Markets

An Epic Short Squeeze Is In Order For This Stock

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Whenever you see a stock with a huge short position, you have one of two actions you can take.

First, you can pile in with the crowd, as many have done with the high-profile short sale target Herbalife Ltd. (NYSE: HLF ).

Or you can buck the tide and go long -- if your research suggests the shorts are wrong. If you're right and they're wrong, then a massive short covering may push shares sharply higher, even beyond justifiable fair value.

The latter is precisely what is happening with software provider Ebix, Inc. (Nasdaq: EBIX ), which surged more than 15% last week on the heels of better-than-expected fourth quarter results.

Last summer, I wrote about how Ebix's growth-through-acquisition strategy created an operational mess, but management was already making progress in streamlining recently-acquired divisions. I figured shares would eventually rise to the mid $20's, though a short squeeze has pushed it past that mark.

Currently, a similar set-up is in place for another heavily-shorted stock: Fully 42% of Carbo's shares are held by short sellers, equating to roughly 10 days' worth of trading volume. The stock fell from $156 a year ago to a recent $33, but shares appear poised to reverse course -- perhaps sharply if short sellers are forced to relent.

Currently, a similar set-up is in place for another heavily-shorted stock: CARBO Ceramics, Inc. (NYSE: CRR ). Fully 42% of Carbo's shares are held by short sellers, equating to roughly 10 days' worth of trading volume. The stock fell from $156 a year ago to a recent $33, but shares appear poised to reverse course -- perhaps sharply if short sellers are forced to relent.

CARBO makes ceramic-based materials, known as proppants, that keep oil and gas wells open after they have been fracked. Ceramic has proven to be more durable than sand or other materials, helping CARBO develop a $650 million annual revenue base in recent years.

The company has also become an industry innovator, developing new formulations that feature greater durability, can help inhibit scale deposits from forming on the walls of a well and can help identify leaks in wells. The company also sells hydraulic fracturing simulation software ("FRACPRO" -- the industry's top seller) and a range of technologies that aid in spill prevention.

As you can imagine, there is suddenly a real concern that fracking activity will dry up, stunting demand for CARBO's materials and services. Sales are set to fall below $300 million in 2015 and 2016, from roughly $650 million in 2014.

Of equal concern: CARBO generated $105 million in operating cash flow last year, but will likely generate only a modest $7 million operating profit this year, according to Goldman Sachs. Goldman forecasts that cost cuts will raise operating profits to $33 million in 2017, but losses (on a GAAP income basis) are likely to persist until energy prices rebound.

The company's $1.26 a share dividend in 2014 is also not going to be repeated for quite some time, as the company conserves cash.

Still, it's important to think about the company's current stress from a financial strength perspective. The company carries no debt, and during the brutal energy downturn of 2008 and 2009, CARBO only generated negative cash flow in one quarter.

The company's variable-cost business model explains why analysts don't anticipate sharply negative cash flows even in tough industry conditions. Analysts at DA Davidson, for example, expect Q1 results to be dismal, but they also anticipate a steady upturn in quarterly cash flow, as sales rebound to around $135 million by the end of 2016, from under $100 million in the current quarter. By then, quarterly operating income should be back above the $15 million mark.

To be sure, there has been a recent pronounced trend away from the use of ceramic and back toward lower-cost sand. That move has been a necessary for struggling drillers facing their own cash flow problems.

But it's crucial to understand that the use of ceramic creates better long-term economics for a fracked well, as it improves gas and liquids throughput. Moreover, ceramics remain almost mandatory when drilling very deep wells, as sand is ill-suited for long, tunnel-like depths. As industry cash flows improve, the shift back to ceramic should become more evident.

Undoubtedly, the company's current market value of $760 million doesn't make shares a bargain in the context of near-term cash flow, but the positive projected cash flow signals that shares have found a floor, trading right near tangible book value of $32.61 a share.

Insider Signal

I first noticed this company last summer when three directors bought a collective $550,000 in stock, while shares were trading north of $100. A lot has happened since. So, it was intriguing to note that company chairman William Morris bought more than $300,000 in stock on February 2. He went on to buy $300,000-to-$400,000 in stock almost daily after that, totaling roughly $7 million purchased in February 2015.

Pivoting back to that massive short seller interest, shorts tend to hang on when they think shares are poised for an imminent drop. Yet shares trade slightly above levels seen in mid-January. At some point, some short sellers simply stop waiting around and decide to cover their short positions. That action alone serves as a buying force for shares. In effect, you don't need to see an improvement in the company's operations or outlook for shares to post a rebound.

Another factor for shorts: the company initiated a two million share buyback program in January. That buying pressure could lead some short sellers to relent and cover positions. The buyback plan equates to two-thirds the size of the short position.

Risks To Consider: Rig counts continue to fall and will only reverse course as oil prices firm. In the near-term, oil prices may slip further as the amount of oil in storage approaches capacity levels.

Action To Take --> This is not a stock for the faint of heart -- heavily-shorted stocks never are. But the book value support, heavy insider buying and variable cost structure signals that this company's obituary is premature. As it operates near break-even and then sees a rebound in operating cash flow in coming quarters, short sellers may need to cover positions, leading to a sharp spike in the stock. It's quite unlikely that this stock will rebound to the $156 mark, as seen last year, but a rebound to just $50 represents a nearly 50% rebound.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.