Could These 3 Heavily-Shorted Stocks Profit from a Squeeze?

February 18, 2011 may turn out to be a notable day for investors. That’s when the S&P 500 hit a 30-month high. Since then, the index has plunged, rebounded and cooled anew, even as global conditions have become much more challenging. Throw in the fact that consumer sentiment and spending levels are dropping as gas prices rise, and we may not reach back to those February highs for the rest of the year.

At least that’s how short-sellers hope things will play out. They’re stepping up bearish bets, hoping the broader market will help their investment targets to fall in price. If they’re wrong and the market can power up to new highs, then these short sellers may be forced to close out those bearish bets and re-buy shares, unwittingly adding buying pressure to the very stocks they want to go down.

With that in mind, I’m looking at three stocks that are increasingly in the sights of short sellers. Each stock has seen at least a 25% spike in short interest in the two weeks ended March 30. What do the shorts see? And how will this play out?

1. Rite Aid (NYSE: RAD)
If you took a look at the stock charts of CVS (NYSE: CVS) and Walgreen (NYSE: WAG), you’d think the nation’s major drugstore chains are quite healthy. Both stocks are within striking distance of their 52-week highs. Yet the industry’s third-largest player, Rite Aid, is missing in action. The stock has been in a steady decline for more than a decade. Now, with shares at just $1, short sellers smell blood, boosting their position from 21 million shares sold short in mid-March to 69 million just two weeks later.

When you see such a low stock price and such a heavy spike in short interest, you should go straight to the balance sheet. Sure enough, Rite Aid is choking under more than $6 billion in long-term debt. Will that lead to bankruptcy, as short sellers may be expecting?

Rite Aid’s cash keeps slipping away, moving below $100 million for the first time in recent history in its fiscal fourth quarter ended February. It doesn’t help that Rite Aid generated $72 million in negative operating cash flow in the most recent quarter. But a cash crunch really isn’t at hand. The company has access to more than $1 billion on its credit line, and if recent quarterly guidance is to be trusted, then cash flow in the current fiscal year should be more than ample to rebuild cash back up above $100 million.

Yet it’s the big picture that short sellers may be eyeing. Rite Aid has a lot less margin for error if the macro landscape changes, so short sellers have taken note of Walgreen’s comments that massive state budget gaps means that Medicare reimbursement is slumping in many states. Walgreen and CVS could handle a drop in business if drug spending falls. Rite Aid probably couldn’t.

Yet there is a positive catalyst that could cause the short sellers real pain: Analysts at UBS note that Rite Aid is quite undervalued based on recent industry deal-making trends. If Rite-Aid were acquired at a similar valuation to Walgreen’s September 2010 acquisition of drugstore chain ApothecaryRX, its shares would zoom from $1 to $4. Is such a deal in the offing? Not likely in the near-term, but it makes it awfully risky to short this stock.

Keep an eye on Medicare reimbursement rates. If they drop by a meaningful amount, then the short sellers will be vindicated as Rite Aid’s debt-laden balance sheet finally crushes the equity.

2. Home Depot (NYSE: HD)
This is an unusual play for short sellers. The housing market debacle has been widely chronicled — and digested — and this do-it-yourself retailer remains a cash flow powerhouse, despite the horrid housing market. Moreover, recent spikes in employment trends imply that an increasing number of consumers will be able to embark on home renovations once they have a stable employment picture. As a vote of confidence, the retailer recently announced yet another stock buyback program.

So why did short interest just spike from 15 million in mid-March to 38 million in the two weeks ended March? I can think of several reasons. First, the quick rise in gasoline prices reduces consumers’ discretionary spending power and also leads to fewer purchases of non-essential items. That puts forecasts at risk. The second, and more likely reason, is simply that this is becoming an expensive stock after rising from $28 last September to a recent $38. Shares trade for more than 16 times projected fiscal (January) 2012 profits, which is pretty high for a company that is seeing sales growth of just 3-4%.

The stock buybacks help the bottom line, but it is clear shares are anticipating better days to come — a lot better. Will the housing market turn up in the next year or two? That’s what bulls are counting on — but short sellers of this stock are betting Home Depot’s outlook will remain constrained for an extended period.

3. Charles Schwab (Nasdaq: SCHW)
Lastly, I’d note that short interest rose 25% in this discount broker in late March. Schwab is a likely proxy for the broader market, as any pullback from the massive two-year surge would dampen the company’s profit forecasts. Right now, analysts are expecting earnings per share (EPS) to more than double to $0.81 this year and rise another 40% in 2012 to $1.14. Yet if the market doesn’t keep grinding higher, those profit forecasts may prove way too aggressive.

It all comes down to interest rates. Schwab makes more money when rates are higher because it earns better spreads in its money market funds. If rates rise later this year (as some increasingly suspect), short sellers will suffer real pain. If rates stay put, shorts may be onto something here.

Action to Take –>
These three plays come down to the broader market. Any further market gains would likely lift these stocks, forcing short-sellers to cover their positions, creating even more buying pressure. This could lead them to outsized gains relative to the rest of the market. Yet if you are already long these names, you’ll need to dig even deeper to be sure that short sellers don’t know something you don’t.

P.S. — Few investors realize that a 20-year energy agreement between the United States and Russia is about to expire. This deal supplies 10% of America’s electricity. As broke as our government is, the situation is so serious that President Obama is asking for $36 billion to avert this crisis. And Republicans support him. Here’s what’s going on…