IPO Confidential: Short This High Flyer for Educational Trading Gains

This week, Cash spills the beans on an unexpected short play. It's a red-hot name that investors have loved so far, but with hidden issues lurking below the surface.

In the strange world of trading, good news can be bad news if it isn't quite good enough... and if that doesn't make sense at first glance, just read on and Cash will explain.

Warm Regards,

JL

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JL: So what did you think of that holiday-shortened week? There was some movement here and there, but activity overall felt pretty light.

CASH: My corner of the market performed just as expected... After a recent burst of action, there was a real drop-off of activity in the new issues market. In fact, there was only one IPO and four secondaries barely worth noting last week. The IPO was Safe Bulkers -- another shipping name -- and I was lucky to keep it from blowing up on me.

JL: That's interesting, because it seems the shippers caught a bid in the last few trading sessions. Dryships (DRYS:NASDAQ) and Diana Shipping (DSX:NYSE) were both up a couple percentage points after big drops not long before.

CASH: Yep. But the funny thing is, short-term strength in the shipping names actually helped the Safe Bulkers (SB:NYSE) deal get done. If they had tried to bring the same deal the week prior, there might not have been enough buyers to prop it up.

JL: So is Safe Bulkers a good short play then? After all, you mentioned some short ideas for the roster this week.

Previously in the Cash McDash series:

Peeking Behind the Curtain With Cash McDash

An Ocean of New IPOs

Playing the Blinds With Cash McDash

Cash Tours the Dark Side

The Beginning: Introducing Cash McDash

CASH: At first blush, it has all the makings of a good short play. The deal had a tough time getting through. SB actually priced at $19, below the established range of $20-$22. The underwriters had to dig deep to find buyers; less than a day before the pricing, there still wasn't enough demand. I got all the shares I asked for, which, fortunately, wasn't too many.

JL: Sounds like just what you would look for in a short. And yet I sense hesitation.

CASH: It's a fundamentals thing. The company itself is profitable, and management has already laid out a dividend policy. At this point, investors in SB can expect to get $1.90 per year in dividends. That means it has a 10% yield at the current price. As an investor, you don't want to buy blindly just for the yield. But as a short seller, there are times when a strong yield is enough reason to stay away.

JL: Okay. So for the record, Safe Bulkers is a "no-go" for now. You're not crazy about buying it but nor would you go short.

CASH: Exactly. So moving on, how about I tell you what I would do in this environment. I've got a few short ideas up my sleeve, all broad and liquid enough for readers to get a piece of.

JL: By all means. What've you got?

CASH: First let's quickly revisit the basics of a good short in Cash's book. For one, I like to see a strong amount of optimism and excitement already priced in to the name. The idea is to get a situation where most everyone who would be interested in the stock has probably already bought. This should be a name that has tantalized investors to the point they couldn't resist.

JL: Sure. You like to ask the question, "Who is left to buy?"

CASH: That's the question. Next, I want to know what could cause the optimistic sentiment to change. After all, we're not going to step in front of a freight train just because we think it's traveling down the track too fast.

JL: And that's the "catalyst" concept. Nailing down a reason for sentiment to change. Maybe an event, an economic shift, an earnings report, or what have you.

CASH: Exactly. And finally, I like to see confirmation from the actual stock price. This gives me evidence that my analysis is correct before I put my trading capital at risk.

JL: So now that we've done a refresher course of the basics, how about the first idea.

CASH: Sure. The first one to check out is New Oriental Education and Technology (EDU:NYSE). This company operates in China (as you might have guessed) and teaches English to school-aged youth. Typically, the company's classes are scheduled during traditional semester breaks, when students aren't enrolled in normal studies. Since speaking English is seen as a critical advantage, the classes are very popular.

JL: I bet. And talk about a sizable market! Sounds like it could be a gold mine for profits.

CASH: It has been. That's why investors got so excited about owning the stock. And now the company is expanding its mandate, offering classes to help students prepare for the National College Entrance Examination, the Chinese equivalent of the American SAT. Students also call it the gaokao, or "the big test." The gaokao is mandatory for all prospective college students in China, and there is big money in offering prep classes.

JL: Hmm. That sounds like a good thing, but I'm sensing your concern again. Maybe the company is stretching itself thin, burning cash and pushing into new competitive areas prematurely?

CASH: That's one of the concerns that I have. The other big concern is the fact that EDU has begun to beat its own sales and earnings guidance by extraordinary amounts.

JL: Isn't that a good thing?

CASH: It's a wonderful thing. But a string of big scores leads to big expectations -- sometimes too big. To give an example, management told analysts to expect revenue growth of 22%-28% for the most recent quarter. This view was reaffirmed halfway through the quarter, so investors were pretty sure the range was accurate. But when the numbers came in, it turned out that revenue growth was over 46%.

JL: Wow. That's more than double the lower end of the estimate -- a home run. But every cloud has a silver lining, no doubt, which is why you're presenting this as a short idea.

CASH: Yes indeed. After that big surprise, management revised their guidance for the next quarter upwards. EDU is now guiding for revenue growth of 29%-34%. But can you guess the range analysts are going to expect?

JL: Well, if last time the company said 22%-28% growth and it finished with 46%, I imagine analysts would look for growth of 50% or more this time -- a healthy bump up from the party line.

CASH: Exactly. We've seen companies where management loses all credibility because they say things are fine, and then the numbers come out horrible. This is the inverse, where few believe management projections because they've always been too conservative. Now, any time management gives guidance, investors expect them to sharply outperform the given number.

JL: And there's the Catch-22, or should I say Cash-22. The first time EDU's numbers merely match the forecast instead of exceeding it, the stock could drop hard. On top of that, it's inviting new competitive pressure by expanding into uncharted waters. And as I pull up an EDU chart, it looks like the drop has already started.

CASH: Bingo. The stock broke down through an important level last week, even as much of the market was trading higher. Volume on the break was strong, too, so I would say the process is underway.

JL: So does that mean you're on the record for a short call on EDU here, with the stock around $65.75?

CASH: Sure, I'll put my name on this one. Or Cash's name, anyway. This is exactly the kind of situation where anonymity is key. I still do plenty of good business with the guys who underwrote this stock a few years ago. Despite the fact EDU is an established name, they would be pretty upset if I showed up on the record shorting it.

JL: Not to worry. Your mild-mannered, secret identity is safe. How about moving on to the next pick?

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CASH: This next one is a little controversial, too (as you might expect). A lot of investors got really excited when the IPO hit last year. While it's not quite ready for a trigger pull just yet, the stock is showing all the makings of a good short play in the near future.

JL: So you gonna keep playing games or give out the name?

CASH: I'm getting there! Sheesh. The company is VMware (VMW:NYSE).

JL: Sure, I know the company. It was a spin-off from EMC last year, big in "virtual software," or something like that. A lot of investors booked huge profits holding that stock after the IPO.

CASH: Yeah, no kidding. Some traders did pretty well on the long side, too - like yours truly, for example.

JL: Ah yes, I should have known. This is one of your "coming and going" type plays, where you first make a killing on the upside and then prepare to do it again on the way down. Thinking back to last years, I don't remember you telling me you were in VMware, though.

CASH: I don't remember you asking.

JL: True, true. And I guess the old saying "loose lips sink ships" really applies in the trading business.

CASH: No doubt.

JL: I'm especially curious to hear why you want to short VMware right now, though. It seems to still have buzz around it, as does big tech in general. Only thing is, we're running short on time now and I don't want to make you rush the details. Since VMW is still setting up and not ready to short just yet, maybe we can dig into that next week.

CASH: Sounds good. And also, just so you know, I only see two deals on the calendar for the days ahead. It's looking more and more like the upside window is closing, which means it's time to start pressing the short bets a little harder overall. That's fine with me, of course, as I love making money on the "dark side."

JL: Who other than a trader could get warm, fuzzy feelings about shorting? I know just what you mean, though. So next week we'll get into the VMware story, and talk more about how to win big when the market is getting whacked.

CASH: That's the plan. Catch you next week.

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