We know how risky short selling can be. It’s generally a more expensive practice due to borrow and margin interest, and the US stock market has a general upward bias. While it certainly has its place, the practice is a negative-sum game on the whole. In light of this, short selling requires extra conviction than a long position.
Today we’re talking about a recent short squeeze that left heaps of short sellers on the wrong side of the trade. The stock is Francesca's Holdings (NASDAQ:FRAN), a $41M women’s clothing retailer applying a fast-fashion model.
FRAN reported earnings on September 10th and was met with a multiplied share price at the next day’s open. In the span of five weeks, the stock saw a low of $2.78 and a post-earnings high of $19.49 before settling around the $15 mark.
Going into the earnings report, about 35% of the stock’s public float was sold short, according to NASDAQ data. A stock’s float refers to the number of unrestricted shares available to freely transact on an exchange.
Shorting microcaps like FRAN is one of the most popular strategies deployed by short-sellers, because microcaps are generally characterized by declining operations and self-interested management.
In the case of FRAN, it’s a company in the declining retail industry with several consecutive quarters of negative growth.
Why Did Short Sellers Love This Company?
Unhealthy Balance Sheet
FRAN’s current liabilities outweighed current assets (known as negative working capital), leaving them unable to pay their short-term obligations. This makes it difficult for FRAN to finance their day-to-day operations because their cash is always being tied up in paying liabilities. Negative working capital makes it exceedingly difficult for companies to think further into the future. They’re forced to only think about paying the next bill.
The company’s current ratio of 0.88 is well below the retail industry average of 1.47, and is meaningfully below many of their peers in the apparel industry.
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Was Under Threat of Delisting
A huge catalyst for microcap short sellers is when the NASDAQ exchange notifies a company of their intention to delist them from the exchange. Most often, this is due to a low share price. The NASDAQ requires companies to have a minimum share price of $1.00.
When FRAN received a “deficiency notice” from NASDAQ, that prompted them to carry out a 12:1 reverse stock split, which merges shares together to make the per-share price higher. This doesn’t affect the value of the company because the shares outstanding are reduced proportionally.
Generally, when a company is forced to perform a reverse split, that’s a huge red flag to investors.
30+ Month Downtrend
For the better part of three years, the stock has basically acted as a melting ice cube: slowly losing value each month.
Combining the company’s weak balance sheet and fundamentals, it’s participation in a declining industry and the strong downtrend in stock price, it’s no wonder why such a large portion of the company’s public float is sold short.
What Happened September 10th?
Looking at the company’s most recent 10-Q, it doesn’t look that great. They’re still losing money and their comparable store sales declined. So what gives?
The stock market is a discounting mechanism, the market discounts all current information and the probabilities of future events into stock prices in a reasonably efficient manner. Essentially, the market had priced in the declining operations at FRAN (NASDAQ: FRAN) and made certain assumptions about the future. So in this case, while FRAN’s operations are still declining, they’re declining less severely than market participants thought.
With this context in mind, here are some factors that might have lead to gap up in FRAN’s stock:
- The company is reporting success with its turnaround plan announced in January 2019.
- Comparable stores declined 5%, which is a significant improvement over the double-digit declines they experienced in the last nine quarters.
- Shift to a data-based approach to inventory management to more efficiently apply a fast-fashion model.
Judging by the lack of move-in FRAN’s stock subsequent to the announcement of their turnaround plan, it’s clear that short-sellers didn’t take the company seriously.
FRAN was so downtrodden, there was hardly ever good news for the company and operations continued to decline. As a short seller, it’s prudent to realize that any positive news for a company like this can significantly move the stock and to factor this into your risk management strategy.
Holding your short position through an earning report in this type of company is especially dangerous. Because the sentiment is already so negative, further declining operations is unlikely to yield a large price drop, buy any positive uptick can lead to a short squeeze.
Companies Mentioned in This Article