Can These 2 Heavily-Shorted Stocks Bounce Back?

Every two weeks, data is released on the level of short interest in specific stocks. You can find this data in places like the Wall Street Journal, for example. It can clue you into possible problems ahead, but it can also spell opportunity. If the short-sellers are wrong, you can make some serious money, as those bearish investors will need to buy back their borrowed shares.

In recent months, technology investors have been focusing on a pair of companies they feel are ripe for a fall. Let’s look at what they believe and try to assess if they’re on the mark.

Advanced Micro Devices (NYSE: AMD)
This chip maker is in a real tug-of-war. Some analysts believe shares are quite undervalued, as the company may be poised to deliver stronger-than-expected results in coming quarters. Still others see AMD in decline, noting that it may finally soon succumb to a long-standing battle with industry titan Intel (Nasdaq: INTC).

AMD’s bulls think the company’s new chip offerings — one that combines graphics capabilities on a core processor and another that is optimized to help servers run in a faster mode — could help rebuild lost market share. [I ran through the bull case for AMD in this article.]

Since then, a few more analysts have started to sing the company’s praises. For example, analysts at Sterne Agee raised their rating from “Hold” to “Buy” in early February with a $15 price target (nearly double current levels), predicting that AMD will steadily take market share from Intel this year after ceding ground the past few years. Analysts at Citigroup recently noted that signs are pointing to a strong second half for PC and server spending, predicting AMD will deliver quarterly results ahead of forecasts.

Short-sellers see a completely different picture. They question whether AMD will really take market share simply based on a strategy of technological parity with Intel along with lower selling prices. They figure Intel can simply cut prices on its chips if it starts to see any market share erosion. And in a price war, mighty Intel always wins. The shorts also presume the abrupt departure of Dirk Meyer, AMD’s CEO, in early January — right as the company was on the cusp of releasing major new products — was a sign that undisclosed problems lurked beneath the surface. Lastly, they think tablet computers such as Apple’s (Nasdaq: AAPL) iPad will sharply erode demand for traditional laptop and desktop PCs.

In this battle, I believe the bulls have a stronger case. AMD continues to secure many new customers for the two new chip designs and results in the second half are indeed likely to start reversing the recent trend of flat or negative sales growth. Much of that view resides on a steadily improving U.S. economy. Employment trends are looking better, which is often a pre-cursor to an upgrade cycle for PCs among corporate customers. There’s no reason why Intel and AMD can’t both flourish if the backdrop is broadly positive.

I also discount concerns about the Meyer’s departure. If something deeper was amiss, we would have heard about it by now. Indeed, the company’s subsequent conference call, which was held three weeks after Meyer left, gave the impression of a very stable ship. The announcement of a new CEO could be one the reasons that short-sellers may look to cover their positions. Lastly, concerns that tablet computers will cannibalize PC sales may be overdone. These devices are great as secondary access devices, but few corporate staffers are going to sit at their desk typing into tablets all day.

My relatively bullish view for AMD, if it comes to pass, means short-sellers will morph into furious buyers to close out positions. They held 64 million shares short at the end of February, which stands as the eighth-largest short position of any company’s stock. The only caveat to this short-squeeze scenario: It remains unclear how the crisis in Japan will affect the PC industry; you may want to wait a few weeks to let that situation clarify before jumping in.

Sprint Nextel (NYSE: S)
Short-sellers are really taking their shots at this wireless phone service company, holding more than 100 million shares short. Sprint has some hard choices to make as it figures out how to better compete with industry giants Verizon (NYSE: VZ) and AT&T (NYSE: T).

To bulk up, Sprint may enter into talks with T-Mobile, the industry’s fourth-largest player, according to the rumor mill. Trouble is, the two firms use different wireless technologies and would have a major integration effort to complete. Sprint already did that when it acquired Nextel in 2004. That deal made Sprint larger, but the combined company got bogged down with transitional problems and many customers defected. Short-sellers predict a deal between Sprint and T-Mobile will bring the same problems and also create a lot of new debt on the balance sheet. It’s also worth noting that Sprint’s heavy investments in Clearwire (Nasdaq: CLWR), a leading provider of high-speed wireless service, now looks like a big money loser.

Most telecom industry analysts think the deal would make sense for Sprint, figuring that technology platform integration issues are not as onerous as they were with Nextel. They’ve been talking up the stock recently, and it is up to $5 again. Yet the short-sellers still may hold the upper hand. T-Mobile’s backers, Deutsche Telecom, have expressed a very stiff — and seemingly unrealistic — asking price for T-Mobile. Investors may be unpleasantly surprised by an agreed-upon price that makes it hard for Sprint to ever get out from under its massive debt load. Without a deal, Sprint also looks to be challenged, as it shifts focus to a more economically-challenged customer base that pre-pays for cell phone usage.

Action to Take –> So what can we learn from this exercise? Well, if you’re looking for a long idea, AMD appears the safer bet.

Despite myriad challenges, AMD looks increasingly well-equipped to fight back against mighty Intel. Incremental market-share gains in coming months could create a positive cycle as more potential customers hear that it’s “safe” to go with AMD. Even if Intel fights back on price, positive reviews from a performance perspective should help AMD’s chips to make further inroads.

Sprint, on the other hand, looks messier. The company may be on the cusp of a “Hail Mary” pass to try to close the gap with bigger rivals. But many Hail Mary passes land with a thud — or are intercepted. Short-sellers appear closer to the mark with this play.