Bear of the Month January 1999
UBid Nasdaq: UBID Short Interest Data
This month's column highlights a short selling strategy rather than a single
overvalued stock. The strategy requires establishing positions in two
companies: a short position in uBid Inc. (Nasdaq: UBID), the online auction
site, and a long position in uBid's parent company, Creative Computers Inc.
(Nasdaq: MALL).
Creative Computers owns 80% of uBid, yet the market value of uBid has totaled at least twice that of
its parent for most of the past month. This discrepancy means that investors purchasing shares of
uBid could obtain an equivalent equity interest in the company through purchasing shares of Creative
Computers for almost half the price.
One apparent reason for the discrepancy: Much of the trading in uBid shares seems driven by day
traders with extremely short-term time horizons. Like a surfer hoping to catch the biggest wave and
ride it until just before it crashes, a day trader wants to ride the prevailing price trend and dump his
position quickly -- within a few days, at most -- with a hefty profit.
The soaring stock price of eBay (Nasdaq: EBAY), the best-known online auction site, has created
investor enthusiasm for other online auction sites such as uBid. Creative Computers, however, does
not directly run an online auction site and thus does not receive the same investor enthusiasm. And
since its ownership interest in uBid does not make the day trader any money, its shares are ignored
in favor of uBid's, because that's where the price trend is strongest.
The gaping market inefficiency apparently produced by day traders provides an opportunity for short
sellers with a longer time horizon: Short uBid and partially offset the risk of the short position by
purchasing shares of Creative Computers. Each share of MALL includes an equity interest of about
0.7 shares of uBid. MALL has stated its intention to distribute its ownership interest in uBid no earlier
than June 1999. When this happens, the investor could use the distributed shares of uBid to close
out the short position.
Investors following this strategy would short uBid and purchase roughly one-and-a-half times as many
shares of MALL, thus owning an interest in uBid roughly equal to the short position. The risk of the
short position would be largely mitigated and the investor could profit by pocketing the difference
between the money received from shorting uBid and the cost of purchasing MALL. A hypothetical
example will clarify what might happen if everything worked according to plan:
1.uBid's starting stock price is $90 per
share.
2.MALL's starting stock price is $40 per
share.
3.Investor shorts 200 shares of uBid for
$18,000.
4.Investor purchases 300 shares of MALL
for $12,000.
5.In June, investor receives approximately
200 shares of uBid as a distribution
from MALL.
6.Investor uses the distributed shares to
close out the short position in uBid.
7.Investor sells the 300 shares of MALL.
Investor's profit equals $6,000 plus the
value of the 300 shares of MALL
(excluding transaction costs, margin
interest, and taxes).
The strategy described above appears to
produce a profit even if uBid shares rise
sharply, assuming the investor survives the
strain on his margin account and other risks
described below.
Even if the investor does not wait for the distribution of uBid shares from Creative Computers, the
strategy should prove profitable as long as the share prices more rationally reflect MALL's ownership
interest in uBid. Shares in the online auctioneer would either fall relative to MALL or MALL shares
would rise much more rapidly than uBid. In either case, the investor that is long MALL and short uBid
in the proportions described above should come out with a profit. The closer the date of distribution,
the more one would expect that each firm's stock price would reflect MALL's ownership of uBid.
uBid's share price recently has fallen much more rapidly than MALL's, narrowing the gap between the
market value of the two stocks, so the strategy has proven profitable in retrospect. If the gap between
their market values continues to narrow, the strategy should remain profitable.
Shorting uBid and going long MALL does
possess significant risks (not to mention
substantial margin buying power and a
tolerance for price volatility). One is timing
risk. MALL has stated its intention to
distribute its shares of uBid to owners of MALL
stock not sooner than six months after uBid's
initial public offering. With uBid's IPO less than
two months old, over four months remain
before the expected share distribution -- an
eternity for Internet stocks.
uBid shareholders have withstood one of the
wilder rides of the Internet stocks. The stock
closed at $188 per share on December 23,
only nine trading days after closing at $33 per
share. After rising $56 on December 23 alone,
the price plummeted $62 the following day.
Since then, uBid's stock price has trended
lower, dipping below $100 per share on
January 12.
This volatility could place severe strain on an
investor's margin account. A danger is that
during the four-month period before MALL's
expected distribution of uBid shares, the trading in MALL and uBid could remain unlinked. uBid's
share price could soar again, while MALL stays flat or falls, perhaps triggering a margin call that
might force investors to buy back the uBid shares at a large loss.
Another risk stems from a possible lack of uBid shares available for short sale -- the shares have
proven difficult to borrow. An investor may take a long position in MALL and then become unable to
establish the offsetting short position in uBid. If both MALL and uBid fell, the unfortunate investor
could find himself exposed to losses from a drop in MALL's stock price without the possibility of
earning a profit from the short position in uBid.
Yet another risk is the possibility that MALL does not distribute its equity in uBid, or delays the
distribution significantly. The investor then runs the full risk of a sharp increase in uBid shares without
being able to use distributed uBid stock to close out the position and avoid a large loss.
The investor wishing to make a profit from the fact that MALL's ownership interest in uBid is not fully
reflected in MALL's stock price could use the strategy described above, but should be aware that it is
still quite risky.
Finally, there is the question of valuation: Is uBid overvalued? If uBid falls relative to MALL, the
strategy described above produces intermediate gains. On the other hand, if uBid rises relative to
MALL, the strategy produces intermediate losses and places additional strain on the investor's
margin account.
The short answer is that uBid appears highly overvalued, and thus its stock price deserves to fall.
uBid sells surplus items by auctioning them on its web site. uBid does not boast the member
community that makes eBay unique among the online auction sites. Also, unlike eBay, uBid carries
inventory and bears the risk that it may be unable to sell its merchandise above its cost. The
business is also easily duplicated by another auction site with access to surplus merchandise.
Additionally, uBid faces strong competition from high-traffic powerhouses such as Yahoo!, which has
teamed up with OnSale to form an auction site. The sites that are able to attract the most bidders
should deliver the highest auction prices. These sites will be able to pay the most for surplus
merchandise, since they receive the highest prices at auction. Manufacturers with surplus items to
sell may also bypass uBid for more heavily trafficked sites in search of finding the highest bids for
their items.
uBid, like many of the Internet stocks, is priced with highly optimistic assumptions of future growth.
The company lost money in the most recent quarter and is valued at many times its current sales,
even though it expects to record profit margins only in the low single digits. In the face of intense
competition from other online auction sites, uBid may never achieve earnings that justify its current
valuation.
At the time of publication, the author maintains a short position in uBid and a long position
in Creative Computers, Inc.
The views expressed in this article reflect one person's opinion and are not intended as investment
advice. The information contained herein is believed to be accurate but may contain inaccuracies.
For a full disclaimer follow this link. beartracker.com
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