Scared of Shorting

Posted on 09/02/2011


HK Central Building HMV Group shop

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In my professional experience as both an equity and credit analyst I have never been involved in analysing any short positions – neither firm I worked for managed any funds which had the ability to bet against the shares and bonds of companies.

However, I have recently opened a CFD (contract-for-difference) account which allows me to leverage my equity and open short positions.  It didn’t take long before I started looking for candidates to take advantage of the additional opportunities that this new account presented.  This makes sense, as intuitively there should be as many over-priced shares as there are under-priced shares.

An issue facing me as I began to consider potential candidates is that going short is simply less attractive than going long. The main reasons for this are as follows:

  1. Stock markets and share prices tend to rise over time as the economy expands, so to go short the market or individual company shares is to swim against the tide.
  2. The potential upside is limited to size of the position (a stock cannot fall below zero) while the downside is potentially unlimited.
  3. Unlike long positions which get larger as they work (and smaller as they fail) successful short positions shrink in size when they work and get larger if they go wrong.
  4. If other investors also hold a short position in the same company, a relatively small piece of good news can cause a “short-squeeze”, or a sharp upward movement in the share price as investors rush to cover their positions.
  5. The lenders of the shares can sometimes demand them back at short-notice, forcing a position to be closed-out at a loss.

The first active short position that I opened was a in HMV during December 2010.  My rationale was that electronic downloads and online retailers will continue to squeeze bricks & mortar retailers of books, CDs and DVDs.  Over the long-term, I do not believe that HMV will be able to remain as a major high street retailer in the face of such competition given that companies such as Amazon, Apple iTunes and LoveFilm can undercut HMV due to their lack of rental expenses.  As such, I believe that HMV is likely to face steadily declining sales which will lead to rapidly declining profits given the high degree of operating leverage in the business due to the high rental expenses.  In addition, the financial situation of the company is relatively weak, with EV/EBITDAR of only 6.6x but net debt/EBITDAR of 6x, a precarious position for a company facing a declining top-line.  To calculate these measures I added annual property rental expense back to my estimate of FY11 EBITDA and 8x the rental expense to the company’s net debt (which also includes the pension fund deficit).

The trigger to enter the position was the release of the 1H11 results on 9th December.  While these were bad, with sales falling 6% and the company making a net loss, the outlook statement was the item that really caught my attention:

The outcome of our full financial year will be largely determined by the next four weeks of the key Christmas trading period, which together with the final four months of our financial year, account for 60% of our full year sales. Despite more encouraging trading at the beginning of the second half, the start to the Christmas trading period has been undermined by the severe weather of the last two weeks, which has significantly affected consumer footfall and consequently makes trading patterns hard to determine at this stage.

My expectations played-out over the very short-term, with the company releasing another profit-warning shortly after Christmas:

The challenging entertainment markets, combined with the severe weather over our peak trading period have had a negative impact on our trading year to date. In addition, there are well-reported consumer headwinds as we enter 2011.

We are taking aggressive action as we continue to tightly manage our cost base. We expect to exit around 60 stores across our UK businesses over the next 12 months as we seek to re-shape our store portfolio. In addition, we have identified a further £10m per annum of cost savings from across the Group.

The combination of more challenging trading conditions, off-set to an extent by a significant step-up in cost savings, leads us to expect, with four months of the year to go, that profit before tax and exceptional items for the full financial year will be around the lower end of the current range of market expectations.

Given the difficult trading conditions over Christmas and the likely outturn for the year, the Board now expects that compliance with the April covenant test under the Group’s bank facility will be tight and is taking further mitigating actions during the next four months to address this.

The company had reported a decline in like-for-like sales of roughly 10%yoy for the key Xmas and New Year and was warning that it might default on its loan facilities.  Clearly the fundamentals were deteriorating.  However, at this point I closed out my position, taking a relatively small profit (both in absolute and relative terms – I deliberately made this a small position).  Even though the position had been small HMV was by far the most volatile position in my portfolio.  I also had another concern.

The problem for a short-seller in a struggling leveraged business is that the company could see a large jump in its share price if a potential acquirer made a bid (for example, a private equity firm focusing on complex situations or another retailer seeking access to the property portfolio).  This actually turned-out to be the case, when on 4th February Bloomberg reported that Permira and Alexander Mamut were considering (separate) bids for the company.  Consequently, the shares have risen 16% since their low on 21st January.  A further potential problem in situations such as these is that other stakeholders in the business may make concessions in order to keep the business afloat and protect their interests.  For example, landlords might reduce rents in order to avoid vacancies, employees might accept wage cuts in order to keep their jobs, or suppliers might reduce prices in order to protect their own sales.

I’m going to continue monitoring HMV, but I suspect this short may now be too crowded and the risk of a potential bidder acquiring the company too high.  I’ll allocate more of my time towards looking for other opportunities.