No stock actually rises to infinity (Coinstar)

June 25, 2009

Shorting stocks is widely considered dangerous. The old adage is that “Stocks can only fall to zero, but they can rise to infinity.” I’ve always been unsatisfied with this explanation, because I’ve never seen a stock actually rise to infinity, and if I did see one I would short it.

The problem with shorting is that it is impossible to open a position and forget it. Unlike a long position in a solid and stable company, no one opens a short position without planning to close it. No one ever inherited a short position from a distant great-aunt, and if a brokerage needs the shares back it can close the position without the shorter’s consent. Furthermore, the best candidates for shorts are those that the market is most optimistic about. If their exuberance continues, the price can stay high and climb higher, giving the shorter a great deal of stress. And generally, shorting a situation of excessive optimism is the only way to do it; if everyone already knows that the stock is a losing proposition the share price will indicate this by being very low and there is really no profit left in shorting it.

Short selling may also be inconsistent with the low-hanging fruit approach. Purchasing an underpriced investment with strong present or potential cash flow gives investors assurance that, if they did their research correctly, the investment’s apparent underpricing will resolve itself. After all, cash is always worth cash. Short sellers have no similar assurances. They are reduced to waiting for the rest of the investment community to wake up to the fact that the company is nowhere near as good as the “story” they bought indicated (Ideally this process would be accelerated by accounting scandals, but you can’t have everything). The waking-up process, since it doesn’t involve cash piling up, has no time pressure to occur, and in the meantime, as Mohnish Pabrai indicated, the company can turn that fake value into real value by issuing new stock for cash, acquiring a real company with its overpriced stock, or allowing itself to be bought out.

On the plus side, shorting stocks, if you have a knack for it, is a way to find a use for unused margin (a margin account is nearly always required, and don’t use up all your margin because optimism has a tendency to feed on itself) and to reduce your market exposure in the face of a broad-based downturn. There definitely are times when optimism is clearly unjustified, and if, after seeing the downside of shorting we still want to short, finding excessive optimism is definitely the place to do it.

Coinstar presents such a situation. It has a market cap of $782 million as of this writing, made only $2 million last quarter, and $14 million the year before, which is an improvement from the previous year in which it lost money. That works out to a P/E ratio of 55, which strikes me as just the tiniest bit high.

I have to admit that when Coinstar came out, I was optimistic. Rolling coins is not most people’s idea of fun and any company that is in a position to exploit the laziness of the average person should have a bright future. However, the execution proved not to be as bright as the idea; the business proved itself to be high in capital requirements and expenses and I never really found an entry point I liked. But when such a company reaches a P/E ratio of 50 what could be more natural than looking for an entry point on the other side?

The cause for the latest round of optimism is Redbox, the DVD rental kiosks in grocery stores and some McDonald’s. They are certainly the driver of Coinstar’s recent sales growth; in the last reported quarter they produced $150 million in sales and $27 million in operating income.It is obviously difficult to value a fast growing entity, but Coinstar’s own latest 10-Q gives us a hint. Redbox used to be a joint venture with Coinstar and several other investors, but last February they acquired GetAMovie’s 44.4% interest in Redbox, plus a note for $10 million from Redbox, for $10 million plus a lot of stock. The company has already paid about $115  million in stock and expects to pay up to $20.8 million more. Taking out the cash and the note, we get at most $135.8 million for 44.4% of Redbox, which suggests that the whole of Redbox is worth no more than $305  million. This price was negotiated between two sophisticated buyers, each in possession of all the inside information they could want. Of course, Coinstar intends to expand this business, and presumably hopes to realize a decent return on capital by doing so, but presumably GetAMovie considered the same course of action and thought it was better to get out. Take away $305 million for Redbox, and that leaves a valuation of $477 million for the rest of Coinstar’s operations, which as I’ve said have not been at all impressive over the years. When Coinstar’s investors wake up to this fact the price should drop accordingly.

So, having heard the drawbacks and benefits of shorting stocks, if you want a stock to short I suggest this one.

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