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Short Stories: Bradley squeezes the shorts

Posted Oct 8th 2006 8:45AM by Peter CohanPeter Cohan RSS Feed
Filed under: Short stories

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Although short selling -- the practice of selling borrowed shares with the hope of repaying the loan by buying back the shares at a lower price -- goes against the American belief that stocks always go up, I have long been fascinated with it. My plan for my new blog series, Short Stories, is to discuss what works, what doesn't, and what some of the leading lights in shorting stocks think about its opportunities and threats. I will describe possible short trades and I'll seek your comments and questions for story ideas. I won't be offering any investment advice and I won't trade on any of the posts I write.

Bradley Pharmaceuticals, Inc. (NYSE: BDY), which acquires and markets products that are too small for big drug companes such as treatments for acne, foot fungus, warts, dandruff, and intestinal problems, has attracted significant short interest. And those shorts are getting badly squeezed. While they have a good case on the fundamentals, there is too much smoke and not enough fire to make the stock go down. I would stay away from BDY altogether.

On the surface, things don't look too bad for Bradley. In the most recent 12 months, it earned $10 million on $143 million in revenues and at the end of June it held $47 million in cash. With a market capitalization of $289 million its stock is up 56% in the last year and it trades at a trailing P/E of 26.5. It could be argued that these shares are overvalued because five analysts who cover BDY predict that its earnings will grow a mere 2.6% from 77 cents/share in 2006 to 79 cents in 2007. But overall BDY does not appear to be in crisis.

The issue with Bradley is a battle over corporate governance. And it's a battle which pits a significant level of short interest -- 4.7 million shares short -- or 27% of BDY's common shares outstanding -- against its biggest shareholder -- Roark, Rearden & Hamot Capital Management, LLC -- which owns a 9.3% stake (1.6 million common shares). Roark manages the Costa Brava Partnership which is agitating to elect a slate of three independent directors to remedy corporate governance problems at BDY.

Do the ills against which Costa Brava and others are railing form the basis for a profitable short position in BDY? In a word: no. Based on my analysis, the factors favoring those long the common -- high margins and cash flow, strong sales growth, and a stock price turnaround -- outweigh those favoring the short sellers -- vulnerable future revenues, poor corporate governance, questionable accounting, and high product returns.

Inherent in this debate is a big irony. Although those who sold short 4.7 million BDY shares have not articulated their rationale, it would not surprise me if Costa Brava and the shorts shared overlapping critiques of BDY. But Costa Brava is profiting from these ills through a public proxy fight in which it may have the tacit support of other hedge funds. By contrast, the shorts are being relatively passive -- hoping that the negative fundamentals they cite will eventually shrink BDY's stock price.

Here are some reasons why the stock could rise:

  • High margins and cash flow. At 85%, BDY's gross margins are still quite high and its net margins have increased from 0.6% in the second quarter of 2005 to 12.6% in this year's second quarter -- hence its free cash flow, at $30 million in the most recent twelve months, is up 24% since 2005.
  • Strong sales growth. BDY sales grew 17% to $71.2 million in the first half of 2006. This increase masks wide variations in the performance of individual products. For example, BDY's acne products saw sales increase 132% to $10 million abetted by a product from Bioglan Pharmaceuticals, which BDY acquired in 2004; whereas BDY's respiratory product sales declined 35% to $1.3 million.
  • Stock price turnaround. Although BDY stock trades 40% below its June 2004 high of $28, it has gained 77% since its April 2005 low of $8.94. Moreover, BDY has risen about 60% since June 2006 when Costa Brava began its public campaign to increase BDY's stock price.

Here are some reasons why the stock could fall:

  • Vulnerable future revenues. The 17% revenue growth cited above is hardly guaranteed to continue. According to my source, only one of Bradley's drugs (Solaraze) has patent protection. All of the others have been attacked by generics. And those drugs are not glamorous -- they often are simple urea-based compounds used for dry skin and hemorrhoids and other common ailments. One bearish analyst went so far a few months ago as to say, in the headline of a research report, that BDY is "a broken business model."
  • Poor corporate governance. Costa Brava has rattled BDY's cage for poor corporate governance. It notes that Dan Glassman is both BDY Chairman and CEO with two classes of common stock. The Glassmans own the class with all the power and hold less than10% of the other class. There's nepotism -- Dan's wife Iris is a BDY director and Treasurer and their son Bradley -- and company's namesake -- is BDY's Senior Vice President of Sales and Marketing, who received the second highest pay of BDY's executive officers in 2005. Moreover, BDY failed to hold an annual meeting in 2005 and it engages in self-dealing -- to wit, BDY leases 33,000 square feet of Dan and Iris's New Jersey office space.
  • Questionable accounting. In 2004, the SEC investigated BDY's revenue recognition practices. Then after restating BDY's financial results for the third quarter of 2004, BDY announced on July 19, 2006 that it would be restating its financial results for the first quarter of 2006.
  • High rate of product returns from distributors. BDY's product returns increased 163% in the second quarter of 2006 to $8.5 million. BDY explained that two of its distributors, Cardinal and McKesson each reduced its inventory of BDY's products under a new contract. This may not be the worst of it -- Costa Brava believes that BDY's accounting for these returns is murky and that the actual products being returned were sold many quarters ago.

Ultimately BDY's short-term stock performance comes down to a simple matter of supply and demand for its common shares. Costa Brava has at least five other hedge funds on its side -- Timesquare Capital, Corsair, Dimensional Fund Advisors, Pequot and Galleon -- which together own a significant long position -- about 39%. Moreover, this week BDY management obtained a waiver from its lenders to buy up to $21 million worth of its shares on the open market.

As demand for BDY shares increases, its price rises -- compelling many shorts to cover their position by buying BDY shares -- which puts further upward pressure on the stock and creates a short squeeze. Unfortunately for the shorts, there does not appear to be an imminent triggering event that would make the shares tumble.

But since the shorts' fundamental negatives are compelling on a longer term basis, it is hard to see the case to own these shares.

I'd stay away from BDY altogether.

Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm, and a Professor of Management at Babson College. He has no financial interest in Bradley.

Tags: Bradley Pharmaceuticals, BradleyPharmaceuticals, short sellers, ShortSellers

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