By CrossProfit

05/10/2007

In our previous article from February 2007 we noted that the party was about to begin. Naturally we had no way of knowing in advance exactly when or to what extent, shape or form this would occur.

This time around we are being inundated with requests to write a follow-up analysis. The vast majority of queries lean towards the possibility of shorting AMZN at current levels. Those who follow our articles know that when we feel that a potential short opportunity is feasible, we are not bashful and state so openly.

It is true to say that the majority of our views, general outlook and articles have been bullish. This mirrors the nature of the stock market. We do not follow the statistics on this issue; however, of the cuff we would say that the market in general and individual stocks in particular goes up about 75% of the time. Even in a bear market there could be more up days than down days, just the intensity of the downside outweighs the upside. This is not the case today.

This however, is not the reason that we are not issuing a short alert.

Avoiding Risky Shorts

There are certain classes of stock that one should avoid shorting.

Naturally every investor has his/her own level of risk tolerance. Also there are numerous investment styles and philosophies. At CrossProfit we take a conservative approach to investing. Our philosophy is as follows;

Any company that has enough free cash on hand to manipulate its stock price performance will eventually do so, sometimes when the broader market least expects it.

This is legal. Most companies view their stock performance as a way of rewarding investors. This is called enhancing shareholder value. For the past several months, for some well over a year, the majority of the S&P 500 listed companies have been looking for ways to enhance shareholder value. This is the reason you have been reading about share buyback programs almost on a daily basis. At other times, dividends and special dividends are the preferred method used to enhance shareholder value. On occasion, spin-offs are used for the same purpose.

All companies that are blessed with a healthy war chest, as we like to call it, are not good short candidates. This is far too risky in our opinion. A company can decide to start repurchasing its stock in volume over a short period of time and this will cause the stock to appreciate considerably. Naturally they are required to disclose all transactions under SEC regulations.

Opened short interests put downward pressure on a stock price. A classic example as to how this works is Overstock.com (OSTK), more about OSTK later. Naked shorts can actually be illegal when exceeding the allotted time frame.

In the case of Amazon, the company did not want to waste its war chest on enhancing shareholder value so it had to wait until there was a catalyst that would enable AMZN to get the biggest bang for a few bucks. The Q1 earnings report provided such.

Previous company guidance was cleverly worded to lower expectations, without actually stating that Q1 was going to be a bad quarter. Had they done this, AMZN would be sued as they did not update their guidance. Instead, the ambiguous wording left open the possibility that Q1 could go either way. Well done, well done indeed. A company can use this sort of tactic only once. Being that AMZN does not have the same cash reserves as Microsoft (MSFT) they chose to clear out the nay-sayers (shorts) via this medium.

Mission accomplished for now, the downward pressure (from 40) has been mitigated.

The Microsoft Comparison

Another company that was facing similar issues is Microsoft (MSFT). The stock had been stagnant for years and the dividend paid just wasn’t cutting it with investors. Investors were getting impatient. The stock started drifting lower. One of our analysts found a classic investor reaction to this phenomenon and actually posted a comment.

In the article, Jason gave his reasoning why he sold his MSFT shares, hoping to buy back in at lower levels once the stock started turning around, excerpt follows;

"I’m obviously in Camp 2. But then why am I selling? Easy: because everyone else is. After shares dropped to $24.50, I brought my position up to 100 shares. MSFT stock become undervalued at this point (see some discussions here: Is Now the Time to Buy?) and I thought there was a good chance the stock would bounce back quickly. After a week or so, it should have been apparent to me that a quick bounce was not going to happen. But I held on to the stock anyway as it tested previous support levels at $24 and then $23. As I write this, technical indicators are showing that MSFT should go down for a little while longer. Institutional investors are moving out of Microsoft and tech in general as they rotate their investments into other sectors (construction, minerals, oil).

I’ll hold onto a falling stock if I have reason to believe that there could be a very sudden reversal to the upside. I want to make sure I don’t miss the gains. While at the same time I’m ready to buy more shares when I feel the true bottom is found. I no longer feel a sudden reversal is in the cards for MSFT. And so I’m selling my stake.
My plan now is to hold off until the stock truly bottoms out (going to be watching the Stochastics, MACD, and Moving Averages) before moving back into the stock. I’m still long on Microsoft as a company and an investment, but the short term is looking bleak for these guys (and the tech sector in general)."

One of our analysts hoping to share some enlightenment commented as follows;

• "MACD is very important. What is also important to know is which institutional investors are buying & selling and why. You can have a situation where several big players are selling at a time when their counterparts are not in a position to buy thus creating downward pressure on the stock price. This situation could self correct a few days or weeks later. One of the tasks of the floor specialist is to monitor the big plays.

Sometimes companies announce share buy back programs in order to alleviate an over supply situation. This has a dual function. The first result is the removal of the temporary oversupply from the market. The second result is that the remaining outstanding shares have a higher value and will reduce the occurrence of other large shareholders reducing their positions. Once this happens the MACD will suddenly reverse.

It is not within the scope of this comment to get into specifics – obviously there is more to it – however to conclude that institutional investors are bailing out of a stock based on 8/17 or 10/30 MACD could be misleading.

Side note: Large institutional investors tend to hold onto large caps for an extended period of time and do not play downturns. The smaller mutual funds tend to turnover their positions on an average of 10 months. We could be in the middle of a turnover."

As an aside, notice how the word "play" is used. The obvious meaning is that this is a short term downdraft that can correct suddenly.

More to the point is how Microsoft chose to correct the situation. Before the selling situation got out of hand, MSFT decided that it would use part of its war chest to correct it. Sometimes, a subtle warning to investors is enough. A warning usually comes in the form of a company announcement like "the board has authorized the repurchase of $xxx of shares".

Sometimes the market ignores the warning. This was the case for Microsoft. Apparently this must have ticked off several people at MSFT, so MSFT devised a plan that would force people to put their money where their mouth was. Counter balancing the plays could cost a ton of cash. Instead, MSFT offered a Dutch auction. This was ingenious, if you think about it. Instead of fighting the trend, go with it.

Very few shareholders cashed out using the Dutch auction and the general trend was reversed. In the end of the day, MSFT accomplished what it set out to do and left its war chest intact. Talk about having your cake and eating it…well, MSFT still has its cake.

Amazon has accomplished the same. As long as AMZN still has its war chest, this is not a stock to consider shorting. Plays are intermittent and need certain market factors to be in place before risk levels are reduced. For instance, if you know that the company will be using all of its war chest for another purpose, that’s a different story.

At times, companies are most vulnerable to short runs on their stock just after they have committed themselves to a large acquisition exceeding their cash reserves. Knowing this, companies are willing to take on debt in order to buoy their shares. When both debt and reserves are maxed out – and make sure they are maxed out, not from the balance sheet – a short opportunity may arise.

A classic current example of the above is International Business Machines (IBM). IBM made numerous acquisitions in 2006 and was being eyed by short experts as a possible play. The company simply announced that its board approved a massive share buyback program to be implemented through the assumption of debt. End of story, shorts move on.

As an aside, this also explains the noticeable VIX behavior, or lack of.

Intrinsic Value

Though AMZN may be in for lower valuations over the long term, there is no practical way the individual investor can play this safely. The only thing an investor can do is avoid sitting on a long term long position.

Think of the following possible hypothetical scenario. AMZN starts to slowly drift downwards in an attempt to realign with fundamentals. 

In order to reverse the trend, AMZN freezes all capital expenditures for a full quarter and uses the budget to repurchase shares. In addition, all option grants are deferred to the following quarter. AMZN reports a blowout quarter with stellar EPS numbers on a lower share count. The results could send the stock to 80! The true test, however, is over time as it is nearly impossible to fiddle with the figures over several quarters. Eventually something starts to give whether it be revenues or margins.

At $62 the stock is clearly overvalued in relation to EPS, including forward EPS. In relation to revenue, ‘the party’ has just started. Take into account though that not only do investors want the stock price to max and company officers who are compensated in part with options, would like to max their earning potential as well.

If you are long term bearish (as we are on AMZN), a long term short at 62 is feasible as long as you are willing to sit out a possible bump up to 70 or 90. Remember, AMZN still has its war chest intact and can decide to deploy it should the stock drift down to let’s say 45. Then what? There is no guarantee that the stock will first go to 45 and then to 90. It could first go to 90 and then to 45. Don’t even try to figure out an accurate time frame because you are sure to get it wrong (one of Jason’s mistakes and every options trader’s nightmare as well). Such being the case, why short now?

AMZN could decide that the short interest ratio is still unacceptable and use other methods and bump the stock from 70 to 90. If that doesn’t work, it could enlist some investment bankers and try to shake out the shorts by making a run on the stock to 150. This may sound like science fiction, it’s not. Once a stock has detached itself from the fundamentals, it is dangerous to short as there is no telling how high the stock will run.

Perhaps an example is in order. Think of a stock that was worth 20, was run up to 50, fell back to 13 (12.5) and today is worth 25. We’ll give you a hint, add two zeros. If hundreds of stocks can be bumped 150% simultaneously over their intrinsic value (NASDAQ 2000), twenty can go out of whack by 300% with relative ease.

The point is though that it is a bump, not based on fundamentals and will not last forever.

The key to all of this is to keep an eye on the outstanding short ratio. Many investors have foolishly concluded that there is safety in numbers. In this class of stock, it is the company that decides when and where enough is enough. As the short interest climbs, the chance of triggering a corporate reaction increases. If the company has the arsenal at its disposal, it will use it. This frees up cash for growing the real business – which compounds the dilemma for the remaining shorts!

Small, Medium and Large Cap

Companies come in all sizes. Until now we have concentrated on large cap that are more likely to have their own war chest and/or have the connections to borrow someone else’s (another factor to be taken into account).

The counterbalances to corporate plays are the hedge funds. Actually, sometimes they are a counterbalance and at other times are allied. Start-ups and smaller companies rely on their market-makers to ‘protect’ their share prices. With these companies, insider selling could be a good indication that support is nearing its peak.

The use of the 10B5-1 does not detract from the fact that insiders are selling. All the 10B5-1 does is shelter insiders from potential lawsuits. In some instances, the use of a 10B5-1 indicates that insiders already know that their company’s stock is overvalued. Check and see when insiders started using a 10B5-1, before or after the price had already increased substantially. If after, this is a dead giveaway. The stock can still go up, but at least you know that eventually it will come back down again as there is no real substance behind the price.

Interim Conclusion

If you are long term bearish on AMZN and are willing to accept possible hefty paper losses along the way, then current short ratios and price indicate a wait and see approach. Should the ratio decrease, it may be time to get in as there is less likelihood of a correction. Make sure that you have enough funds available to back up your position. Should it increase again and your position is in the black, it may be time to take profits. The above does not refer to extreme swings based on positive or negative unforeseen developments.

If you are long term bearish and intend on shorting using a margin account, as most do, skip over AMZN, this is not the class of stock to short.

If you are long term bullish on AMZN, then what were you waiting for until now? The longer you wait, the less profit is awaiting you. Remember, no one can time the market.

Sentiment Influence

We do surf the web. Yahoo! board members for AMZN provide a true ‘street’ sentiment, first hand, that does not always concur with Wall Street’s sentiment. For sentiment, the boards are fine. For an array of analysis and opinion, we would suggest going elsewhere. Our recommendations are Seeking Alpha and 24/7 Wall St.

A company like Amazon might use sentiment in order to fine tune its timing. Should both the street and Wall Street sentiment turn overly bearish again, this could trigger a response from AMZN. We are pretty sure that most board contributors have no idea that their innocent one liner could accumulatively cause a chain reaction.

Where is the Competition?

What first caught our attention was an Amazon want-to-be stock called Overstock.com (OSTK). This internet retailer did not have any friendly support. To make a long story short, OSTK cut out the middleman and went directly to the public with its IPO. The establishment never forgot and most likely wanted to teach OSTK a lesson though no foul play has ever been proven. After seeing what OSTK went through, newcomers will think twice before initiating a Dutch auction for an IPO.

Taking into account that there is no price support for OSTK, the stock still managed to pop 20% in February – on terrible earnings! This was an eye opener. There were several items that contributed to this; however we will concentrate on one aspect.

One of the reasons that we are long term bearish on AMZN is due to the competition factor. Even if our entire thesis in our previous article is totally incorrect, we would still be bearish on Amazon. Here’s why.

You may have heard of the father that calls his son who moved to the middle of the Sahara desert to open a ski resort. The father asks the boy – so son, how’s business? The boy replies: must be great because I already have 3 competitors!   

To date, Amazon has no serious competition. The closest ‘thing’ that can be called a competitor is OSTK. We call it the ‘thing’ as our vocabulary is somewhat limited. At least the ‘thing’ has the necessary infrastructure to be transformed into a formidable competitor with relative ease. Of course it would take a Google, Yahoo! or Microsoft to do it, but that is a totally different issue. While investors were crying over the AMZN quarterly report and Q1/2007 guidance, the smart money was going back into OSTK. (Demmy Nancy Pelosi is a shareholder and she is no dummy).

Should AMZN ever become truly profitable, on a sustainable basis, you can guarantee that it will have serious competition overnight. One of the likely platforms to be used is OSTK. Based on the above, the smart money does not seem so impressed with Amazon’s last quarter’s fiddle.  A sustainable jingle is what the smart money is looking for. Had OSTK appreciated along with AMZN; now that would be something to look into.

Apparently, when it comes to making money, the internet retail business is still worse than a ski resort in the Sahara desert – still no competition!

Another way at looking at the business model is through capitalization. If you were to take AMZN’s cap and put in a bank account for the past eleven years, the interest would be more than double AMZN’s earnings and the compounded interest will continue to be greater than earnings for the foreseeable future. In other words, to date Amazon has continuously lost money – taking into account the reported profits.

Welcome to the Party

As mentioned in our previous article, the party was about to begin. How long the party will last, we don’t know. How wild will it get? We also don’t know. The party will go on and on as long as revenues keep climbing. Every time there is a serious downturn in the stock price, shorts risk being flushed away. If you have recently shorted at 62, set your 10/15percent profit margin and stick to it. It doesn’t look like AMZN will allow the stock to fall below 45 before Q2 earnings are out.

The two themes in this article compliment each other. Both the high stock price and the ever growing revenue are aimed at creating an optical illusion.

Margins can drop to zero, AMZN can post losses and the stock may continue going up. The market is concentrating on revenue, not fundamentals. The market is not looking at same store sales but at overall sales. In a regular business, this comes to an abrupt and usually ugly ending. In the internet world, it could take a lot longer.

Let the good times roll.

Disclosure: No current conflicts though our position can change at any time (short bias).

CrossProfit http://www.crossprofit.com

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