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A customer drives a Model S electric car out of Tesla’s factory in Fremont, Calif., in this June 22, 2012, file photo. Tesla shares are up 65 per cent in the last seven trading days. (NOAH BERGER/REUTERS)
A customer drives a Model S electric car out of Tesla’s factory in Fremont, Calif., in this June 22, 2012, file photo. Tesla shares are up 65 per cent in the last seven trading days. (NOAH BERGER/REUTERS)

STRATEGY

Three short-seller targets that defied the skeptics Add to ...

Some of the most beaten-down, unloved stocks of 2012 are having a fine 2013, particularly in the last few weeks.

Netflix Inc., Tesla Motors Inc. and Green Mountain Coffee Roasters were all favourites of short-sellers, the investors who profit when share prices fall, not rise. And for periods of time, those three stocks provided ample profits to the “shorts.” Their 2012 lows represented declines of between 35 per cent to more than 80 per cent from all-time highs.

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As it turns out, it was the 2012 buyers who are now the winners. All three companies are up more than 300 per cent from those lows. All have gained at least 30 per cent since late April, with Tesla up 65 per cent in the last seven trading days.

A big part of this phenomenon is the short-sellers who now must buy the stock to cover their positions in what’s known as a “short squeeze.” But clearly, many of the most pessimistic views on these stocks have failed to come to fruition. As all three have bested competitive challenges and gained more customers than expected, their futures look much brighter than they did a year ago. But does that mean investors should now feel safe buying – or has the pendulum swung back again to irrational exuberance?

Netflix, which said this week it’s ramping up for a major Canadian expansion, stumbled in 2011 trying to separate its profitable DVD-by-mail business from its content-streaming business. By 2012, the prospect of ever-rising costs to secure desirable content and expand internationally suggested Netflix would be perpetually squeezed.

What’s changed? The company is now posting healthy gains in the number of subscribers, in part because of its own original content, such as the critically praised House of Cards series.

While acquiring other companies’ content hasn’t been cheaper than expected, Netflix has still managed to secure movies and television programs people want to see, such as Disney content (starting in 2016). Now, we are hearing the suggestion that “Netflix is becoming HBO faster than HBO is becoming Netflix.”

Analyst Barton Crockett of Lazard Capital Markets says he’s “concluded that Netflix is essentially a successful TV network company.” He sees Netflix’s operating margins for its streaming business going from about 4 per cent now to more than 36 per cent by 2020, close to HBO’s. “This view makes Netflix cheap,” he says, as he has raised his price target to $325 (U.S.), implying another 37-per-cent gain from here. (Its forward P/E tops 120, per Standard & Poor’s Capital IQ.)

Analysts who have been more cautious have eaten the stock’s dust. But that doesn’t mean they’re tossing away their concerns.

Morningstar analyst Michael Corty, who has a fair-value estimate of just $110 on the stock, says Netflix has “moved beyond” the 2012 fears about its streaming business.

“But the question becomes what’s the value of that business over time, and in my view, at the current price a lot of that potential and upside and growth is built in,” he says. “As the stock has gone up, I’ve rethought it, but the price keeps going up faster than I think the business is improving.”

Tesla Motors reported a quarterly profit last week. For many companies, that wouldn’t be news. But Tesla is a car company that trades like a tech stock – a “tech story” stock that’s valued on a perceived limitless future, rather than the current quarter’s results. (It has no earnings-based multiple because there still are no expectations for a full year of profit.)

For most of its life as a public company, its losses, combined with the perception that its electric cars were just expensive toys for a limited audience, kept the shares in check. Last week’s results, however, included expanded profit margins and significant new demand for its cars – two things that analyst Andrea James of Dougherty & Co. LLC said the Street needed to see to support the company’s valuation.

“There is exuberance for Tesla’s stock, and we believe it is rational,” she said in doubling her price target May 9 from $45 to $90.

Tesla blew past her 12-month target by the close of trading Thursday, however. Analyst Trip Chowdhry of Global Equities Research offers a flavour of some of the most exuberant views of the company with his comments regarding the 17-inch touchscreen in Tesla’s Model S.

“Tesla is not just a car company, it’s a platform for developing and distributing mobile applications,” he says. “And as a technology company, its market opportunity is infinite, no different from Google, Salesforce.com, or Amazon.”

By contrast, Deutsche Bank analyst Dan Galves raised his Tesla price target from $35 to $50 Tuesday, the day after the shares pushed $88. He’s using a multiple that’s a modest premium to Porsche’s multiple during its growth phase of a decade ago. “We do believe that Tesla, after all is said and done, is an auto company and will eventually be valued as one,” he says.

Green Mountain Coffee Roasters, the seller of the Keurig machine and its single-serve “K-cups,” created a whole new way of consuming coffee. The question was whether it could continue to sell more and more machines – and, importantly, whether Starbucks and other competitors would crush the company when its key patents expired in 2012. A gigantic revenue miss in May, 2012, helped underscore the fears.

It didn’t take long, however, for sentiment to reverse, as the company began to beat the diminished expectations. As part of its May 9 earnings report, it said it had expanded its deal with Starbucks to include more of the giant’s products in K-cups. Brian Kelley, Green Mountain’s chief executive officer, told Reuters “this certainly puts away any fear that the Keurig system isn’t the winning system.” Shares jumped nearly 30 per cent; its P/E is about 23, still less than half its peak multiple in 2011.

“Green Mountain has come a long way in the past nine months,” says analyst Jonathan Feeney of Janney Capital Markets, as the “sizable earnings beat” and Starbucks announcement “were the icing on the cake.”

Still, Mr. Feeney notes the company missed revenue expectations in the quarter, and the company’s sales outlook “is at least slightly discouraging amidst an evolving competitive landscape … we would look for a better entry point given the risks inherent in the business.”

Investors may never get that chance on Green Mountain – or Netflix, or Tesla, given their rocketing shares. Then again, all three of these high fliers were laid low once before. Their biggest challenge now is meeting investors’ newly robust expectations.

 

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