Like a looming pack of buzzards, short sellers are beginning to crowd the branches of LendingTree (NASDAQ:TREE). Depending on your point of view, this is either ominously bearish (shorts are smart sellers) or contrarily bullish (shorts are eventual buyers) -- or perhaps something else entirely. Let's take a look at the facts and see which view makes the most sense.

According to the latest data (March 14), 33.7% of LendingTree's publicly traded float has been sold short. Not only that, but Nasdaq.com shows LendingTree has a rising short interest for the entire past year.

Just as a circling pack of buzzards is a telltale sign of death below, a congregation of shorts is usually a sign of corporate trouble ahead. As such, I have the following rule of thumb: I'm cautious whenever short interest is higher than 10%, and I outright avoid stocks with a short interest higher than 20%.

Exceptions to the rule
But as with all rules of thumb, there are exceptions. One is if I understand the shorts' thesis and have good reason to believe it's either flat-out wrong or, at least, insufficient cause for betting against the stock. You saw an example of this last year when I held onto Meridian Medical Technology, a stock that was heavily shorted in the $20s and soon thereafter bought out by King Pharmaceuticals (NYSE:KG) for $44 cash.

Another exception to my short interest rule -- and the one I want to focus on today -- is when a company has some type of convertible security, whether it be convertible debt or convertible preferred stock. These "convertibles," as they're called, carry a provision whereby the security can be converted into common stock. Because of this, convertibles invite short selling as a means of hedging the common stock exposure. (I'll show you how this works in a minute.)

LendingTree happens to have a large chunk of convertible preferred stock. As such, I believe the preferred shareholders are the primary short sellers here. As you'll see in a moment, convertible holders have a strong incentive to be short, even if they're fully confident in the company's prospects.

I told you last week I'd use today's column to review some highlights from LendingTree's 10-K. As it turns out, I believe this convertible preferred security deserves the most attention. Over the past few years, a lot of companies have issued convertibles, so I hope the following account of LendingTree's situation will be instructive in understanding the implications of any convertible security.

LendingTree's convertible
In March 2001, LendingTree was in desperate need of cash, and therefore had to raise financing at very disadvantageous terms. Equity financing was unattractive because LendingTree shares were scraping bottom at around $2.81 -- a price so low that issuing equity would've been highly dilutive. Similarly, debt financing was unattractive because the company's poor finances would've necessitated a junk-bond level interest rate.

So instead, LendingTree opted for a hybrid of equity and debt -- a five-year convertible preferred stock, paying an 8% dividend and convertible into common stock at an exercise price of $3.50. Think of this as an 8% bond with a long-term call option ($3.50 strike) attached to it. If it sounds like buyers of this security got a good deal, you're absolutely right.

But given the dire circumstances, LendingTree did OK, too. By making the security convertible to common stock, the company could secure a lower interest rate than that available through a pure bond offering. And by offering the 8% dividend, LendingTree was able, essentially, to sell its stock for higher than the then-going rate ($3.50 vs. $2.81), resulting in less dilution to common shareholders.

The convertible owner's dilemma
All told, LendingTree issued about 6.7 million shares of convertible preferred stock, with buyers paying $3.50 per share. Today, those preferred shareholders are a happy bunch, as they own a security with a convertible value of $14.90 -- a return of more than 325%. (Here's how the math works: The preferred stock's value equals LendingTree's common stock price, currently $13.72, multiplied by the conversion rate. The original conversion rate was 1:1, but it's now 1.086:1 because the first four quarterly dividends were paid in stock, resulting in a higher conversion rate. So, $13.72 x 1.086 = $14.90.)

On top of the awesome capital gain from the convertible feature, the preferred shareholders are still receiving 8% cash dividends (paid quarterly), and will continue to receive them until at least March of next year, at which time the securities are potentially redeemable by the company.

So, put yourself in the shoes of a convertible preferred shareholder: You have a huge capital gain waiting for you, but it's only officially yours after you convert to the common stock and sell it. Yet once you convert to the common, you lose your 8% dividend. See the dilemma? Take the capital gain and lose the dividend, or keep the dividend and risk losing the capital gain. What do you do?

The shorting solution
There's an elegant solution to this dilemma that allows you, the convertible preferred shareholder, to have your cake and eat it, too: You can "lock in" all or a portion of your capital gain by selling short LendingTree common stock. In essence, you're just selling in advance the common shares you stand to eventually receive upon actual conversion. (Take your time; mull it over for a moment.)

This procedure allows you to continue to hold your preferred shares and receive the 8% dividend without risk of losing your capital gain. Then, after you eventually convert the preferred shares to common, you can cover your short by handing over the common shares that you just received from the conversion. (Again, mull.)

So, now you see why LendingTree's preferred shareholders are inclined to sell short the common. Furthermore, this inclination to lock in future gains is all the more prominent right now because time is running out on the preferred shares. On March 20, 2004, LendingTree will have the option to redeem any unconverted preferred shares for $4.56 in cash (according to terms of the original issuance).

Of course, no right-minded preferred shareholder is going to allow that to happen, given that each preferred share has a current conversion value of $14.90. Hence the rapid increase in short interest over the past year. Those are gains being locked in. Expect to see the short interest continue to increase through 2003, but then decline rapidly in the first quarter of 2004 -- after the last cash dividend has been paid and before the March 20 redemption date.

The answer is 'c'
So, to the original question of whether LendingTree's high short interest is a) bearish, b) bullish, or c) none of the above, the correct answer is, in fact, 'c.' As you saw, convertible shorting isn't a sign of corporate distrust or bearish opinion -- just rational profit taking.

For those who think 'b' is still true, remember that there isn't any pent-up buying from these short sellers -- when the convertible shorts eventually do cover, they won't be buying existing stock, but rather handing over their newly issued common shares.

LendingTree's high short interest is just a function of the wacky financial gymnastics available to convertible security holders.

Matt Richey (MattR@fool.com) is a senior analyst for The Motley Fool. At the time of publication, he owned shares of LendingTree and, for the record, doesn't consider short sellers to be "buzzards." For Matt's best stock ideas and exclusive in-depth analysis each month, check out our newsletter, The Motley Fool Select . The Motley Fool is investors writing for investors.