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Nautilus Inc. Message Board

  • astral_tsar astral_tsar Dec 19, 2003 1:23 PM Flag

    Why Stay Short? (And a Short Trap)

    Ok, why are NLS shorts are paying dividends to stay short? [AND I think there's a potential trap that shorts may want to think about.]

    A. Say you sold short at $35. You could cover today for $13.50, realizing a profit of $21.50 before tax. Unfortunately 35% tax would cost $7.50, leaving you with only $14 in cash.

    B. Or you could stay short indefinitely. You get your $21.50 profit tax-free, but you have to pay $0.40 in dividends each year. I estimate the present cost of that dividend stream at about $5 (12x$0.40), much less than the tax bill for closing your position. So you're left with a present value of about $16.50. Better to stay short and pay the dividends, eh? ; )

    C. *BUT* what if NLS continues to earn $1 per year? Even if NLS just retains $0.60 per year ($1 less $0.40 div) in cash, sellers will expect that much higher share price each year. So TOTAL cost to shorts will be $1 per year. The net present value of that cost is 12x$1 = $12, much higher than paying tax on gains right now. Shorts are left with only $9.50 present value. Shoulda paid the piper after all ; (

    Thanks to doggydogworld for correcting an error in my previous post on this subject.

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    • The mechanics of shorting are widely misunderstood and I've butted heads with many people over this issue. You are the first to go off and do the research necessary to figure it all out. Well done.

      I have a philosophical disagreement with your scenario C:

      <<C. *BUT* what if NLS continues to earn $1 per year? Even if NLS just retains $0.60 per year ($1 less $0.40 div) in cash, sellers will expect that much higher share price each year.>>

      If NLS must reinvest 0.60 each year just to maintain the 1.00 EPS, then that 0.60 is not "true" earnings. True earnings in this case is 0.40. That reinvested 0.60 only adds to intrinsic value (and, over time, to the share price) if it produces EPS growth.

      I've read enough of your posts to know you understand this and didn't mean to imply otherwise with your simplified example. But I figured I'd bring it up anyway because it's easy to misvalue retained earnings if you aren't careful. It gets to the core of successful value investing. You see plenty of otherwise smart people do nonsensical DCF analyses where they double count both the reinvested cash flows and the growth that the reinvestment produces.

      • 3 Replies to doggydogworld
      • <<If NLS must reinvest 0.60 each year just to maintain the 1.00 EPS, then that 0.60 is not "true" earnings. True earnings in this case is 0.40. That reinvested 0.60 only adds to intrinsic value (and, over time, to the share price) if it produces EPS growth.>>

        well that depends what you mean by "reinvest". If they're spending it on capital costs or things like inventory and receivables then sure. And that should show up in the cash flow SEC filings. Eventually it should filter down to their GAAP results and sap their earnings bringing it down to the "true" .40 level.

        However if it's just accumulating in the bank as cash then it's still "true" earnings, even if it doesn't produce EPS growth (or rather, doesn't produce EPS growth over the risk-free bank interest). It'll sap ROI and eventually there will be pressure on the company to either invest it better or return the money to investors. But at a minimum the stock should go up dollar for dollar with the cash holdings.

        If it produces EPS growth then it should go up *more* than dollar for dollar, it should go up proportionally with the existing price/book ratio which is well over 1 (currently 2.12) indicating investors think NLS can produce better returns than risk-free bank interest.

      • Thanks! & Here we go.

        To keep things (relatively) simple, assume that NLS just keeps reporting flat earnings of $35 million per year on sales of about 460 million. We're after the stream of cash dividends that the company *could* pay out under those conditions.

        The biggest issue is probably capex vs depreciation. Historical average capex for NLS is about 3% of sales. Depreciation is presently running just about 2.4%. If we bump up the depreciation charges to 3%, we have to take 2.75M per year from the reported earnings above. The 3% value came from a period of earnings hypergrowth, so I'd argue that it's a conservative estimate even as product lines change over time.

        Checks in the Mail
        Next, receivable lag has grown from 30 days (Q3'02) to 45 days (Q3'03) and will probably swell up to 60 days as the retail segment grows. The extra 15 days will get sucked permanently into equity so it's effectively a one-time charge against *owner* earnings. 15 days of sales comes to about 17 M. (Silver lining: for the same reason (retail), the inventory held by Nautilus itself has and will probably continue to decrease.)

        Does Nautilus Group depend on purchase of an endless stream of new brands? No, I don't think so, not to maintain earnings at $1. In fact their existing stable of brands is already helping them expand into retail. Will management just buy things for no reason? Well, I hope not. Something to watch, certainly.

        The resulting hypothetical cash flows I get are Y/E 2003: $2 (cash on hand) - $0.50 (cash set aside for swelling of AR) = $1.50
        2004: $1
        etc: $1.

        So I think NLS can maintain their sales and earnings, and fund conservatively-estimated capital spending even if they were required to mail out $1 per year dividends. Probably a good deal for longs (7% of the share price). Probably a bad deal for shorts as I've claimed already.

        What if the opportunity arises to grab more sales at the same 7.5% net margin and capex running at 3% of sales? Ignoring additional one-time charges to owner earnings, and assuming they don't acquire any more damn companies, 110 M in sales pays 8.25 M in earnings ($0.25 EPS) while leaving capex funded. We can't grow sales 24% while paying our full dividend. But it won't cost any more than the 32M owner earnings to gear up. So even if we put the entire dividend into non-cash retained earnings, it's possible financially (and historically) to grow 24% in one year. We increase the future earnings stream by 24% less the discount rate -- net 15% or more increase in present value if we accomplish it in just one year; perhaps more like 8-10% if it takes two.


      • You bring up an interesting point. And this always the case with stocks. GAAP is not necessarily a good measure of the owner's share of earnings. Sometimes it's better to look at changes in cash & cash equiv. In NLS's case, the change of cash and cash equiv for the year ending September was just under $26 million. If you divide that by the current market cap, that gives you a yield of 5.75%. Since this deducts dividends we'll have to add that in as well. 5.75 + 2.9 = 8.65%. (It's also to note that the debt level has not increased.) This is the current yeild that owners enjoy by owning shares of NLS. So, basically if you agree with shorts you think this yield is going to go down. In terms of long term investors, if you agree with longs you think this yield will either stay the same or go up.

    • Come on flea, you know as well as everyone else on this board if they beat in January the short side is the wrong side. It might be a big if but the economic news throughout the fourth quarter sure sems to point to a potential surpprise to the upside..

    • o stop it your making me dizzie with all that spin most shorts will be at the big party at the flea cirsus you and the rest of the bagholder are invited we will have a soup line we will even buy that lump of coal you all have we know how to trun it into gold!!!!!!!

    • lol you're right flea. Shorts have finally become the bagholders. And no matter how much lipstick I offer them (tax savings, margin cost), the short pig is gonna spend the New Year sitting all alone, sitting by the phone.

    • "Note for Nerds"

      once again data boy has it wrong (or the way he wants to spin it)it should read note bagholder!!! he has put so much lipstick on this pig it can't even hold it head up anymore!!!!

    • i dont know what the academe definition of a squeeze is, but i think you're on the right track. the extreme volatile of this stock above $15 makes it clear that shorts have one eye on the exit

    • Yeah, I agree. I think we're approaching a decision point for shorts. At $13.50, and with tax year 2004 just weeks away, many of the pre-crash shorts are still making money by having the guts to hang on. We gotta give them credit.

      But in January, tax-deferment starts to cost money again. Shorts below $40 will be losing money by hanging on even at $13.50. If the share price also remains up a point in a January rally then all shorts will be losing money by hanging on.

      If that happens, then it won't be a question of guts anymore. Just crowd control. They'll all want out. I betcha short interest falls to 3 million shares before the end of Q1.

    • Astral, I agree that it's a factor, just not the only factor. I wouldn't be surprised to see a lot of short covering in Jan due to the tax factor. Let's hope so. The smart shorts may cover before Jan, becuase there is the possibility of squeeze.

    • joker_78_21:
      >If shorts no longer think that the share price is going down, they will cover.

      I don't quite agree, joker. Maybe I can give you a better answer (or at least the same answer but skipping fewer steps).

      Your point makes perfect sense for longs. Holding a long position ties up money. So if we no longer think that the share price is going up then we will sell.

      But it works backwards for shorts. They haven't bought, they've sold. So they get money up front, although it's stuck in escrow at first. But as soon as the stock price falls (October '02), cash is released from escrow. They can invest all that new cash, so long as their short position remains *open*. But *closing* the position will tie up money. (Not immediately, a few months later at tax time.)

      And that was doggydogworld's point a couple of weeks ago: If shorts feel comfortable that the stock price isn't going anywhere, they'll tend to sit tight. If their unrealized gains per share are high enough, they'll even pay dividends to sit tight. A lot of them have been doing that for the better part of a year.

    • I'm not insisting that all shorts will pay such close attention to the cost of keeping their positions open. I'm just sharing an estimate of that cost. Sure, increasing share price is factored into that estimate, but so is the value of deferring taxes.

      I believe that many shorts are at least aware enough of taxes that they've avoided covering this autumn. Short-term capital gains are still a big bite.

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