Every two weeks, we get a chance to look at fresh data on how heavily stocks are being shorted. It helps to see what short-sellers are focusing on — especially if you own one of the stocks being targeted.

You’ll often see short positions in a particular stock slowly rise as an increasing number of short sellers start to sniff trouble at a company. But it’s highly unusual to see a short position rise from 60 million shares to 139 million shares in just two weeks, as I did. It’s as if the entire short-selling community has raced to get on the bus and watch this stock tumble.

#-ad_banner-#Normally, these short-sellers spot red flags in a quarterly report and want to bet against a stock before even worse numbers appear in subsequent quarters. But that’s not why they are targeting wireless services provider Sprint Nextel (NYSE: S). The company actually delivered pretty decent results during that interim period between short seller release dates (April 15-30).

Instead, short sellers are focusing on a news item that hit the wires on April 19, a full week before quarterly earnings came out. That’s when New York State Attorney General Eric Schneiderman slapped the company with a $100 million lawsuit alleging under-collection of sales taxes. The scary part: New York could win triple damages if successful. The really scary part: other states may follow New York’s lead, opening Sprint up to a liability in excess of $1 billion.

Since I am not a legal expert, I’ll lay out the facts for others to digest. Sprint claims it didn’t owe taxes on sales associated with out-of-state phone calls. So the company decided to put a reduced amount of taxes on each customer’s bill as a way of cementing its reputation as a low-cost industry provider. In my cursory review of the resulting fallout, this is indeed a gray area. Other communications firms have reportedly adopted similar tactics regarding interstate commerce without any pushback.

Sprint further believes that even if there is a liability for unpaid taxes, it’s the responsibility of consumers to make good on their unpaid taxes, not the company. Sprint would obviously like to avoid that route, knowing it would make its customers irate to receive a one-time $100 bill for past unpaid taxes.

A settlement in the works?
One thing is for sure. This is an unwanted distraction for Sprint as it belatedly embarks on a massive technology upgrade known as Network Vision. The company is in the process of ditching all of its past losing technology moves (such as acquiring the Nextel push-to-talk network that is now down to 5 million users, or the Clearwire (Nasdaq: CLWR) debacle that continues to play out) and aims to establish a national high-speed network on par with industry leader Verizon (NYSE: VZ). Even that effort will require another $1 billion or so that the company doesn’t currently have. (Sprint hopes to secure “vendor financing,” which entails low upfront prices for base stations, chips, etc. and payment streams down the road.)

That’s why Sprint need to settle this lawsuit problem, perhaps agreeing to pay 20, 30 or 40 cents on the dollar. New York, for its part, might simply take that deal rather than end up in a very protracted lawsuit that only enriches the lawyers.

This isn’t to dismiss the seriousness of this problem, nor is it to suggest that Sprint will escape unscathed. But it’s a risky gambit for short-sellers, who might get caught up in a sudden short squeeze that forces a big chunk of those 139 million shares to be bought back.

What could go wrong for the short-sellers and right for Sprint (and you if you decide to buy shares)? Well, four factors could trigger a furious short squeeze…

1. First, there’s market risk. If the market rises higher from here, program trading, which now constitutes the majority of all stock market volume, buys stocks indiscriminately and the rising-tides-lifts-all-boats action tends to make short sellers cover, even if they know their investment thesis is correct.

2. Second, even a rumor that the company and New York State will seek some sort of settlement will quickly eliminate short-sellers’ hopes that Sprint will end up on the hook for billions.

3. Third, signs are emerging that industry consolidation will accelerate this year. In the past few days, both MetroPCS (NYSE: PCS) and Leap Wireless have been bid up on rumors that Deutsche Telekom is in search of a partner to beef up its lagging T-Mobile unit. Sprint’s beleaguered CEO, Dan Hesse, who has inspired the ire of many investors, would probably like nothing more than to enter into those discussions with these other industry laggards. Yes, this lawsuit is an impediment for a deal, but the company’s current market valuation would be quite tempting to a potential buyer.

4. Fourth, Sprint’s recent quarterly results showed clear signs of a company getting healthier, most notably in the area of average revenue per user and further solid numbers in the second quarter may just be too much for short-sellers to bear.

5. The leading wireless carriers, including Sprint, have begun to sharply reduce smartphone subsidies to improve their profit margins. Asking consumers to effectively extend the usable life of their existing phones should start benefiting the wireless service providers’ margins as soon as the current quarter.

Where are the analysts?
Curiously enough, Wall Street analysts have been largely silent on this contentious issue. I ran through the recent research from a dozen different investment firms that follow Sprint, and only Guggenheim Securities bothered even to analyze the issue. And a week after the lawsuit was filed, Sprint held a quarterly conference call with analysts, and not a single mention of the issue appeared in the call transcript. It’s as if this potentially major lawsuit never happened. Short sellers on the call must have been apoplectic as they sat through a series of “Hi, how you doing buddy” comments from management and the sell-side analysts.

Risks to Consider: This is a hugely risky stock. Sprint not only needs to secure an agreement with New York State, but also get nationwide indemnification from suits from other states.

Action to Take –> By placing such a huge negative bet on Sprint, short-sellers are running the risk of fueling a stock melt-up if some short-covering leads to a tsunami of short covering. With such a huge short position in place, it’s unwise to pile on the short side at this point. The risks of a massive short squeeze are just too great. If you want to play the contrarian long angle for this $2.50 stock (and sell-side analysts value Sprint at $4 to $6 a share on the basis of comparable industry metrics), then dig into the lawsuit issues and be prepared to buy as soon as it appears as if Sprint will devise a face-saving solution out of its legal morass.