Microsoft (MSFT.O) seems to like the future prospects of Barnes & Noble (BKS.N) – or at least, it liked those of the retailer’s Nook e-book business division enough to announce it would invest $605 million in exchange for a 17.6% stake in a division of Barnes & Noble that will include that e-book unit as well as the firm’s college bookstores. And investors seemed to like that idea, sending Barnes & Noble’s share price sharply higher: the day of the announcement it soared 52% to $20.75 a share, its highest close in about two years.

The question remains, however, whether the investment will change any of Barnes & Noble’s fundamentals. Even as the retailer has made heavy investments in Nook in order to compete effectively with Amazon’s (AMZN.O) Kindle e-book reader, it has seen sales of traditional books shrink, putting downward pressure on profit margins. (Same-store sales in the company’s fiscal third quarter, ended January 28, 2012, rose only 2.8% compared to a gain of 7.3% in the year-earlier period.) And by many metrics, it is a far from appealing stock.

For instance, Barnes & Noble scores only 1 out of a possible 100 on the StarMine SmartRatios CreditRisk (SRCR) model, the lowest possible level. This proprietary model combines financial ratios and metrics that are predictive of credit risk into five general categories: a company’s profitability; its leverage; its debt coverage ratios; liquidity and its growth rate. (Where appropriate, it incorporates industry-specific metrics.) That rating of 1 indicates that Barnes & Noble has a much higher risk of defaulting on its debt than other companies; this model has been shown to be a far more effective predictor of such defaults than many commonly used alternatives.

The StarMine Structural Credit Risk Model (SCR Model) evaluates the stock market’s view of the probability that a company will either default on its debt obligations or file for bankruptcy court protection over the course of the coming 12 months – and this measure also takes a dim view of Barnes & Noble’s prospects. The company earns a score of only 5 out of a possible 100 on this model, StarMine’s proprietary extension of a framework first introduced by economist and Nobel laureate Robert Merton that models a company’s equity as a call option on its assets. (The volatility of its stock, the current market value of its equity and the structure of its debt are used to infer a market value and volatility of the company’s assets; the final default probability is equivalent to the probability that the market value of assets will fall below a default point with in a year.)

Barnes & Noble lagged Amazon in introducing an e-book reader, and it is generally believed that the Nook has a market share that is roughly half that of the Kindle. Nonetheless, Microsoft’s investment gives the division a market value of $1.7 billion – more than the market believes the $1.08 billion the company’s overall business is worth today, based on its most recent share price of about $18.75. While the parent company is profitable, the digital division isn’t; meanwhile, profits at the parent company level are falling, thanks to higher expenses.

So, why did the stock rally so sharply? The answer may be as simple as looking at the short interest in Barnes & Noble, which has been climbing and which as of mid-April, the date of the last report, represented a remarkable 19 million shares, or more than 72% of the 26.21 million shares that make up the company’s public float. (The company has 60.2 million shares outstanding.) StarMine’s Short Interest (SI) model gives Barnes & Noble a score of only 1, an extremely bearish sign. This model uses the empirically verified sense that high levels of short interest reflect negative sentiment on the part of some of the market’s most sophisticated investors, and stocks with low scores have tended to generate losses for investors in the future.

The one StarMine model on which Barnes & Noble does post a high score is the Short Squeeze indicator – a high score of 96 that may go some way to explain just what happened to the retailer’s stock in the immediate aftermath of the announcement of the Microsoft investment. Indeed, as the chart below demonstrates, the company’s share price has frequently seen sharp spikes upward in recent years, even as overall, its price has drifted lower.

Indeed, the Short Squeeze Indicator signals that there is a high probability of a short squeeze taking place that would force the short sellers to pay higher and higher prices to repurchase borrowed stock and close out their bearish short sales. That high Short Squeeze ranking may explain the stock’s rapid ascent last week – and, together with the other StarMine data, may also suggest that investors who bet that it will continue trading at such levels may find themselves disappointed. The StarMine models show that this is a stock that currently faces significant headwinds, and when a short squeeze abates, investors may return to focusing on fundamentals.

 
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