RealMoney Silver - A Short Trip Down RVBD

A Short Trip Down RVBD
By Jonathan Moreland
RealMoney.com Contributor
1/16/2008 4:11 PM EST

Ideally, one would initiate a short position on a stock as it spikes intraday in what in hindsight, proves to have been the blow-off top for the security. Alas, using insider sales to find the perfect short is a frustrating task. Insiders selling as a stock hits new all-time highs is one of the most common types of selling activity I see. At least half of the time, the stock powers higher despite the sales.

This doesn't mean insider data aren't good for shorting. While it may just be human nature for insiders to sell shares at new highs, it is definitely not intuitive that insiders would continue selling their holdings as their stocks sink. But this raises the question, does such activity warrant shorting the company?

Insiders selling significantly into a share-price decline is the basis for one of the screens I run each week in my InsiderInsights newsletter to identify stocks to potentially short. Riverbed Technology (RVBD) has been a frequent entry as of late.

Loss of Faith

Anyone who has been an employee of a publicly traded company with a stock hitting new highs knows the sense of giddiness there is around the office when everyone's options or direct holdings have boosted fortunes yet again.

Hopes spring eternal for second houses, large engagement rings and Ivy-League tuition for the kids. Who knows what the vagaries of the stock market will bring? Selling into new highs locks in the dream -- and who can blame insiders for doing so?

But the real faith insiders have in a company's prospects is exposed when these dreams start to unravel as a result of a firm's stock falling markedly from its highs. Do insiders panic that even reduced dreams will vaporize if they don't sell now, or do they exercise patience that their full dreams can be realized by waiting to sell after an expected recovery?

In my experience, significant insider selling in a stock that has weakened convincingly from its highs is a huge red flag. It shows a troubling lack of faith in the stock's ability to rebound by the people who should know. Riverbed has this sort of troubling insider-selling profile. And besides negative insider and technical metrics, it also still appears fundamentally expensive even after its fall.

Great Products, But Still Lofty Valuation

Riverbed makes wide-area data-service appliances that have proven very attractive to IT departments. Wide-area networks (WANs) may have greased the wheels of efficiency and collaboration within companies, but they offer new problems for tech managers in terms of individual-application performance, backing up data and integrating increasingly mobile road warriors -- among other issues.

Riverbed's "Steelhead" products address many of the concerns WANs generate, as evidenced by soaring sales. Revenue in Riverbed's third quarter increased 157% year over year. Growth for the first nine months of 2007 was a very impressive 184%.

Yet RVBD fell hard when the third quarter was announced last October. The stock has continued weakening since, and is now more than half off the all-time high of $52.81 it hit just before the third-quarter numbers were released.

What's the problem? It seems that Riverbed merely met third-quarter expectations instead of beating them. That's a sin to the growth-stock investors who had bid RVBD up to lofty valuations earlier in 2007.

Once a mo-mo stock's momentum is broken, it's tough to win back the overpaying-growth crowd. For they have figured out that one "bad" quarter often begets another. And with fears of an economic slowdown growing, it's hardly a stretch to imagine that businesses may need to slowdown their IT spending.

So, like other abandoned growth stocks, RVBD must wait for its valuation to come back down to earth before more value-oriented investors deem it worthy enough to support.

Looking for Some Positives

It is quite normal, however, for insiders to show some support for their beaten-up shares prior to it bottoming. This is usually signaled by a curtailing of sales, followed by open-market purchases.

For those insiders who reaped hefty profits from sales of their previously soaring stock within the past six months (thereby making them ineligible to buy shares in the open market due to "short-swing" restrictions), bullishness is often signaled by an exercise of options using the past profits -- and then holding on to the shares instead of selling them. This is a smart tax move if the insider expects their stock to recover in the coming year.

Alas, RVBD has none of these healthy indications of value from insiders. Instead, executives are overwhelmingly continuing to sell into their stock's decline.

Fundamentals appear to support insiders' actions. Despite RVBD's decline, the stock still trades for 29 times the firm's average EPS estimate of 76 cents for 2008. Considering that that estimate only represents 19% earnings growth, RVBD appears far from even being able to justify itself on a simple P/E/G basis. And that assumes that estimates won't be lowered as a result of any economic slowdown.

So there are two ways to win on a short of RVBD: multiple contraction or estimate reduction. At least one of these negatives appears likely. I may have missed a heck of a lot of downside in the stock already, but there is plenty more that seems not only possible but probable.