Fabrice Taylor, CFA, publishes the President's Club investment letter, for which The Globe and Mail provides marketing services and receives compensation.
Is the mother of all short-covering rallies shaping up in the stock of Badger Daylighting?
The much-loved company's shares have attracted the attention of short sellers, and they're not merely dabbling. More than a quarter of Badger's stock has been borrowed and sold into the market by hedge funds hoping the company stumbles, allowing them to buy the shares back at a lower price and return them to the rightful owners.
After speaking to the company, analysts, Badger investors and a firm that is shorting the stock, my money is on the long investors, not the shorts, who could be in for some serious financial trauma.
A couple of weeks ago, Barron's ran a story saying Badger's stock could fall more than 30 per cent. It was obvious that a short seller had whispered the story into the writer's ear. The magazine cited a slowdown in the oil patch as one reason for its bearish view. Daylighting is the process of digging holes using pressurized water and then vacuuming up the resulting mud. It's safer and more efficient than using a backhoe. It's often used by the oil patch for pipeline excavation and repair. The Barron's article also questioned the company's valuation and cast doubt on its accounting.
I take this as the core of the short argument, and I think it's weak. Factor in technical factors that I'll address further down, and this looks like a very poor short idea that may in fact end up profiting those long on the stock.
On the question of valuation, the shorts and Barron's say the stock trades at rich multiples that are higher than its peer group, which consists of only a few players, including Alberta-based Lonestar West Inc. and Massachusetts-based Clean Harbors. The peer group is pretty small, however, and Badger is the first mover, biggest player and market leader. And while those numbers don't scream bargain, valuation is typically not a great reason to short a stock. Of greater importance, Badger beat expectations in the last quarter – in August, which led to a spike in its stock price – and increased its dividend, which implies better times ahead. Boards don't increase dividends when things are tough.
The shorts are also trying hard to scare investors away by criticizing Badger's revenue recognition policy, which Barron's called "unusual for any industry" because the company doesn't say its revenues have to be collectible in order to count as revenue. Say what?
Badger's policy says: "Revenue is recognized to the extent that it is probable that the economic benefits will flow to the corporation…" It's hard to see how the benefits flow to the company if it doesn't collect its revenue, isn't it? Plus, analysts tell me, there are differences between U.S. and Canadian accounting practices. North of the border companies don't use the concept of "collectibility." Strike two against the shorts.
Next is the allegation that Badger hasn't written off enough of its receivables. Barron's pointed out that Lonestar West, one of its only direct competitors, has written off almost three times more receivables, proportionately, than Badger. But Lonestar is much smaller and more regional so it stands to reason that it will have a higher-risk clientele. Barron's also says two-thirds of receivables are past due but haven't been written off, which, while something to watch, is hardly surprising. When things are tough, customers "slow-pay." If I don't pay my credit card off fully for a couple of months, should I declare bankruptcy? Further, the amount of receivables that Badger calls "past due but not impaired" fell sharply last year.
The shorts have also pointed out that Badger changed auditors, which is a common line of attack hedge funds try to use to scare investors. But moving from Ernst & Young to Deloitte to save more than $150,000 in audit fees is hardly cause for concern. It's to be applauded.
All in all, the hedge funds who have sold short 10 million of Badger's shares have a pretty weak case that reeks of desperation. I spoke to a firm that has been trying to spread panic by calling analysts and company employees and I got nothing but stammering, banal and evasive responses. I've spoken to a lot of short sellers in my career and they are usually very keen to convince me to tell readers to sell a stock. These guys seemed more worried about being embarrassed.
That brings me to the technical difficulty the shorts face. Borrowing stock to sell it short is expensive. You have to pay the owner the dividend yield plus interest, which all told is almost 13 per cent and probably going higher. More than two-thirds of the stock is held by institutions so it doesn't trade much, perhaps 100,000 shares a day. How long will it take for the shorts to buy back the stock they sold? At today's valuation it's 100 trading days. They could do it faster, of course, but they'd have to bid high to get investors to sell. In other words, if Badger's last quarter was a harbinger of things to come (and the oil and gas industry is rebounding) the huge short position becomes an argument to buy the stock rather than to be afraid.
Badger announces its third quarter results on Monday. I don't own the stock. If the results are shockingly bad, the shorts may be okay. But if the results are good, then I'll be an aggressive buyer and I'll be happy to sell my newly purchased shares to a desperate, hemorrhaging hedge fund for a lot more than I paid. They've dug themselves a hole that will cost a lot to get out of.