With shares off more than 50% year to date, and short interest hovering near 52-week highs, it's worth asking if 3D Systems (DDD +11.11%) is a compelling short-selling candidate.
Short-selling 101
On a high level, selling a stock short means an investor is wagering that the stock price will decline in the future. Behind the scenes, a broker arranges a short-seller to "borrow" shares from another stockholder's brokerage account that owns shares outright, and the short-seller uses these shares to sell to another buyer. When the short position is opened, the short-seller receives the proceeds from the sale of the stock, and would only make a profit if they closed out the position by buying back said shares at a lower price than what they initially sold the borrowed shares for.
As far as risk is concerned, short-selling is acknowledged to carry unlimited risk because a stock's price can technically rise indefinitely, which may force the short-seller to buy back shares at a price they simply cannot afford to cover. Because of the significant risks associated with short-selling, it should only be employed in special situations by investors who are willing to expose themselves to potentially outsize risks.
Twice a month, a stock's short interest, or the total number of shares that are sold short and remain open positions, is reported to the stock exchanges. When short interest is high, the number of shares sold short represents a significant percentage of a company's total shares outstanding. As of Sept. 15, 3D Systems' short interest stood at 35.8 million shares, representing 32.6% of its shares outstanding. With nearly one-third of 3D Systems' total shares outstanding being actively shorted, it's currently quite popular to bet against 3D Systems' future.
The case for shorting 3D Systems
With a trailing P/E ratio hovering around 130, it's easy for bears to make the case that 3D Systems' stock is too richly valued and is priced beyond its future earnings potential. In recent quarters, 3D Systems has had a difficult time meeting investor expectations, which has helped the bears substantiate their beliefs about 3D Systems' current valuation. Hedge fund manager Whitney Tilson has even gone on record saying that 3D Systems' intrinsic value is $10 per share, which, if true, suggests significant downside from today's mid-$40 level. Combined, these factors have helped investors drive 3D Systems' short interest to near 52-week highs and the stock near its 52-week lows.
Putting the bears to rest
Anyone who's listened to one of 3D Systems' recent conference calls should know that the company is more concerned with investing in the long-term success of its business than it is with short-term earnings, and this strategy can cause its P/E ratio to remain stubbornly high. After all, 3D Systems is operating in a highly competitive, high-growth industry, and the window of opportunity to solidify what it believes is a competitive advantage as the most vertically integrated 3D printing company could be limited. This dynamic has motivated 3D Systems to make about 50 acquisitions in the last three years, aimed at bolstering its 3D printing portfolio and broadening its market opportunity.
Moreover, 3D Systems has set an ambitious plan to nearly double its full-year revenue between 2013 and 2015, which happens to align nicely with management's promise that its operational leverage will be "fully restored" in 2016, as the heavy pace of investment and concentrated product introductions begin to normalize. In other words, come 2016, investors should be able to get a better sense of 3D Systems' true earnings potential.
What should a Fool do?
With 3D Systems shares off more than 50% year to date and short interest hovering around 52-week highs, it's safe to say that investor expectations and sentiment are currently in the doldrums. Although it may be popular to short 3D Systems shares today, given the fact that the company remains more committed to the long-term success of its business than with its short-term earnings, and has adopted a strategy that it believes will capitalize on the growth of an industry that's expected to grow by over 30% a year through 2020, it seems to me like it's too risky of a proposition to bet against this potentially massive upward trajectory. If you don't believe in 3D Systems' long-term prospects, or think shares are too richly valued, you'll certainly be safer sitting on the sidelines than short-selling shares and exposing yourself to a significant amount of risk.
