Short selling allows investors to bet against a company by borrowing and selling its shares. This causes the stock to underperform, but it can also trigger explosive growth because of something called a “short squeeze” — which happens when a growth catalyst makes shares quickly rise, forcing short-sellers to cut their losses and buy back borrowed shares at a higher-than-expected price. A company’s short interest represents how much of its float is currently sold short. Virgin Galactic (NYSE:SPCE) and Revolve Group (NYSE:RVLV) are two heavily shorted stocks that look poised for a short squeeze because of their compelling growth drivers.
1. Virgin Galactic: Short interest of 32%
Virgin Galactic is a small-cap company that focuses on space tourism and point-to-point hypersonic travel. Many investors are shorting the shares on concerns over the company’s lack of revenue and significant cash burn, but it is well-positioned to execute on its ambitious strategy because of its access to capital and the pent up demand for its services.
With zero revenue in the second quarter and operating costs of $63.2 million, Virgin Galactic is a risky bet. The company’s operations burned through around $206 million in cash flow in 2019, and it is on track to burn even more in 2020 as it pours money into research and development to make sure its space planes are safe for passengers. But with a market cap of $4.8 billion and nearly $360 million in cash on its balance sheet, Virgin Galactic should have no problem funding itself with cash on hand and equity dilution until its first commercial flight, scheduled for the first quarter of 2021.
In August, Virgin Galactic issued 23.6 million additional shares at $19.50 each for proceeds of approximately $460 million. While this diluted existing shareholders, management probably won’t have to raise capital again before the start of commercial operations (assuming cash burn doesn’t skyrocket).
Despite the near-term challenges, Virgin Galactic is on track to create a scalable business, which could send short-sellers running for cover. The company reports a pipeline of 600 future “astronauts” and 700 qualified candidates as part of its “One Small Step” offering, which gives potential customers priority access to available seats. Management expects tickets to cost $250,000 each, and with six passengers, the company can generate $1.5 million in revenue per flight.
2. Revolve Group: Short interest of 46%
Revolve Group is an online fashion retailer that uses proprietary algorithms to manage inventory and respond to consumer demand. Short interest has soared to a staggering 46% of its float because of the coronavirus recession, which hurt sales in the second quarter. But the company is poised for recovery because of its high-margin business model and the rapidly improving economy.
Unlike Amazon, which took several years from its IPO date to turn a profit, Revolve Group hit the ground running. Revenue grew at a CAGR of 24% between 2016 and 2019 — while net income soared from $2.2 million to $35.7 million over the same period.
Revolve Group’s online-only business model gives it an advantage over hybrid brick-and-mortar competitors in this uncertain economic environment. The company reported a net profit margin around 10% in the second quarter, compared to competitors Nordstrom and The GAP at -13.7% and -1.9%, respectively. The brick-and-mortar retailers face a higher cost of goods sold because of occupancy costs, while Revolve Group can save on these costs and deliver more profits to investors.
Revolve’s high-margin business model could result in tremendous earnings growth if consumer spending recovers and the company regains its pre-crisis growth rate. While the U.S economy is still in rough shape, analysts at Goldman Sachs expect third-quarter GDP to grow by 35% — with consumer spending accounting for over one-third of that expansion. With a potential recovery in consumer spending, high profit margins, and almost half of its float sold short, Revolve Group looks poised for a massive short squeeze.
Risk and Reward
With big risks come big rewards. And the high short interests in Virgin Galactic and Revolve Group show that many investors are skeptical about these companies because of their challenges with revenue and scale. But sometimes the market is wrong, and risk-tolerant investors can make outsized returns by betting on a short squeeze. Virgin Galactic is a better pick for investors with a bigger appetite for risk because it is pioneering the completely new space tourism industry, while Revolve Group looks like the safer bet because of its proven business model in an already established market.