Martha Stewart Bears Gnawing on Paws

New short-selling rules appear to fuel a rally.
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With the prospects for Martha Stewart's namesake company improving, investors might believe recent gains in the stock are a sign that Wall Street considers it a good buy. Such investors would be wrong.

In fact, analysts are overwhelmingly bearish about the stock's towering price. Recent positive headlines about Stewart, in the highly publicized atmosphere surrounding her travails, have lent upward momentum. But in a twist resulting from a technicality in the mechanics of the stock market, Wall Street's overwhelming skepticism is actually pushing the stock higher.

Shares of

Martha Stewart Living Omnimedia

(MSO)

have soared 24% in the past three weeks, with over 9% of that gain coming in the past two days. Meanwhile, the verdicts from five Wall Street analysts who rate the stock range from underperform or underweight to strong sell. It ranks high up on Thomson First Call's weekly list of the lowest-rated stocks with a following of analysts.

The pessimism stems from the media and publishing company's euphoric valuation. If its estimated loss for 2005 were magically converted into a profit of the same size, its stock would now be trading at roughly 89 times earnings. With media mavens like

Time Warner

(TWX)

and

Washington Post

(WPO)

trading around 24 times estimates, the price of Martha Stewart Living, with its disgraced founder serving a prison term and its bottom line awash in red ink, appears outlandish.

So who is buying the stock and why?

Some traders are going long Martha Stewart, hoping for a short squeeze on the stock as the sizable crowd of bears following it abandon their short positions due to a new securities regulation. The regulation, instituted by the

Securities and Exchange Commission

early this year, is designed to crack down on an abusive short-selling practice known as naked shorting.

Short-selling, or selling borrowed shares in hopes that the price of the stock will go down so they can be replaced later at a cheaper price, is a common, legitimate and sometimes highly profitable practice on Wall Street. However, when traders place short bets before bothering to actually borrow shares -- or even making sure shares will be available for borrowing -- it's known as naked shorting. It results in the total number of shares sold short on a stock exceeding its float -- the total number of shares available for trading. Essentially, naked short-sellers are trading shares that don't exist.

In order to curb this practice, stock exchanges are now required to compile a so-called threshold list of heavily shorted stocks that are more likely to be involved in naked-shorting transactions. A trader looking to place a short bet on a stock in the threshold list is either turned away by their brokers or forced to pay a premium price when shares are available to borrow.

Martha Stewart Living has now been listed on the

New York Stock Exchange's

threshold list for 17 days, and some traders have concluded that as investors are no longer able to short the stock, bears will start abandoning their positions out of fear that others will do the same. The result would be a short squeeze, a rapid gain in the stock as short-sellers are forced to buy the shares at higher prices to stem further losses.

As traders anticipate this phenomenon, they bid up the stock. In other words, excessive bearishness on Martha Stewart Living has led to even more upward momentum on the stock, thanks to the new rules.

Stephen Monticelli, president of Mosaic Investments, took a long position in Martha Stewart Living recently with all this in mind, and he profited handsomely.

"There's always some conjecture involved when you're talking about why a stock went up, but I think it stands to reason that

the threshold list had something to do with it," Monticelli said. "I don't know anyone who is long on that stock based on fundamentals at this valuation."

To be sure, shares of Stewart's company have recently benefited from the media frenzy surrounding Martha Stewart, the domestic diva who was imprisoned for lying to investigators about the timely sale of her stake in

ImClone Systems

(IMCL)

. When Stewart is freed, she is slated to star in a syndicated, daily TV show, as well as a prime-time show with NBC produced by Mark Burnett, who is known for his spectacular success with reality-TV shows such as

Survivor

and

The Apprentice

.

The shows have big potential in light of Stewart's name recognition and the controversy surrounding her, which has only been elevated by her brush with justice. The company recently attracted a well-known entertainment executive, Susan Lyne, as its chief executive. Its recent decision to shed nearly all its online and catalog operations should help earnings. Also,

Kmart's

(KMRT)

planned acquisition of

Sears

(S) - Get Report

stands to boost the company's most profitable venture, its merchandising partnership with Kmart.

On the basis of these developments, William Blair & Co. analyst Alissa Goldwasser recently upped her outlook for the company in 2005, predicting a loss of only 38 cents a share for the year, down from her previous estimate for a loss of 75 cents a share. She increased her outlook for the publishing division's ad sales by 17%, doubled her outlook for the company's television revenue and lowered her expense estimate by 9%.

Goldwasser also "dramatically" improved her outlook for 2006, when analysts expect the company to return to profitability with earnings of 18 cents a share, but even all these improvements fall short of supporting today's astronomical valuation.

"We are skeptical that the company will be able to return to its prior money-making stature," Goldwater wrote in a recent research note. (She has no position in the stock, and her firm has no banking relationship with the company.)

Bear Stearns analyst Michael Meltz pointed out that even if Martha Stewart Living rebounded to its peak performance in 1999, today's price would still value it at 54.3 times earnings, more than double that of its peers. (Meltz has no position in shares of Martha Stewart Living, though his firm makes a market in the stock. It has no banking relationship with the company.)

"Short-covering has likely led to most of the recent price gains," he said in a recent research note. "In addition, the market (possibly retail investors) may have overly optimistic expectations as to what the new year may bring for the company, in our opinion."

In another ominous sign, an investment company run by one of Martha Stewart Living's directors, Jeffrey Ubben (who was recently replaced as the company's chairman), has been selling chunks of its controlling stake in the company. In December, ValueAct Capital Partners, where Ubben is a managing partner, sold a total of 475,000 shares of Martha Stewart Living worth $13.7 million, according to disclosures. In November, the company sold 2 million shares worth roughly $36.3 million. Since September, the firm has lowered its stake in the company from about 20% to 6%.

Despite Wall Street's misgivings, Monticelli thinks the stock could keep its momentum for some time, wholly on the basis of hype. He sees only positive headlines on the horizon, with Stewart set to be released from prison in March, when she will start a five-month period of home confinement.

"The news flow going forward is going to stay positive," he said. "When Martha is released, she's going to be on the front page of every newspaper, giving interviews and the whole nine yards. So there are animal spirits that are driving this thing up, and that could continue for quite some time.

"Eventually, it will run out of steam," he added. "But for the moment, it's a bit of a powder keg."