastly, sticking within the telecommunications sector, we have Frontier Communications.

Unlike AT&T, there are clear reasons why pessimists are betting against Frontier. The company's acquisition of wireline assets from Verizon in 14 states, announced in 2009, added a monstrous weight of debt onto Frontier's back and also gave the company a large constituency of rural landline customers.

Generally speaking, landline customers are high-margin. However, improvements in wireless technology have brought coverage to some rural areas of the country where cellular service previously wasn't possible. The end result is that rural landline customers have been leaving steadily since this deal closed a few years ago. This shrinking residential customer base, coupled with high debt levels, has forced Frontier to reduce its dividend payout twice since 2010 in order to conserve capital and ensure it has enough cash flow to maintain and upgrade its infrastructure, as well as pay its shareholders.

Today, not much has changed. In Frontier's second-quarter earnings results, the company noted another period of strong broadband gains and an uptick in residential revenue but once again pointed out that residential landline customers fell year over year by 31,800.

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Source: Frontier Communications.

Make no mistake about it: Frontier has been noting this problem for years and is attempting to counteract it with residential broadband additions. However, the long-term outlook for Frontier shows continued revenue deterioration, which, when coupled with high debt levels, could put its 6% dividend yield at risk of another cut. Though betting against a stock with a 6% dividend is rarely prudent, I'm struggling to see where the bull thesis takes shape with essentially no top-line growth in sight.

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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 Sirius XM Radio. 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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